You have probably heard of recurring revenue. If not, we’ve written an article about recurring revenue. Many Internet companies nowadays use a recurring revenue business model, including big names such as Netflix and Spotify. By offering your services on a subscription basis, you are able to create a predictable, recurring revenue stream. This is known as the Monthly Recurring Revenue (MRR).
The predictability of revenue streams under a subscription-based model has a lot of advantages. To find out more about these advantages and how to implement a recurring revenue model in your business, please read the ‘Recurring Revenue for agencies’ whitepaper. As for how you assess the successfulness of the model you have chosen, you can do so by calculating these five KPIs.
Customer Acquisition Costs (CAC)
The Customer Acquisition Costs (CAC) are the average acquisition costs for each new customer. This KPI is interesting mainly because it shows you exactly when you will have earned back the acquisition costs for a particular customer. For example, say it costs €250 to acquire a single new customer, and the service you are offering your customers costs €50 a month; this means that you will have earned back your investment after five months.
The way to calculate the CAC is by adding up all of your monthly marketing and sales costs (including salaries), and then dividing the CAC by the number of new customers acquired in that month to obtain the average costs per new customer.
CAC = (Marketing & Sales costs + Marketing & Sales Salaries) / (Number of new customers in the past month)
For example, say you spent €5,000 on advertisements and sales, and €7,500 on salary payments for that month. If you acquired 50 new customers that month, the CAC would be: (€5,000 + €7,500) / 50 = €250 per customer.
Churn is the number of customers that left you in any particular month. Churn can easily be calculated by dividing the number of customers that left by the total number of customers at the beginning of the month. The churn is then represented by a percentage.
Customer churn = Number of churned customers / Number of customers at the beginning of the month
Say you had 50 customers at the beginning of the month and two of them left, the churn would be 2 / 50 = 4%.
It is more interesting to calculate churn based on revenue, because it results in a more precise figure. This is due to the fact that you also include customers who are subscribed to multiple services and customers who cancel some of the services they are subscribed to. Here is how to calculate how much revenue you have lost compared to last month.
Revenue churn = (Churned MRR) / (Last month’s MRR)
Say your MRR last month was €15,000, and your churn this month was €500. That would mean that your churned MRR would be (€500 / €15,000) = 3.3%.
A healthy churn rate is below 4%. However, it should be said that churn figures differ from one field to the next. The average in the SaaS field is a little over 6%.
Lifetime Value (LTV)
The LTV is your total customer value. CAC allows you to calculate how much it costs to acquire a new customer, and churn allows you to calculate the number of customers or the amount of revenue that disappears each month. Conversely, LTV indicates how much gross profit a single customer generates during the time that they stay with you.
To calculate the Lifetime Value, you need to first calculate the average revenue per customer, also referred to as the ARPU (Average Revenue Per User). The way to calculate the LTV is by dividing your total revenue by the number of customers. For example, say you have an MRR of €50,000 and 800 customers; the corresponding ARPU would be €50,000 / 800 = €62.50 per customer.
You then use the ARPU and your gross profit margin to calculate the LTV:
LTV = (ARPU * Gross Margin %) / MRR Churn %
For example, if your ARPU is €62.50, your gross margin is 70%, and your MRR churn is 3.33%, that means your LTV is (€62.50 * 0.7) / 0.033 = €1,326; in short, each customer results in €1,326 in gross profits.
The LTV/CAC ratio gives you a better idea of whether the investment you make to acquire new customers (CAC) actually results in sufficient revenue in the end (LTV).
LTV/CAC ratio = LTV/CAC
The LTV in the example we have been using is €1326, and the CAC is €250. This means that the LTV/CAC ratio amounts to €1,326 / €250 = 5.3. Generally speaking, an LTV/CAC ratio of 3 is considered to be the bare minimum. If your ratio is below three, this means that it costs too much to acquire a customer, or you need to raise your net revenue per customer. If your ratio is well above three, this means that your company could grow more quickly if you spent more on acquiring new customers. With a ratio of 5.3 in our example, our example business falls within this category. Obviously, it is great to know that you are easily earning back your investment for each customer, but such a high ratio means that you are likely missing out on more business; after all, you have the financial room to invest extra and still maintain a healthy revenue level per customer.
How long does it take for you to earn back the costs for acquiring a new customer (CAC)? You can find out by calculating the recovery time. Here is how to calculate your average recovery time:
Recovery time = CAC / (ARPU * Gross Margin %)
With a CAC of €250, an ARPU of €62.50, and a gross margin of 70%, the resulting recovery time is €250 / (€6250 * 0.7) = 5.7 months.
The graph below shows the average customer’s revenue stream in this situation:
Image 1: The average customer’s cumulative revenue stream
If you are going to be implementing a recurring revenue model or already use a similar business model, we recommend that you monitor the KPIs mentioned in this article on a monthly basis. This will allow you to keep an eye on the acquisition costs for each new customer, the amount of revenue that is churned each month, and the profit generated by your average customer. Moreover, the LTV/CAC ratio and recovery time will allow you to monitor whether the growth pattern of your business is a healthy one.
Know more about KPIs
If you want to know more about how to grow your company by implementing these KPIS, please download the free whitepaper: ‘Recurring revenue for agencies: Profit on both sides’. This whitepaper explains what happens to your cash flow when using the recurring revenue model for dozens of customers and provides ideas about how to offer your own recurring revenue services. If you are already using these KPIs to measure growth, please share your experiences with us in the comments!