As you build your direct response marketing campaign discussed in Rule #1, remember to focus on the lifetime value of your customer, or how much profit that customer will generate during the course of your relationship.
The textbook definition of CLTV is the net present value (NPV) of the profit from a customer’s purchases. Remember to include all the sales that result from a customer’s repeat visits, less any associated costs to service the resulting orders (include variable costs like COGS, credit-card processing fees, shipping, warehouse-order processing, etc). A profitable customer will have a CLTV in excess of its customer acquisition cost (CAC). Treat these profitable customers well.
Once you have a good handle on this metric, you shouldn’t be afraid to spend until the marginal CAC (your CAC to acquire the next customer) approaches the CLTV of your next incremental customer, even if it costs more to acquire that new customer than you recoup on his or her first purchase. Note: This doesn’t mean you should spend until the average CAC approaches your CLTV. Rather, you want to spend to acquire customers until your marginal contribution (CLTV – CAC for each new customer) equals zero. Anything less is under-investing in your business.
Obviously, this can be a very scary pill to swallow, so make sure you really understand your CLTV before jumping in. For early-stage companies, estimating a customer’s lifetime value can be more of an art than a science. If you’re not fully confident you have a handle on this, instead spend right up to the average, fully-loaded gross profit of a customer’s first order. Then you can focus on driving repeat usage.
In the beginning, your average CLTV will be low because you won’t have scale. But as you grow, you’ll start to see some of the benefits of scale, such as:
- Getting better terms from vendors, because you’re buying more (which drives up your gross margins);
- The ability to offer your customers a broader selection of higher-margin, slower-moving SKUs (which increases your average order value, your gross margins, and your customer satisfaction);
- The data to offer better product recommendations (which also increases your average order value and improves conversion rates); etc.
All of these things will increase your CLTV. This kicks off a virtuous cycle: CLTV goes up; you can afford to spend more money on marketing; you start to grow faster; you get more scale —and on and on and on.
It’s critical to calculate CLTV as accurately as possible, since it will drive much of your marketing decision making. At scale, follow this rule of thumb: If your CLTV is at least 2X the cost of acquiring a new customer, with at least 1X coming in the first 12 months after acquisition, you’re in great shape. If you’re doing any better than that, it’s irresponsible for you not to be spending more aggressively on marketing. (And please, call us so we can invest in your company!) If your CLTV/CAC ratio is less than two, then it’s worth reigning in your marketing spend until you grow into it.
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