LCV and CAC- Is this Important parameter for analysis?

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LCV and CAC are the terms we heard a lot of times in the financial newspaper or any article but we are dubious to understood how this concept can help us to understand, evaluate and make good investment decisions in our or any businesses.

Life is really simple, but we insist on making it complicated- Confucius

Let me make it simple. Let’s say a person called Bala stays in a small town where he has a high demand for the flower vase. He thinks to start his own business and come up with an enthusiastic idea to sell vase in his small town. He rents a small place where he can store and sell the vase and suppose he pays Rs10k/ year for the rent. He is the only one to sell the vase in the market so he can charge whatever he wants to charge but he is a kind person and he also maintains his selling price by actively taking care of the standard of living, so he buys a pot at 100rs and sells his pot at 200rs per piece, Let’s assume that he has just started his business so he hired 2 people each at 5k/year to maintain the inventory and taking care of customers. Bala is very bad at sales, so he hired 2 more people each at 5k/year hoping that they can bring the customer on to the table. So total fixed cost for Bala is 10k+10k ( rent+ 2 salaried Administrative People). Bala variable cost is10k( 2 people hired for sales). So what Bala needs to earn per year to get profit or a breakeven point? your answer would be 30k (10k+10k+10k). yes!! you are on the point. So how many pots Bala needs to sell to get at a breakeven point? your answer would be 30,000/100=300 pots per year. ( we consider no cost of electricity, transportation, Miscellaneous cost and storage cost to make it simple).

Let’s suppose Bala made a huge debut and made a sale of 500 vases, so he earns profit above 300 pots i.e on 200 pots which is equivalent to 20k per year. Bala gets too happy and thinks that this is just a start and hires 3 more salespeople to boost more revenue, Bala is a great entrepreneur, he made it big and he qualified his name in the vase market. Now yearly sales of Bala is 1000 pots and think he won’t require that salesperson anymore and to increase his profit he fires 3 people and saves 15k per month. WOW!! that’s a great saving.

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You really didn’t realise you learn the concept of it of LCV and CAC now let’s dig deeper and get some more understanding on each term.

LCV( Lifetime Customer Value).

In our example, Bala has a monopoly of selling vase in the market and he expects no player to arrive in upcoming 5years, so Bala has the highest retention ratio and Bala is too smart he doesn’t ever compromise on the quality so we expect that each customer is buying single vase for their house per year and Bala have made the sell of 1000 vase in the last year so what will be our LCV?

LCV = average value of a purchase X number of times the customer will buy each year X average length of the customer relationship (in years)

So 200Rs for one vase, 1 time per year per customer and 5 years no competition (expects stiff competition after 5 years) so retention ratio is 100%

LCV=200*1*5=1000Rs/customer.

So Bala already has 1000 customer and each customer will pay minimum 1000rs for next 5 years so Bala expects revenue of 10,000,000Rs in next 5 years. Ohh That’s a hell lot of money.

What are the benefits of finding LCV

Calculating the CLV for different customers helps in a number of ways, mainly regarding business decision-making. Knowing your CLV you can determine, among other things:

  • How much you can spend to acquire a similar customer and still have a profitable relationship

  • What kinds of products customers with the highest CLV want

  • Which products have the highest profitability

  • Who your most profitable types of clients are

Together, these types of decisions can significantly boost your business’ profitability.

Now let’s talk about

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CAC ( Customer Acquisition Cost)

Customer Acquisition Cost (CAC) is the best approximation of the total cost of acquiring a new customer. It should generally include things like advertising costs, the salary of your marketers, the costs of your salespeople, etc., divided by the number of customers acquired.

calculate customer acquisition cost

Let’s Understand by our Example

Bala is a superhero he made customer base of 1000 from 200 within a year so he had increased his customer base by 800 and let’s assume all customer is targeted by the salesperson. ( No Advertisements)

Let’s Assume the salesperson ratio

1st salesperson bought 250 new customers

2nd salesperson bought 150 new customers

3rd salesperson bought 200 new customers

4th salesperson bought 150 new customers

5th salesperson bought 50 new customers

We pay 5k/year per salesperson so what cost did bala spent to get new 800 customers

1st salesperson = 5000/250 =20rs per customer

2nd salesperson =5000/150 =33.33rs per customer

3rd salesperson 200 =5000/200=25 per customer

4th salesperson 150 =5000/120=41.67 per customer

5th salesperson 80 = 5000/80=62.5 Per customer.

So you concluded that CAC of 1st and 3rd is the best and so he fires all 3 in his firm after finding CAC.

“You could cut your business by 75 different dimensions in pursuit of a growth opportunity, or just focus on the big ones and actually go and do your job. I suggest the latter”

We understood the basic motive of LCV and CAC. Let’s dig further and understand what are the LCV and CAC for Netflix.

As per this article, Netflix has a churning ratio of 11% in the year 2018-19. So what is churn rate?

Churn rate is a rate where the customer left the services of the service provider. Suppose after 5 years Bala gets a new competitor and he sells the vase at a lower price and Bala has a customer base of 1000 but due to competition, some customer let’s say 200 people shifted to the new shop and since Bala faced a serious problem, the churn rate for Bala is 20%

Churn rate (%) = 1- Retention ratio (%)

we can also say that Netflix has a retention ratio of 89% which is HUGE. ( As per the statistics provided), so much addiction!

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Some data also shows that in this year Netflix has a churn rate of only 2% but let keep aside( for simple understanding), why we keep more focus on the churn rate because now they are the target person which could be easily converted to their subscription or other revenue models. (as they already used their products/Services)

So I drawdown the LCV and CAC for Netflix for the year 2018 and 2019. You can easily observe that LCV has increase that leads to understanding that Netflix is increasing its base due to high retention ratio and acquiring new target customers.

We can observe that CAC has increased due to multiple online platforms and getting direct and stiff competition like amazon prime. we still think that Netflix holds great potential for the future. As per us, we think this CAC cost would be low in the near time and lockdown has positively affected the Netflix subscriptions. we will soon update with their results till then….

Hope you like and understand the core of LCV and CAC, in our next blog we will come with new and exciting insights till then don’t forget to subscribe, like and please comment what do you feel about LCV and CAC. If you liked our post please let your friends and family know how cool we are..

Thanks For Reading,

EquityManiac.

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Sources

https://www.shopify.in/encyclopedia/customer-lifetime-value-clv,

https://en.wikipedia.org/wiki/Customer_lifetime_value,

Netflix Business Model: is the Flywheel humming or coming off?

https://medium.com/@tanayj/how-much-are-you-worth-to-netflix-2fb61feb5441,

https://www.intercom.com/blog/what-is-customer-acquisition-cost/,

https://blog.hubspot.com/service/what-does-cac-stand-for,

https://s22.q4cdn.com/959853165/files/doc_financials/2019/ar/2019-10-K.pdf,

https://medium.com/@paul.levchuk/churn-rate-evolution-at-netflix-701c28be8c96,

https://medium.com/@gibsonbiddle/4-proxy-metrics-a82dd30ca810,

https://www.muvi.com/blogs/ott-churn-management-strategy-like-netflix.html#:~:text=Netflix%20is%20winning%20the%20streaming,any%20other%20subscription-base,



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Pujan Shah
Pujan is a Commerce Graduate from Mumbai and CFA Level-3 candidate. He does Financial Analysis, Financial Modelling, Valuation, Sector Analysis, and loves to read about every aspect related to Finance.
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