Paul Orlando is Incubator Director & Adjunct Professor at the University of Southern California

If you’re in a CPG business, something you hear a lot about is lifetime value (LTV) and customer acquisition cost (CAC). That is, how much does the business earn from a customer over the entire experience the customer has with the company and how much does it cost the company to acquire that customer. Figure out these two terms and you’ll be at an advantage in growing a successful CPG company.

LTV and CAC sound pretty simple, but they can actually be tough to figure out. I’m going to show you some simple ways to calculate them and also some things that might cause confusion.

If you ask around you’ll find different ways to calculate LTV but the way I prefer is this.

LTV = (Price you charge per item – Unit costs) x Repeat purchases.

Now let’s go into each part of that equation.

The price you charge per item seems pretty straightforward. But is it? Depending on your situation, you may be selling direct to consumer (D2C), on an ecommerce site, or in a retail location. Each one of those may have a different price point. Let’s stick with the D2C model for now.

Say you sell your item from your own website for $10. At a small batch size, let’s say your unit costs are $3. And let’s also say that people tend to buy one item a month for six months until they get tired of it and leave (churn).

Using the simple formula above:

LTV = ($10 – $3) x 6 = $42.

(We’ll set aside other issues like processing fees and shipping, etc to keep this simple.)
Is that LTV good or bad? Let’s try to understand more by bringing CAC into the mix.
You’ll see different ways to calculate CAC out there, but the one I generally prefer is:

CAC = Cost to get someone “in the door” / Conversion rate once they’re there.

I use the term “in the door” because then we can associate this with someone literally going in the door of a shop as well as the online “door” of a website or app. That cost might be an ad that we run. How much does it cost to get someone to click on it? We can also get potential customers “in the door” without spending on ads, for example through mailing lists, social media, word of mouth, or more.

The conversion rate means that once they are there, how likely it is that they convert to becoming a paying customer. Here’s a sample of a company with an ad campaign, using a $2 cost per click and a 10% conversion rate.

CAC = $2 / 10% = $20.

Is this good or bad?

Well, if I think my LTV is the $42 above, I am earning more from customers than I spend on acquiring them, but not a really great multiple. That is, the LTV calculation doesn’t include all the other things that I need to pay for that don’t go into unit economics, for example: rent (if you have that), compensation for you and others, equipment, spoiled product, returns, insurance, and more.

That’s why you’ll generally see a rule of thumb for LTV to CAC ratios of 3 to 1 or 4 to 1. I tend to believe that you should often aim a bit higher, like 5 to 1 or more. But, that also depends on your strategy. Are you trying to gain market share? Do you have money in the bank and have no rent? Every situation is different. If your ratio is really high, then that might instead mean that you should be more aggressive on acquiring customers.

To improve the above situation, we can look for places where we can optimize.
On the LTV side, is it possible to charge more? To produce larger batch sizes that reduce our per unit costs? Can we keep customers longer?

On the CAC side, can we decrease our cost per click (or use more free acquisition channels)? Can we improve our site to convert at a higher rate? Or can we optimize our ads so that we target them more effectively, resulting in people who convert at higher rates?

Let’s say we’ve done all that successfully (which would be amazing) and now things look like this:

LTV = ($11 – $2.50) x 7 = $59.50

CAC = $1.50 / 15% = $10

In this model, everything improved. We have a better LTV to CAC ratio. We pay off our CAC in a little more than one month rather than almost three.

But is this better?

It seems like it. But, here’s something else that might have changed — we might be able to sell to many fewer customers in this model. Better per customer margins, but fewer customers total.

And this is just scratching the surface.

If it’s helpful to you, I wrote a direct, useful book on this topic, called Growth Units. Check it out if you’re working on figuring out and improving your own LTV and CAC. And good luck on building your CPG businesses!