In the past, businesses used profit and loss statements as the measuring stick of success. This works well when you sell goods with a known cost-of-sale with profit and loss being relatively easy to measure.
However, subscriptions are fundamentally different. They’re essentially “rented” over a period of time instead of paying the full cost in one upfront price.
- While selling a product for $100/month rather than a one-time $1,000 sale results in more revenue over the year, the initial impact on a company’s bottom line is only $100.
- This means that when an organization switches to a subscription model, they usually experience a period where they appear to veer into the red. This has resulted in some companies abandoning their subscription model for fear that losses will continue.
But the appearance of losses in this case can be deceiving. This is why subscriptions demand new metrics to track success and determine if subscription companies are headed in the right direction. The two metrics that accomplish this best are Customer Lifetime Value (CLV) and Customer Acquisition Cost (CAC).
Understanding Your Customer Lifetime Value and Acquisition Cost
What is my Customer Lifetime Value? It’s fairly straightforward – it’s the amount of a recurring payment multiplied by the average time a subscriber remains signed up, less the cost of servicing a customer during that period.
- For example, if your subscription is $100/month, an average customer stays for 24 months, and your costs are $20/month to service, your LTV is $1,920.
What is my Customer Acquisition Cost? Also not a complicated number, it’s simply the amount of money spent on sales and marketing to acquire a client.
- For example, if your total marketing costs for the year were $100,000 and you obtained 2,000 subscribers, your CAC would be $50.
For those starting out, it is critical that you wait until you have an accurate view of CAC. New businesses often enjoy low hanging fruit by attracting those within their networks but the effort to onboard this cohort is usually not reflective of all your customers and can skew CAC numbers down.
What it Means – The Viability Threshold and the LTV:CAC Ratio
David Skok, a partner in the venture capital firm Matrix Partners, regularly evaluates subscription businesses to determine whether they are suitable for investment. He has found that the most important metric for evaluating subscription businesses is the LTV:CAC ratio.
Specifically, he found that to be viable a company collecting recurring payments needs to have a LTV:CAC ratio of at least 3:1. Put another way, the monetary value of a client must be at least three times what it takes to acquire them. Tracking this metric will inform on when its time to invest in gaining more users or take steps to lower your cost of acquisition.
Other Factors – Churn and Margin
Other metrics that are key to optimizing recurring revenue are churn rate and margin.
Churn is the rate at which subscribers leave, often calculated as the amount Monthly Recurring Revenue (MRR) lost each month.
- To calculate churn, take the MRR at the beginning of the month and divide it by the amount of MRR lost to cancelled subscriptions.
- For example, if you started the month with a MRR of $100,000 and lost $8,000 in MRR due to cancellations, then your churn rate is 8%.
Because churn affects your LTV:CAC ratio, it is critical to understand and mitigate it. To that end we’re including a few additional articles on churn to help:
- How to Calculate your Churn Rate
- 5 Reasons Your Churn is Increasing
- Growing Revenue with Negative Churn
- 4 Ways to Reduce Churn
- 4 Ways to Improve Customer Retention and Reduce Churn
Margin includes the cost required to service a new customer through the life of their subscription.
- For a B2B software company for example, this would include the salaries of the teams needed to onboard customers and keep them operational. This is often factored into the cost of goods sold and needs to be included in LTV calculations as well.
Measuring Your Business’ Health in the Longer Term
Subscription businesses are growing exponentially because many have realized the long-term value of recurring payments over one-time sales. In order to determine the health of your subscription business, a new set of metrics are required with the most important one being the LTV:CAC ratio.
If you have a subscription based business, here’s more information on