DTC Founder, Your LTV:CAC Ratio is Lying to You

Key Takeaways for Ecommerce Brands:

1. ‍That 3:1 LTV:CAC ratio everyone swears by? In eCommerce, it's probably masking some serious profit leakage.
2. Simply including your gross margin in LTV calculations can cut your supposed profitability metrics in half. (and, probably rightfully so)
3. It’s just yet another example of what it means to have “financials” that “get ecommerce”

Sometimes, when I can’t sleep at night, I think of financial metrics. It definitely beats counting sheep. One of the metrics I’ve been thinking about lately is the LTV to CAC ratio.

LTV vs CAC is the classic metric to show how your LTV - lifetime value (not to be confused with loan to value used by banks with respect to loans) - correlates with your CAC (Customer Acquisition Cost).

The golden standard that the market has always discussed is 3:1. Meaning, that your customer lifetime value is three times the cost of acquiring that customer.

The basic formula for calculating LTV is: 

LTV = AOV × purchasing frequency × retention period

To put it in simple, tangible terms, if your customer buys a $120 earphones, twice a year, and on average, lasts as a customer for 1 year, the LTV would be $120*2*1= $240.

(Just to clarify, when we talk about “Retention Period” or “how long the customer lasts”, we are basically talking about churn and churned customers. In non-subscription-based ecommerce, important to note here, defining “churned” customer could be based on behavioral data)

CAC, on the other hand, reflects your marketing expenses (however you choose to count them - there’s more than one way), divided by the number of customers acquired in a given period. In other words, if my marketing costs in a given period (let’s say 1 year) are $100,000, and I have 1,000 customers acquired in that period, my CAC would be $100,000/1000= $100.

Why eCommerce is Different: Beyond Traditional Metrics

This is all nice and well, and may work well in SaaS type companies, but in eCommerce? I beg to differ. And to me, it's all about developing ecommerce metrics that accurately reflect the unique dynamics and operational realities of your businesses. (that’s partially what we mean when we say you need to work with bookkeeper, accountants, and other financial professionals “who get ecommerce.”)

You could, for example, use a different, more nuanced or sophisticated metric altogether. Something like “Payback Period,” calculated as CAC/Contribution Margin - which may be a more fitting measurement for ecommerce brands.

(Payback Period shows how quickly you recover your customer acquisition costs through contribution margin, which is especially important in eCommerce where cash flow management is crucial due to inventory costs and seasonal variations)

Gross Margin: The Missing Piece

But, as long as you stick to the LTV/CAC, my recommendation is to simply - but crucially - add the Gross Margin into it.

[Gross margin represents the percentage of revenue retained after accounting for the direct costs of producing and selling the product (COGS - Cost of Goods Sold). For example, if you sell headphones for $120 and they cost $48 to manufacture and ship, your gross margin would be 60% (($120 - $48)/$120).]

This is due to the fact that while in SaaS the difference between sales and gross margin is oftentimes relatively insignificant - in e-commerce brands, it is huge. And not taking into account is leading yourself on.

You see, a lot of eCommerce brands’ main expense is their product COGS, and as such, just taking top line metrics, like gross AOV, totally misses this point.

While the 3:1 LTV/CAC ratio has become the standard benchmark, the unique characteristics of eCommerce businesses demand a more nuanced approach. Unlike SaaS companies with their high gross margins, eCommerce businesses generally have much lower gross (and contribution margins), due to the high costs of COGS.

And so, a 3:1 in a SaaS company doesn’t at all equal a 3:1 LTV:CAC in an e-commerce brand. Because here, your COGS would mean an actual much lower real effective LTV-to-CAC, as the gross margin could be 50-70% of the net sales.

Here’s an example:

Staying with the headphones business we used in the previous example - our LTV was $240. But my point is that it should be also multiplied by the gross margin percentage (let’s say, 60%).

Which would give an effective gross margin LTV of $144.

When we compare the new LTV, to the CAC in our example, then instead of a solid 240:100= 2.4, we now get a more realistic 144:100= 1.44. Quite the difference.

Moving Forward: Metrics That Matter

That’s why this metric should be adapted to eCommerce by either taking the Gross Margin into account (multiplying the LTV by the Gross Margin percentage) or using a different type of metric.

If you still are using the standard LTV:CAC, you’ll still be stuck back in 2021, basing yourself on the topline vanity metric of gross sales. You know, back when ecommerce was about “growth” and not profitability. You don’t want to go there.