Aidi — Metrics (Part II)
In the previous article, we established that building and scaling a successful business starts with knowing what to measure and how. We also outlined factors founders should have in mind when choosing what metrics to consider.
The second part of the series will discuss what the Pirates Metrics means and how to calculate 2 chosen metrics - the customer lifetime value (CLV) and customer acquisition cost (CAC).
Let’s begin by taking a look at David McClure’s Pirate Metrics. This model categorizes the metrics a startup requires to achieve acquisition, activation, retention, revenue and referral - AARRR. It describes the five steps through which your customers must progress, so your startup can get value from them. This value isn’t just revenue but also includes referral and retention. Here’s what the model looks like
How users become aware of your offering. This can be through SEO (Search Engine Optimisation), SEM (Search Engine Marketing), email, PR, campaign, an active blog, etc. When choosing an acquisition channel consider these - what are high-volume channels? What are low-cost channels? And, what are the best-performing conversion channels? Some acquisition metrics to track are- traffic, mentions, CPC (cost per click), search results, cost of acquisition and open rate.
This uses product features on the site to get people to engage. Here, do not be too smart. Do a lot of A/B tests and landing pages. Do you want them to subscribe, book a demo, test the product, etc? This will be influenced by features (spend 80% of your time tweaking features and 20% on new feature development), design, tone and compensation. Here are some activation metrics to track - enrollments, signups, completed onboarding, using the service at least once and subscriptions.
How to ensure that the one-time user comes back and becomes engaged. Notifications, alerts, reminders, emails (you can automate this and make them life-cycle emails starting right from when they join, 7 days after, 30 days after, etc), updates, etc. Some metrics for this include engagement, time since the last activity, daily and monthly active users and churn.
This is figuring out how to make money from your product. This can be dependent on transactions, clicks, subscriptions, etc. For this, you can track customer lifetime value, conversion rate, click-through revenue, etc,
Do users refer your product/service? You can track this through emails, widgets, campaigns, retweets, likes, etc. Some relevant referral metrics are invites sent, viral coefficient (the number of new users that each user brings), viral cycle time, etc.
Remember that it is not about measuring tons of metrics; less, not more. Focus on 5, 10 metrics and nothing more than this. When you measure, iterate; change what isn’t working. Focus on conversion improvement, hypothesize customer lifecycle and refine.
Next, let’s take a very close look at some of the metrics highlighted - what they mean and how to calculate them.
This is defined as the total financial contribution from the current period into the future - that is, revenues minus costs of a customer over his/her future lifetime with the company and therefore reflects the future profitability of the customer. In simpler terms, it is the metric that reveals the total revenue a business should expect from one customer for the duration of the business relationship. It is the worth of a customer to a business. Please keep in mind that different businesses require different models to calculate the lifetime value of a customer- CLV for a SaaS business will differ from that of e-commerce. However, why should founders focus on this metric?
- This metric helps the business to know how much to invest in retaining a customer to achieve a positive return. Startups try to stay lean and spend only on what is relevant, so calculating your CLV will help you invest in customers who bring the maximum return to your organization.
- Calculating your CLV will help you focus on allocating limited resources to achieve a maximum return. Additionally, it is the basis for selecting and ranking customers, selling the next best product/service and deciding on communication strategies best suited to your customers. This metric can be considered as the one that guides resource allocation for marketing activities, especially for businesses taking the customer-centric approach. It gives insight into which of your customer segment are more loyal and generate more profit and then, helps you focus your acquisition efforts on this group.
How is the CLV measured? It can be either calculated as an average CLV using an aggregate approach or at an individual level using an individual approach. You can know the lifetime value of a customer by measuring recurring revenue - recurring costs, gross contribution margin - marketing costs, net margin - expected number of purchases over the next 3 years (3 years is used mostly because 80% of profit comes in 3 years) or accumulated margin minus acquisition costs. This may sound complicated, so here’s a simple 3 part process
- Estimate revenue: Calculate how much money a typical customer generates per purchase. The best way to do this; average revenue from several customers within a segment or from your market as a whole. You can derive the average revenue by looking at the data from current sales to obtain correct averages.
- Estimate frequency of purchase: The appropriate time frame, called the purchase cycle is dependent on the industry. A confectionary business may discover that the most relevant time frame is one week and each customer buys twice a week. For purchases like computers, it may be between 2-3 years and so on depending on your industry.
- Calculate revenue per customer over a specified period: This can be obtained by multiplying the revenue per purchase by purchase frequency. That is - Revenue per purchase X Frequency of purchase = revenue over a specified period.
So if we are to calculate the CLV for this confectionary business, we will calculate how long the average customer buys from the business and, how much revenue is generated during the period the customer purchases from you. It is
Revenue per purchase
X Frequency of Purchase
X Customer lifetime = CLV
Looking at the confectionary startup example and formula, let’s assume - revenue per purchase (#400) X 2 purchases a week X 52 weeks a year X customer lifetime of 5 years = #208, 000.
There are other formulas for getting a more definitive and precise CLV taking into consideration retention and discount rate. But the formula above is a good place to begin.
- Customer Acquisition Cost (CAC):
The first thing to note is that a customer pays the business for what it sells or the service it provides. So, if they are not paying, they’re not a customer. Philip Orlando defines CAC as the measure of the cost to start a relationship with a new customer. He stresses that while the acquisition can be free, most of the time it costs something. Some CAC metrics are - cost to reach potential customers, conversion rate, cycle time, time to pay back, etc.
Some founders calculate CAC this way- total spent on marketing in a period / the number of customers in a period. This formula is unhelpful as it doesn’t exactly show which of your marketing activities brought new customers. Also, looking at this formula where the total spend is divided by the number of total customers, it means that if people take more time than the period that is measured to convert into a customer, then you will count the wrong people. It also doesn’t show where improvement can be made; if you are spending too much on marketing or not acquiring enough customers based on how much you spend. So, what is a more helpful way of doing this calculation?
The best way to do this is by thinking on an individual basis. Instead of calculating CAC overall, you measure - the cost to get one potential customer and the conversion rate at which this potential customer actually becomes a customer. Let’s break it down a bit using an example from Paul Orlando; Let’s say you run an online ad and it costs $1 every time someone clicks on your ad. This cost is a function of some things like the segment being targeted, competition for the same access and the relevance of that ad to the particular product.
The second part of the equation is the conversion rate - the percentage of people who see information about your product/service and buy it/ pay for it. If 100 viewed your Delaware Incorporation taxes ad and 5 paid for it, then your conversion rate is 5%. This rate is subject to change overtime based on certain factors like the type of ad content, the people you target, the awareness of your product or service, etc.
Based on our formula your CAC will look like this - $1/ 5%=20% of acquisition.
There are also other ways of calculating your CAC - by channel (with this you see which channel currently works. Eg, if Linkedin works better than Instagram etc), through conversion funnels, etc. It is best to choose the method that will give you the best results and the only way to know this is to try the different methods and see which delivers the most optimal results and insight that will enable you to make tweaks and improvements.
The concluding part of the series will show you how to calculate your monthly recurring revenue, annual recurring revenue, viral coefficient and churn rate. If you need to speak to our team concerning how you can improve your business metrics and grow your business, please send an email to email@example.com and we’ll help you get started.