Setting the right marketing target for your ecommerce business is a critical step on the path to success. It's a process that requires a deep understanding of financial metrics and the ability to apply this knowledge in a marketing context.
In this blog post, I will explain every single step in the process ensuring you are able to do the same calculations in your business.
Let’s start by understanding the basic metrics that go into the calculations.
When calculating customer lifetime value, there is an easy way and a more advanced way, which in turn provides more useful information.
To do it the easy way, we sum up all the revenue during the period of analysis and divide that by the number of unique customers.
The formula in, e.g., Google Sheets is:
This version is great both for getting a quick number and for checking the work of the advanced method. However, the advanced method is preferred, as the value of the underlying data points is very valuable to your business.
Let's move on to the more advanced method.
To start with, it's essential to understand the Average Order Value (AOV).
This metric gives you an idea of the average amount a customer spends per order at your business. Moreover, it’s a metric we will use extensively going forward in our calculations.
AOV is calculated by dividing the sum of total sales (excluding VAT) by the total number of orders.
The formula in Google Sheets is:
The next metric is the Average Customer Lifetime, which is calculated in months.
This metric is very important for you to know, as it shows the time period in months that you are able to retain your customers. This is a metric that you should focus on increasing over time through, for example, loyalty programs or email marketing.
To determine this, you first need to calculate the days between the first and last order for all customers, as we later need those numbers to get the average number of days between orders for all customers.
You can do this in Google Sheets by making a pivot table, which groups by the customer's email address and makes a custom metric with the following formula:
Next, divide the total number of days by the unique number of customers. Finally, to get the result in months, divide the outcome by (365/12).
This is how it appears in Google Sheets.
Note: To be 100% accurate, you should divide by 365.25 instead of 365 to account for a leap year every four years. But... keep it simple 😄
After calculating the AOV and Average Customer Lifetime, you should determine the Average Purchase Frequency per month.
This metric indicates how often your customers make purchases from you on average. As we are scaling the metrics to a monthly basis, the output is the average number of purchases made by your customers per month.
This metric is calculated by dividing the average number of orders per customer by the average customer lifetime in months, as you have just calculated.
It appears like this in Google Sheets:
Finally, with the above metrics, you can calculate the Customer Lifetime Value (CLV).
The CLV is a crucial metric as it tells you the total revenue you can expect from a customer over their lifetime as a customer of your business.
This is the product of AOV, average customer lifetime in months, and the average purchase frequency per month.
To calculate this in Google Sheets, you can use the following formula:
An example of calculating these four metrics in Google Sheets can be seen below, where the AOV and CLV is also calculated with and without VAT.
One last step before moving on to the fun stuff, setting the right target, we need to calculate the average number of orders per customer over the lifetime of the customer.
This is one of the most simple calculations. We use the pivot table again, which is grouped by the customer email, and calculate the average number of orders by this Google Sheets formula:
Now, we have all the basic metrics in place. Therefore, it’s time to get into the fun stuff - calculating and setting the right target.
Before we are able to set the right target, we need to understand a few more financial metrics.
The first being your Contribution Margin 1 (CM1), which dictates the share of the sales value that’s left after paying for your variable costs like product costs, shipping, payment fees etc.
It’s calculated in Google Sheets like this:
Note: Revenue is ex. VAT for both inputs.
With the CM1 calculated, you can then set different ‘% of net sales targets’ for your Contribution Margin 2 (CM2), which is the CM1 minus the Customer Acquisition Cost, which is calculated as so:
Based on the CM2, it’s now time move on to the targets itself.
The right target depends a lot on your fixed costs and target net profit margin, as these are the final expenses that need to be paid after CM2.
When subtracting these costs, we arrive at Contribution Margin 3 (CM3), which is a representation of your profits.
Now, it’s time to calculate the target.
Several different targets exists, and can be calculated by the following formulas:
OBS: AOV and CM1 is ex. VAT in the above.
An example of the target calculations are below. All number are fictive and for the sake of the example.
Now, it’s time to the last step of the exercise.
All target options have been calculated for the different scenarios. We now need to choose the right target to use in our marketing operations. But how do you decide on the right target for your ecommerce business?
Your choice of target type depends on your cashflow and how quickly you need to get your money back.
If you have a strong cash flow and a high repurchase frequency, an LTV/CAC ratio may be suitable. However, if you need to earn money on the first sale to avoid a liquidity squeeze, a ROAS / POAS target might be better.
By understanding these financial metrics and how to apply them to your ecommerce business, you can set the right marketing targets. This not only helps you achieve your business goals but also allows you to make informed decisions that can shape the future of your business.
Remember, the key to success lies in the continual application and reassessment of these metrics as your business grows and evolves. Redoing the calculations each quarter is highly recommended.
Best of luck with your own calculations. In case you need assistance in this exercise, feel free to reach out to me for guidance.