Unit Economics: Is Customer Lifetime Value > Cost of Customer Acquisition?

Have you ever tried to calculate the Unit Economics of your business model? If so, you’ll know that it is difficult because it is not straightforward to attribute revenue and cost to the single customer level. SaaS or cloud-based subscription businesses have a tough time estimating unit economics. This is because lifetime values and lifetime metrics are so uncertain. There are no established accounting standards for attributing and valuing the cost for software development, marketing, and sales, making it tricky to estimate both LTV and CAC.

This post will let you experience a Unit Economics calculator to introduce key metrics such as LTV/CAC Ratio and CAC. You will learn how to calculate Unit Economics in 7 steps to make sure that you provide the most accurate projections of your unit economics to secure your funding avoiding the stupid common mistakes which Founders and sometimes investors make in the absence of the right business plan blueprint.

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Many Entrepreneurs, Business Managers, and Investors have found success using simple Excel-based calculations using simplistic assumptions. But there are a few things you must know before you start calculating unit economics to ensure that you provide the most accurate and trustworthy figures to win investors’ trust. 

What is Unit Economics?

Unit Economics provides a simplified model enabling you to validate if the business model for any SaaS or subscription/recurring revenue business is viable. Unity Economics is generally defined as the sum of all economic activities related to one unit of each product or service from one single customer. Companies that offer services such as eCommerce or SaaS typically measure this as Customer Lifetime Value (CLTV) and Customer Acquisition Costs (CAC ). You have to understand 3 steps

What is the most important question that Unit Economics answers?

Unit Economics answers an important business question:

CLTVvsCAC

Does the customer's Lifetime Value (CLTV) significantly exceed the cost of acquiring a customer (CAC)?


We jointly look at several factors which make up unit economics and their sensitivity, i.e. how they can affect Unit Economics. We also give you guidance how to calculate your Unit Economics in 7 steps. Why is this so relevant? Only when you understand your Unit Economics, you can make proper and informed decisions to invest money in scaling up your business.



Why understanding unit economics is so important

Every subscription-based business model has an initial income/cash-flow gap. The start-up period needs funding for sales and marketing to get customer traction, while recurring revenue streams take some time to stack up. Once the company shows that it can succeed, futher investment decisions must be taken. Should it heavily invest into sales and marketing for growth or is more investment required to find product-market fit? Unit Economics is a resource to ensure that your growth/investment initiatives benefit them and that you are ready to grow your business at the right point in time.


Customer Acquisition Cost (CAC) is a direct reflection of the future success of your SaaS business. If you’re too cautious about your CAC, you will likely be missing out on customers and future revenue. Yet, if you spend too freely, you won’t be profitable and will likely end up in Deadpool.


The challenge is that you want to spend the right amount of CAC to drive new customers to your service without jeopardizing the Lifetime Value (LTV) and revenue from that customer. Two great ratios to gauge this balancing act are the LTV/CAC ratio, which is sometimes even referred to as the “god metric” of many successful SaaS companies, and the CAC Payback Period.


We reference them as Business Viability Metrics:


unit economics - key metrics
  • The long-term indicator CLTV/CAC ratio, also referred to as “God Metric,” shows how many times the Customer Lifetime Value (LTV) exceeds the Customer-Acquisition-Cost (CAC)   
  • The short-term indicator CAC Payback period or “Months-to-Recover-CAC” defines how fast you recover the Customer-Acquisition-Cost over the lifetime of your customer.

Unit Economics Calculator

Inputs into the model

To experience Unit Economics hands-on, we created a simplified, interactive Unit Economics Calculator for you below. You can play with the model to understand how the input factors Cost-of-Customer-Acquisition, Customer Lifetime in Months, Monthly Recurring Revenues per Customer and Gross Margin relate and how they impact the CAC Payback Period and the LTV/CAC Ratio. As inputs, you can enter

  • the estimated Customer Lifetime in Months (initially set to 24 months)
  • <
    the Average Monthly Recurring Revenues (MRR) (initally set to 100$)
  • the Gross Margin of your Service in % (which represents revenues reduced by direct costs associated with producing the goods and services sold by your company) - the initial value is set to 80% which means that your Gross Profit on the MRR is 80. 
  • the Cost of Customer Acquisition (CAC) (initial cost to acquire a customer set at 480$)
Input

