Understanding critical DTC business metrics
With all the different terminologies and metrics in the advertising and marketing communities, it can be hard at times to remember all the proper definitions. It’s also critical to understand which ones are best for predicting your company’s future growth and health.
Here at Digicom, we thought it would be helpful to offer a quick refresher course and break down some of the more important terms and definitions to know.
Let’s dive in!
Customer Acquisition Costs (CAC)
Customer Acquisition Cost is simple. You take the amount spent on an advertisement campaign and divide that number by how many individuals purchased your product. That’s your CAC.
You can adjust this calculation based on whether you are using outside help or organizations that influence how much is spent on the campaign.
The beauty of the CAC is that little improvements can sometimes lead to massive percentage decreases, and it can be the result of strong synergy within your organization.
The goal is to have a low CAC, and this can be aided by improving your onboarding process or lowering the price.
Conversion Rate (CVR)
Conversion rate is a narrower look into the advertisement campaign.
While CAC focuses on the money, conversion rate centers on how many individuals actually begin and complete the process with the end goal of a transaction.
You tally this percentage by dividing how many people actually complete the transaction by how many people began the process. Conversion rate can also always be calculated by dividing up the event for conversions with any of the steps before. For example, purchases/add to carts or purchases/clicks.
You can also go as granular as you’d like to help find where you can improve the process (aka the conversion funnel).
Let’s say your advertisement includes the selection of a plan. You can see what percentage of individuals who click on the ad actually begin a plan, and compare that to the percentage that choose a plan and then make a purchase. You can see where potential clients may be lost.
Average Order Value (AOV)
This is another simple definition. You take the amount spent by your customers by the amount of orders. However, this metric can be skewed by purchasing changes.
Customers ordering items over different timelines, such as monthly versus quarterly, or deciding to buy in bulk can affect these numbers.
Note that a dip in AOV does not necessarily translate to a bad trend.
There are three main margin groups: Product margin, gross margin and contribution margin.
For product margin, we use the cost of the goods sold (COGS) divided by the gross sales price. This will give us a percentage that we use.
If you purchase a collection of goods at a set price, you can calculate your product margin by taking the gross sales price and subtracting the COGS and dividing it by the customer price.
Gross margin is the cost of sales (COS) divided by the gross sales price. COS is the direct costs related to the production or supply chain. Gross margin factors in the cost of labor, shipping, packaging and the handling of the merchandise.
Let’s say you have your COGS. You can then add in the other costs to get your total cost. Take your AOV and subtract the total cost, and then divide that by the AOV.
The third and final margin is the contribution margin, which accounts for any discounts or deals that may pull from the total.
Let’s say you have your total cost, but your company is adding a discount. Subtract the average discount from the AOV and then subtract the total cost to get your new gross margin. Subtract that from the AOV and you will have your contribution margin.
It’s easy to remember the contribution margin since that has the biggest “contribution” on what your company is actually making on its sales.
While different companies use varying terminologies for this margin exercise, make sure your brand or company is consistent in your approach.
To help your margins, you can boost your AOV or attempt to decrease your packaging costs.
Here’s a quick recap: You want your CAC to be low and your conversion rate, AOV and margins to be high. The goal is to increase the former and decrease the latter.
Remember that each pillar affects the others.
Lowering the cost of your product, for example, will help your conversion rate and CAC, but hurt your AOV and margins. If you increase the price of your product, helping the AOV and margins, it likely will hurt the conversion rate and increase the CAC.
Decreasing the packaging costs is one recommended avenue since it likely won’t affect the AOV, CAC or conversion rate, provided your customers remain happy with the product.
Ultimately, you and your company have to decide where you are willing to sacrifice in hope of increasing or decreasing one of these categories in the short-term or long-term.
TAKING IT TO THE NEXT LEVEL
We just detailed the terms and metrics involved with a customer making a purchase.
Now, let’s focus on retaining that customer and their future interactions with your company!
Retention is key for all companies. You want your customer base to return and keep making purchases. It is defined by measuring the continued use of products and services.
We’ll start with order retention.
Let’s say you have x amount of customers buying your service in January. You then track how many orders there are from that initial group over the following months. You can translate that into a percentage by using the amount of orders in the months divided by the original base.
You can also go as narrow as you would like, tracking more granular topics such as frequency, types of product and age groups. This can provide more details on certain segments.
Your retention percentage is key since it showcases that your product has a strong presence in the market and is providing value to the clients. Customers are not going to continue to invest in your product if it does not benefit them or make their lives better.
Having strong retention can lead to an increase in revenue and profit, which can allow you to build your company and product offerings and perhaps bring back in new clientele.
