Richard Branson, the founder of the Virgin empire, famously discovered the difference between “net” and “gross” profit in his 50’s, in the board room. In this blog post, I’ll be talking about similar fundamentals. As an engineer put in charge of marketing, I had the luxury of being able to say “I don’t know anything, can you explain the basics” - that “newcomers mindset” freed me from many misconceptions. Many that I’ve met haven’t had this luxury.
In this article, I’ll talk about lifetime value (LTV), customer acquisition cost (CAC), and return on ad spend (ROAS). All of these terms are thrown around by vendors and marketers alike, and so often, fundamental agreement on what these mean is missing.
In the examples below, I will use eBay as an example; it’s a well-known marketplace that facilitates the sale of third-party goods. The numbers are for illustrative purposes only; they aren’t real eBay business metrics.
First, foundations. These are over-simplified - if you’re in finance, bear with me.
- Gross Merchandize Value, or GMV, is the total amount that a buyer pays for the item.
- Revenue, or “top line:” eBay takes a 10% cut from most sales. Thus revenue is roughly 10% of the GMV.
- Profit, sometimes referred to as earnings, income, and EBITDA, is the portion of revenue that remains after accounting for all expenses that were involved in creation of this revenue.
- Contribution profit is the portion of revenue after accounting ONLY for variable expenses - not fixed costs. In eBay’s case, one example of per-order, variable expenses is customer service: it scales up as more orders come in. An example of fixed costs that’s not included in contribution profit is rent for office buildings, or salaries of the marketing team.
Building on these, let’s define our concepts we’re interested in.
Lifetime value of a customer, or LTV, is the infinite, time-discounted sum of all contribution profits you will ever make from a given customer. Let’s break this down:
- Sum of profits. That’s right, profits - not revenue, not GMV. In eBay’s case, let’s say a buyer paid $50 for an item; that $50 is GMV. 10% of that is eBay’s revenue ($5) and probably $3 of that is contribution profit. Let’s say this user makes 4 purchases like this across their lifetime. Thus, LTV of this user is 4 * $3 = $12
- Infinite time horizon. Discount future-year profits by some discount rate (say, 10%/year). You’ll see folks talking about “1-year LTV” which is a bit of a misnomer; bear with them. In that scenario, they cap the profits to what you make within the next year. So, to stay on the safe side, when someone says LTV, your immediate reaction should be “what’s the time horizon?”
Customer acquisition cost, or CAC, is the total amount of money you spend on acquiring a customer. CAC is sometimes referred to as CPA, cost per action, where action = new customer acquisition. Breaking it down:
- Spent on acquiring a customer: this means variable cost portion only; marketing salaries and cost of rent doesn’t count in CAC.
- Total amount: this means both your coupons and media costs are included. Did you give this user $10 off their first purchase, and spent $20 in media costs (Facebook) to acquire them? Your CAC for this user is 10 + 20 = $30.
Average CAC, as the name implies, is the average cost to acquire a customer. Incremental, or marginal, CAC is the cost to acquire the last customer. As you’d expect, each customer costs you a little bit more to acquire than the previous one. The last customer is the most expensive one. Your incremental CAC is thus higher than your average CAC.
Finally, Return on Advertising Spend, or ROAS, is a very confusing concept. The way your CEO thinks about it, ROAS is the amount of LTV marketing has generated, divided by total advertising spend. The way ad platforms want you to think about it, it’s the amount of “purchase conversion value” divided by advertising spend. Wait, are you actually signaling true LTV at the time of purchase to your ad platform? I didn’t think so. At best, you’re signaling first-order revenue. And as we just discussed, revenue and profit are not the same thing.
Marketing spend comes from profit; if you spend $10 on marketing, it should generate more than $10 in profits. It’s that simple. Not revenue. Not GMV. Profit.
- Don’t be afraid to admit that you’re missing some concept / economics don’t add up in your mind. Many discoveries started with “Hmmm, this is strange…” Nothing is wrong with asking questions. Everything’s wrong with being defensive at the detriment of the business.
- Make sure that you understand the unit economics of your business. If you can’t tell your per-order GMV, revenue, and profit numbers by heart, make friends with someone on the finance team. They’d be delighted to be friends with you.
- Don’t trust any ad platforms’ ROAS calculations - they’re largely BS.