A Follow Up to Our Sales Pipeline Discussion
In the latest installment of our company metrics series, we’re sharing a follow up to our sales pipeline metrics discussion and going deep on determining the lifetime value of a customer (LTV), the cost to acquire a customer (CAC), and ultimately generating a clearer picture of whether your sales spend makes sense.
Following your review of this article, you will be able to make assessments about your sales expenses to determine if you’re making the right investments (and track them in this tool). Because it is, in fact, possible to throw a whole heap of cash at sales (people and commissions) and land awesome clients but for the business to still lose money.
Unfortunately, this can happen all too often because the TRUE cost of each sale exceeds the REAL profit you are able to generate from each sale (#lossleader #embarrassed). Don’t worry, we’re here to help on both accounts in this article and beyond.
Lifetime Value of a Customer
It’s better to start early and correlate your sales’ costs with your actual operational costs for return on investment (ROI) to make sure your business will remain viable for years to come.
This starts with assessing the Lifetime Value (LTV) of your typical customers.
As Jay Abraham explains in his three ways to grow a business you really only have three levers to pull to grow top-line revenue in any business: 1) the number of customers you serve, 2) the average transaction value of those customers, and 3) the frequency at which those customers purchase from you.
Whilst I love the simplicity of Jay’s approach there are a couple of limiting factors that are worth mentioning and are important when trying to derive LTV for all types of businesses.
- Number of Customers (and Churn / Retention Rate). Understanding and forecasting the number of customers is simple if you have a one-time sale, however, if you offer a recurring / subscription service it is best practice (and a little more complicated) to estimate customer churn as part of your LTV calculations. This is important as a customer is unlikely to be with you forever.
- Average Transaction Value. The word value can be interpreted in two ways – 1) ARPA (Average Revenue per Account) or the Net Customer Income created from each sale. We prefer the latter as addressing the top-line revenue on its own says nothing about how effective your business is at translating top-line revenue into profit and hence surplus cash after servicing that customer. This is also important to factor in when assessing true LTV and determining sales ROI.
- Time Value of Money (aka Discount Rate). The value of money today is worth more than the value of money tomorrow. The easiest way to think about this is to consider inflation. $100 today can usually buy more than $100 a few years from now. In order to keep things more simple Jay Abraham avoids discussing this impact on cash flow due to the time-weighted value of money. But we’re going to take you a level deeper!
So, in summary, to determine your customer’s LTV, you must start the process of understanding the “economic value” of the customer and economic value simply means the net cash flow earned by your company over the duration of the customer agreement.
Nothing beats an example, so let’s give you one….
You Just Closed a Customer (Month 1)
Pat yourself on the back, you’ve just closed a customer! The first month a customer joins your business may look different than servicing them ongoing so Step 1 is to determine what this customer is contributing to your business and any sunk initial / onboarding costs you have.
Step 1. Ask yourself the following questions during month 1:
- What is the size of the customer you have just closed? You can predict this by looking at the average size of customers you have closed in the past. This is your average revenue per customer or ARPA.
- How much did it cost your business to close the sale with this customer? Subtract these closing costs from the first month of income the customer contributes to your business.
- How much does it cost to service your customer? Subtract this cost to arrive at your first month of Net Customer Income or the contribution margin to the business.
Ongoing Customer Maintenance (Month 2+)
Now that you understand the size of your customer and the initial costs you’ve incurred to get that relationship started, you can begin Step 2 which is getting a handle on their ongoing revenue contributions for months 2 and beyond.
Step 2. Ask yourself the following questions for months 2+:
- Do you offer fixed pricing i.e. is your ARPA the same in month 2 and beyond? You’ll want to forecast the ARPA as accurately as possible in the coming months / years.
- How much does it cost to service your customer on an ongoing basis? Subtract this cost from your ARPA to arrive at your second and subsequent months of net customer income generated for your company.
- What is the duration or the Churn / Retention Rate of customer payments? In other words, how long are you going to receive this income from the customer? Whether you offer fixed contracts or month-to-month subscriptions you’ll still need to estimate the likelihood of your customer renewing the contract or staying around for another month of service.