Lifetime in Months

MRR in $

Growth Margin in %

CAC in $

Output

Payback in Months

6.00

LTV/CAC Ratio

4.00
 
Created with Highcharts 8.2.2End of Customer LifetimeCustomer Lifetime in MonthsDollars ($)Chart context menuSaaS Key Viability MetricsLifetime valueCustomer Acquisition Cost12345678910111213141516171819202122232425262728293031323334353637383940414243444546474805001000150020002500

Outputs of the Model - Impact on Viability Metrics

When you change any input, the model re-calculates the two lines in the chart and the viability metrics in the upper right corner.

  • the blue line represents Cumulated Customer Lifetime Value (= Customer Life Time in Months * MRR * Gross Margin) at a given point in time (reaching its final value at the end of customer lifetime) - for the initial set of values, CLTV = 24 * 100 * 80% = 24 * 80 = 1920)
  • the red line represents the Cost of Customer Acquisition (which actually occurs at or even before the customer signs up)

The customer starts to pay monthly for your subscription service, and you eventually break even (where the two lines intersect). Using the initial value you have spent 480$ upfront to acquire the customer which you make back on the initial CAC investment after 6 months ( = 6 * 100$ * 80%). This is the Payback Period in Months.

From then on is a magical period where you’re rolling in the dough and netting a profit from that customer to optimize your LTV/CAC ratio. Lifetime Value increases until the customer decides to churn, and its lifetime ends. For the intial set of inputs, the lifetime increases for 24 months up to 1920$ which is exactly 4x higher than the CAC.

The model output shows

  • Payback Period = MRR * 12 * Gross Margin / CAC
  • LTV/CAC Ratio  = Lifetime Value / CAC

Based on the calculated values for the Payback Period’s and the LTV/CAC ratio,  the model gives you a red/green-traffic-light-indication of the viability metrics.

Traffic Light Guidelines of Viability Metrics

David Skok in his blog post "SaaS Metrics explained" set up a few traffic light guidelines for B2B companies: 

  • the Payback Period should ideally be less than 12 months and
  • the LTV/CAC ratio should ideally be higher than 3 meaning that for every dollar you put in your SaaS machine you’re getting three dollars out (in this case, both output parameters will turn green). 

This exercise should help you understand and tune your subscription business input thresholds to enable a viable business. The thresholds do not apply to all SaaS businesses in the same way. For example, a business without a salesforce with a touchless conversion usually has a far lower investment in sales and marketing expenses and becomes cash flow positive far earlier. On the other hand, a business with a lower gross margin might require a longer break-even. You should be able to adjust these thresholds to your specific expected business.


Understanding sensitivies

Playing with the model, you can now draw a few conclusions and ask how sensible the Payback Period and LTV/CAC Ratio react upon a change of any input variables. Specifically, you can test how the viability metrics change upon a change of an input variable. Check it out in the Unit Economics Calculator:

  • If you increase the Lifetime value, short-term Payback Period remains unchanged, but the long-term LTV/CAC ratio increases.
  • If you increase MRR per customer, the Payback Period decreases (that's a positive result and the LTV/CAC ratio increases.
  • If you increase the Gross Margin, the Payback Period decreases and the LTV/CAC ratio increases.
  • If you increase the CAC, the Payback Period increases and the LTV/CAC ratio decreases

The table below summarizes the positive or negative impact of an increase of any of the input variables.

Increase of ...
Impact on CAC Payback
Impact on LTV/CAC Ratio
Customer Lifetime in Months
-
Monthly Recurring Revenue
Gross Margin
Cost of Customer Acquisition

Is it all that easy in real life?

As simple as the above model, is the answer to this question: "NO!"  There are many more variables which impact the Viability Metrics such as

  • Churn
  • Revenue Expansion
  • Sales Team Compensation
  • Sales Team Quotas
  • Cost per Lead
  • Lead-to-Deal Conversion Rates

The impact of a change of one of any of the input parameters on any of the Viability Metrics can differ dramatically. This is what is called a Sensitivity Analysis. The image below shows the results of a Sensitivity Analysis from one of our Lean-Case projects.  For example, check out the green line in the chart below, which shows the impact of a change of churn on the LTV/CAC Ratio.

