3 common mistakes that bloat your marketing budget
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It’s a mystery. Your sales and marketing expenses have been over budget for months, but you’re missing your revenue forecast. You are burning a lot more cash than you expected just a few months ago. And yet, your CFO and VP of Marketing assure you that the ROI of your marketing spend is best-in-class for your industry. How is it possible ?
In my work with venture-backed startups looking for a path to profitability, this is a common pattern of fact when I begin my initial assessment of a company.
One of the most important KPIs for your business is the LTV:CAC ratio, which compares the lifetime value of a customer to the average cost of acquiring that customer. The math seems quite simple. Customer lifetime value is the average value of orders placed over the projected lifetime of a customer. Customer acquisition costs are the sales and marketing expenses incurred to convince a customer to make that first purchase. Divide LTV by CAC and you get a ratio that helps you determine the effectiveness of your marketing spend.
It sounds simple. What could go wrong? Eventually, a little, and the result is increased losses and accelerated cash burn. The problem is that multiple variables feed into the calculation of this ratio, and companies can get quite creative when it comes to choosing which ones to use.
How to determine the value of an order? What is the projected life of the customer? What sales and marketing expenses should you include in the CAC? So many decisions to be made, each of which can have a dramatic impact on the outcome. Here are three common mistakes companies make when calculating their LTV:CAC ratio:
Related: 3 Ways to Avoid Marketing and Budget Pitfalls
1. Calculation of LTV according to income
Sales do not equal value. I often see that a company calculates LTV based on revenue. Instead, you should calculate your LTV based on your contribution margin by subtracting your variable production and selling costs from net income. This is the real value that your customers generate for your business.
2. Use a projected life that extends beyond your cash trail
Should your projected customer life span be three years if you only have 12 months of cash left and there is no clear path to raise more money? Using a projected life that extends far beyond your cash trail will increase your LTV, but that’s a pitfall. Although your marketing dollars are soaring today, the positive ROI of that spend won’t arrive until it’s too late. You’ll be out of money before the customer even reaches year three of their purchase cycle.
If you want to help your team properly determine the right spend metric for your marketing efforts, choose a customer lifetime that matches your cash flow plan. You can then use a longer, more accurate lifespan when you have a clear path to extend your lead, giving you the opportunity to increase your sales and marketing budgets.
Related: How to Determine Your Customer Lifetime Value and Take Your Brand to the Top
3. Cut CAC expenses
Retail mogul John Wanakaer once lamented, “Half my advertising spend is wasted; the problem is that I don’t know which half. This quote is particularly relevant when considering the calculation of the CAC. Different layers of marketing support each other in ways that can be impossible to measure. For example, your brand marketing and PR efforts increase awareness, which will hopefully make your customer acquisition marketing more effective. Your creative team, which constantly tests the images and content of your ads, has a huge impact on the effectiveness of your advertising campaigns.
And yet, far too often, I’ll see a CAC calculation that only includes direct spend on customer acquisition. When you ignore all the other costs associated with your marketing efforts, the lower CAC will inflate your LTV:CAC ratio, leading you to increase your expenses far beyond what your business can afford.
Fully load your CAC with all the costs associated with your marketing efforts, covering your marketing funnel from top to bottom. Don’t forget to include the salaries of your employees and the cost of any outside agencies they have hired.
Related: 6 Marketing Metrics Every Business Should Track
Make the right calculations first
The ideal target LTV:CAC can vary from company to company, depending on your company’s margin and cash flow profile. As a rule of thumb, an LTV:CAC of 3x or more should put you on the path to profitability and positive cash flow. A lower ratio can lead to accelerated cash burn versus inflated sales, which can create a downward spiral if not corrected quickly enough.
A well-funded startup with high gross margins and a clear path to scalable growth might set a lower target for a while to capture market share. A startup with less than a year of cash in the bank had better tighten the calculations and operate with a higher ratio if it doesn’t want to run out of cash. But none of that will matter if you don’t calculate the ratio correctly. Get the math right first, and then you can decide which target works best for you and your team.