- Lastly, as we project the anticipated income from months 2+ we need to discount that future income so it is in line with today’s dollar value by using a Discount Rate. By discounting each future month of income (the process of generating net present value) we are able to determine the TRUE lifetime value of your customer or the TRUE economic value of a customer.
What is Your Cost to Acquire a Customer?
In addition to understanding the lifetime value of a customer (starting in month 1 and then ongoing), you will need to calculate your cost to acquire a customer (CAC) to fully understand the return on investment you receive from any sales program spending.
While CAC will vary from company to company, its costs will always include prospecting costs and closing costs.
Calculating Prospecting Costs
How much does it cost your business to prospect one single customer? To calculate this, you must first determine how much you spend on prospecting in total over a certain period of time and then determine how many sales you are able to close over that same period of time.
For instance, let’s say you spend $5,000 per month on prospecting and you close 2 customers in a month, the prospecting cost is $2,500 per customer. Similarly, if the deal closure rate is half a customer per month then the prospecting costs are $10,000 per customer.
Don’t forget to also include the full prospecting team costs like any earned commission on customer sales too.
Calculating Closing Costs
The second piece of identifying your cost to acquire a customer is tracking the actual cost to close a sale (taken as an assumption of time, material, travel etc.). This will allow you to answer the question ‘how much does it cost your business to close one single customer?’
For example, if your sales associate takes a week to close a lead spending their time in multiple meetings, conversations, and emails with that lead – their hourly rate for these costs needs to be accounted for in your ROI calculations for determining your CAC.
Side Note on Tracking CAC
Tracking your CAC will not only help you keep a close eye on sales spend, but may even help you identify opportunities for improvement by decreasing time to close through training initiatives or finding communication efficiencies your sales team can implement.
Where the ROI Happens
Let’s put our lifetime value and cost to acquire a customer to work in a ratio.
The LTV to CAC ratio (also known as the payback period metric) helps you identify if your company is, in fact, generating value from each sale OR if it is actually losing money because the cost to acquire a customer exceeds the net value each sale is generating.
The goal is for the ratio result to clearly be greater than one and depending on the business, less than about 6. A ratio of 1:1 means there is the same amount of cost to the economic value of a customer, so essentially you’re breaking even on your sales spend. Anything less than one indicates a loss per sale and anything more than one shows a profit per sale.
A good benchmark for an LTV to CAC ratio is 3:1 or better. This will mean a customer contributes three times (or more) than the cost to acquire them in the first place. A 4:1 ratio indicates your business model is AMAZING and any higher than that means you may have room to invest more in sales.
A Note on the Payback Period Metric
Since businesses tend to prefer focusing on investments that will provide a faster return, knowing how long it will take to recoup a sales expense is a good way to choose how worthy it is of spending in the first place especially when weighing one investment opportunity against another.
Shining the Spotlight on ROI
Clearly, there are many moving parts when getting to the root of your sales ROI, but if you only learn one thing from today’s discussion, I hope it is this. PLEASE don’t blindly spend money on sales and think that it is going to be enough to grow your company. Always ask questions – question the ROI – and you will be better off in the long run.
Closing Thoughts & Close Metrics
Determining if you’re making the right investment call on sales activity is a big factor in your ability to sustain your business model. At the core of this discussion, we want you to understand that it’s possible you can hire salespeople and spend money on sales that you will never recover.
I have also observed less savvy investors contribute capital to businesses that on the surface appear to be fast-growing companies but in actuality are bleeding cash by spending more to make each sale than they can generate from the customer. #brokenbusinessmodel #sadinvestors #lessmoneytogoaround
So while the old adage that “you have to spend money to make money” may be true, we’d like to amend that statement to say that “you have to spend money WISELY to make money.”
Now I know we’ve thrown a lot of finance terminology at you today, and maybe you have a headache because finance isn’t as energizing to talk about for you as it is for us.
That’s okay, let us be the salve that soothes you and your business and helps you reinvigorate your sales model! A quick call with one of our Simple Startup team members is a great first step to building REAL ROI into your sales program.
Need help tracking all these metrics? Download our handy metric tracker and library here.