  • A 20% reduction of Churn increases the LTV/CAC Ratio from 5.8 to 7.3 (that is an increase of almost 30%) whereas
  • a 20% increase of Churn decreases the LTV/CAC Ratio from 5.8 to 4.8 (that is an decrease of almost 20%)  

Why you should track unit economics as an early-stage startup

“If you can’t measure it, you can’t improve it.” – Peter Drucker.

The sooner you start mastering Unit Economics for your early-stage Startup, the better your chances of building a strong foundation in your market and achieving a healthy growth curve. Founders may be overly optimistic about the concept behind their company. One of the biggest Startup killers is the "pick it up and come on" attitude.
Many founders start without thinking enough about the product-market fit, pricing strategy, and cost structure related to their business model old-fashioned accounting models. All these factors - if ignored - can dispel the first dream of how cash starts to flow in their business.

  • Understanding Unit Economics early will allow long-term financial projections to more accurately calculate your revenue and cash flows. You need a healthy growth rate early on, but you also need to become profitable.
  • By taking a Unit Economics approach to business, early start-ups will better understand their business as it develops, scales, and grows. Paying close attention to Unit Economics helps identify opportunities, manage cash flow, and address many of the challenges involved in scaling up SaaS startups.

Without getting Unit Economics right, your Startup WILL FAIL

Getting the right Unit Economics is the only single most important part of your financial model. Surprisingly, not many people, even in the startup community, know it, or understand it. If you do not know what advertising you need to generate income, your financial model will always be wrong. Let us be clear about this.


Gone are the days when investors were overlooking profitability in favor of hypergrowth. Start-up founders must understand their unit’s economics, not only to raise money successfully (or to avoid the need to raise money) but to build a scalable and stable business.

Common Mistakes Founders Make with Unit Economics

To be honest, most founders have only a basic understanding of financial metrics and Unit Economics in particular. What often surprises me is the degree of ignorance founders show when it comes to Unit Economics. They try to analyze because investors expect them to but they do not really understand why Unit Economics are important. In particular, I am seeing one gerneal error that founders make  (Note: there is also a surprisingly high number of investors who also do not understand these principles.)

Not Understanding Which Costs Are Truly Fixed vs. Variable

By far, the biggest mistake people make when conducting a Unit Economics analysis involves the cost side of the equation. As we've seen above, whether you're just measuring what you add or doing a more ROI-based CLTV / CAC analysis, an essential part of the equation is which expenses you choose will be deducted from your revnues. In principle, the rule is simple: Unit Economics only takes variable costs into account, not fixed costs. But in practice, the distinction between fixed and variable costs is often less clear-cut.

One definition of variable cost as per textbooks is that variable costs are costs directly related to revenues. This is the definition we apply in Lean-Case. We differentiate

  • "Cost of Customer Acquisition (CAC)" which are the cost of selling and the cost of marketing to acquire NEW customers and 
  • "Cost of goods sold (COGS)" which are all the cost related to keep your EXISTING customers running (such as production, hosting, or shipping costs)

Your Unit Economics in 7 steps

If you want to get more hands-on and grow your experience beyond the use of the Unit Economics calculator, check out the 1-min video below. It shows how you can calculate your unit economis in Lean-Case in 7 steps.

  1. 1
    Select your revenue model
  2. 2
    Define your average customer contract
  3. 3
    Forecast how many new customers you want to sign up 
  4. 4
    Add Churn
  5. 5
    Add the Cost of Goods sold
  6. 6
    Add the Cost of Selling
  7. 7
    Add the Cost of Marketing

That's all you need to do to check your revenue forecast and your unit economics.

Check out how your business case could look like 

The frame below allows you to browse the result dashboard of a sample Lean-Case Business Plan including  

  • a Profit & Loss Statement
  • Insights Dashboards on the number of customers, revenues, headcounts, expenses, profitability and cash-flow and
  • .. of couse, the dasboard to check the key metrics like Unit Economics

This is how a decision maker could look at your business plan results - all this without using Excel. Even feel free to enter your own parameters and sign up for a trial account.


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