A payback period is the time it will take to pay back in contribution dollars what was spent to acquire the member group. If you spent $100K in your initial customer acquisition phase, then you are looking for the time it will cost to cover that initial investment.
The goal is obviously to decrease the payback period and make a profit faster.
Increasing retention, AOV and contribution margin and decreasing CAC are potential avenues to help decrease the payback period. All branches of your company can contribute to this goal via their research. Finding ways to be more cost-efficient is always a collective effort.
Lifetime Value (LTV)
Once you acquire a customer, you can calculate lifetime value (LTV).
LIfetime value is the cumulative net profit with a customer. Take your total contribution and divide it by the original group total (since that’s what you opened with) to get your LTV. It will be hard to predict your LTV at the start, but you will get a better sense as time goes by.
When projecting for the future, try to see where your percentages are stabilizing and use that number (conservatively is probably the better option) to make your projections. Subtract the first year from the second year to get your net profit for that second year of sales.
LTV can be boosted by increasing your AOV (assuming margin and the frequency of orders constant), margins, retention and customers adding new products into their purchasing cycle.
Retention, again, cannot be understated. Increasing retention will lessen your payback period and lead to more LTV since customers are sticking with you longer and buying more goods!
THE ADVANCED METRICS
Now that we’ve laid the groundwork, let’s take a deeper dive into several more notable metrics that can give you a better idea of your company’s success and long-term health.
LTV to CAC Ratio
The LTV to CAC ratio is the lifetime value of a customer divided by the customer acquisition cost. An easy way to remember this metric is to think of it as the number of times a customer pays for their acquisition costs. The goal is to obviously have a high ratio.
One key is to remember the timeframe you’re using for your LTV.
If a customer only spends what it costs to acquire them, you have no profit. But let’s say they spend twice as much as the CAC. You then have a ratio of 2.00.
You’re obviously aiming for a high LTV-CTC ratio, with some companies aiming for a ratio that matches the number of years that customer has been with your company. But this ratio can be influenced by many factors, including the product and the state of the economy.
Some companies may aim to have a ratio of just one over the first few years of the relationship with the customer because they believe they will be paid back and then some in the long run. This can be a risky proposition, though, since it requires several years worth of patience.
Remember that having a strong retention rate can increase the LTV, which could allow your brand to increase the customer acquisition cost. You could also keep your CAC constant, which will lessen the payback period and allow you to see profits sooner.
Your company has to decide what it believes is the best strategy for your budget and your ultimate goals both in the short-term and long-term.
The LTV to CAC ratio is a strong tool since it helps you see the efficiency of your customer acquisition. If you’re struggling to get your ratio to the range you want it to be, you can take a deeper look into what you are spending to acquire customers.
Net Revenue Retention
Net Revenue Retention is the revenue your company makes after you remove discounts, credits and returns. You’re removing factors that would be included in the gross revenue for your product, such as the aforementioned discounts or credits.
If a customer has a $10 discount and uses it on a $50 purchase, your gross revenue would be $50 compared to your $40 net revenue.
The goal is for your net revenue retention to be greater than 100%, which stems from your retention rate being 100 percent and those individuals buying more or your retention rate dipping but the remaining group is spending more on your products than they did before. Customers could be using the same product more and/or adding a new product into the fold.
The retention rate dipping but the net revenue retention increasing is a strong goal to shoot for since a perfect retention rate is tough and this means clients are continuing to invest. You are offsetting your decrease in customers by getting those who are retained to spend more.
This tool allows you to see how your customers are spending over a certain interval. You are providing value if they are continuing to spend.
Net Profit Per Member Per Cohort
Yes, we know. This one is a mouthful.
While Net Revenue Retention provides details on spending, it does not indicate whether you are actually making a profit over that time. If you provided a free month to your users, your Net Revenue Retention in the second month would obviously be greater than 100%.
Net Profit Per Member Per Cohort allows you to see the profit trends.
Don’t be surprised if this metric dips due to retention rates perhaps dropping. That is to be expected. The LTV per customer can be increasing while the Net Profit Per Month decreases.
There may come a time where you see that the Net Profit Per Cohort is 0 since customers are not ordering or there is no contribution margin. The cohort also may not be adding any profit.
The Net Profit Per Month can also increase if customers start adding to their purchases or if your customer base is recognizing and appreciating the value of your product.
These metrics are very helpful for analyzing where and how you can improve. They each play off one another and provide a look into different elements.
We hope these explanations have helped you get a better understanding of the metrics to know and pay attention to, and how you can utilize them going forward.
Be sure to keep reading the Digicom blog for useful tools and articles to help your business thrive!
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