What type of online business model do you have?

In order to properly manage your online business, you first have to understand which type of online business model you have. The most popular online business models are blogs, niche sites, and e-commerce sites. If you are selling specific products and services to a predetermined target group of consumers, then you have a niche site. Niche sites tend to be the go-to for most online start-ups and will be the focus of this article.

How do you reach your customers?

Unlike the traditional brick and mortar stores, online businesses give entrepreneurs a platform to engage in business without the smothering fixed costs associated with occupancy such as rent and utilities. On the flip side, consumers cannot discover your online business by simply traveling past it on the street. Thus, the first major hurdle of the online entrepreneur is to attract new customers to the website at a cost that still accommodates healthy profits. Niche sites gain the most traffic by ranking well among popular search engines for specific keywords. Researching the popularity of keywords in your business name will go a long way in steering traffic your way. Exposing your target customers to your site through social media is also very effective. And pay-per-click (PPC) advertising will increase the site’s exposure, but is more costly than social media outlets.

How do you overcome this first major hurdle?

It is paramount to the online entrepreneur to understand that acquiring customers is not easy and it will come at a cost. And to make sure that you begin with a healthy business model that will be profitable, you must make sure that the cost to acquire each customer (CAC) is reasonably less than the value received from the life of each customer (LTV). An optimal LTV:CAC ratio to set as your target is 3:1. In addition, it’s important to maintain positive cash flow related to customer acquisition by recovering such costs in less than 12 months.

What exactly is CAC & LTV?

In its simplest form, the cost to acquire a customer is the total cost associated with targeting your customers divided by total new customers won, within a certain period of time. CAC is used to help the online entrepreneur make informed decisions about marketing costs. The lifetime value of a customer is one of the most important analytics for the online entrepreneur. It will tell you which customers are generating the most revenue, but more importantly, when applied to the LTV:CAC ratio, it will help you make better decisions about marketing channels that generate the most profitable customers.

How do you calculate CAC and LTV?

Calculate CAC as follows:

Where:
CAC = Cost of customer acquisition
MC = Total marketing costs related to acquisition only (does not include retention costs)
Pr = Total payroll expenses of marketing and sales employees
Sw = Total cost of marketing and sales software
PS = Cost of professionals hired (consultants, graphic designers, etc.)
NCA = Total new customers acquired
Calculate LTV as follows:
• First calculate average gross margin over your customer’s lifespan (AGML)

Where:
Ta = Average number of monthly transactions per customer
Pa = Average customer purchase price
AGM = Average gross margin % per sale
La = Average customer lifespan in months (how long they remain your customer)
 Note: La above can be figured quickly by 1 / (1-R)

• Now calculate the lifetime value of a customer (LTV)

Where:
R = Monthly retention rate
Formula: R = ((CE – CN) / CS))
Where: CE = # of customers at the end of period
CN = # of new customers (gross) acquired during period
CS = # of customers at the beginning of period
Example: Let’s say you start the month with 100 customers and you end the month with 105 customers (of which you lost 15 existing customers and acquired 20 new customers). Your retention rate would be 85%.
 R = ((105-20)/100) 100= 85%
D = Monthly discount rate: This rate should generally be 10%

How do you apply the LTV:CAV ratio?

Example:
ABC Company sells tickets to sporting events online at an average sales price of $100 per ticket which yields an average gross profit of $40 per ticket. The average customer will purchase an average of 6 tickets per year. At the beginning of the 12th month in year 1, ABC Company had 500 customers. At the end of the 12th month in year 1, ABC Company had 501 customers of which 50 were newly acquired in the 12th month. The total marketing costs incurred by ABC Company during the month was $6,000.
CAC = 6,000/50 = $120 per customer
R = ((501-50)/500) 100 = 90%
AGML = ((.5 x 100)(40/100))(1/(1-.90) = $200
LTV = 200((.90/(1+.10-.90)) = $900
LTV:CAC = 900:120

Analysis:

ABC Company has a LTV:CAC ratio of 7.5:1. Every $1 spent on marketing to new customers is earning $7.5 in lifetime value from those new customers. This sounds great because ABC is making healthy profits on its new customer acquisitions. But when combined with the lack of customer growth for the period, this ratio indicates that ABC Company is under spending on marketing which results in a poor annual customer growth percentage of only 2.6%. Given that the optimal ratio is about 3:1, ABC Company needs to ramp up its marketing campaign and increase its annual customer growth. Growth goals are different for each company, so in analyzing your LTV:CAC ratio, you have to choose a ratio that best fits your growth goals. If ABC were a large company that had economies of scale, then 2.6% annual customer growth would be a lot better.

Written by: Josh Wells