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You have completed Introduction to Churn and Lifetime Value (LTV) Analysis!
You have completed Introduction to Churn and Lifetime Value (LTV) Analysis!
Preview
We highlight an important consideration when calculating LTV, Cost of Goods Sold, also known as COGS.
Example Files
- COGS spreadsheet example from this video
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In the previous video,
we introduced a flawed LTV model.
0:00
LTV equals one divided by
gross churn times ARPU.
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The problem with this formula is
that not every dollar of revenue
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has the same value to the business.
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The calculation is simply reporting
a gross revenue LTV number, but
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we have to take into account how much
it costs us to create that product.
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In other words, we have to factor in what
an accountant typically refers to as
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costs of goods sold, or COGS.
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In some businesses these are called
cost of revenue, right, COGS,
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what's all that about them?
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Well, when we buy a cup of
coffee the coffee shop is
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going to incur some costs
specific to that cup of coffee.
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The water and the coffee used to brew the
contents of our cup, the actual cup that
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the coffee comes in, any milk we take,
etc, those are COGS.
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The salary of the barista,
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the rent of the shop, those are generally
not considered COGS because
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they would've happened regardless of
whether we sold the coffee or not.
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Often, these costs,
not directly related to the cup of coffee,
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are referred to as overheads,
they are usually fixed costs.
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You may have heard people
refer to variable and
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fixed costs, but
we're not gonna cover that in this course.
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Indeed, I want to acknowledge that
accounting is a massive topic area,
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and we could create several
courses on calculating COGS alone.
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Now, as thrilling as that sounds,
especially to me,
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maybe not to you just yet, this is sadly
beyond the scope of this current course.
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So just be aware that as you grow
your understanding of finance and
1:45
accounting, I encourage you to think
critically about what you are doing and
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the nuances of the situation
you are analyzing.
1:52
All right, let's dig in to how COGS
impact our LTV calculations by walking
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through an example.
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Here we are looking at some financial
information on a hypothetical software
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business.
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We see we have the inputs for
our flawed LTV formula,
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we have our monthly churn,
we have our ARPU, we have our
2:12
average customer life based on
the inverse of our monthly churn, and
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then we have the LTV that
those inputs output of $495.
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As we said, some people talking about
LTV will just leave it at that,
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our LTV is $495.
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Really though we should be thinking at
the cost we know of effectively guaranteed
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just to service that revenue,
think back to the coffee example.
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For every cup of coffee we sell there
is cost associated with that product,
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the same applies to a software here,
there is a merchant process fee.
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Our customers pay us online and
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pretty much everywhere in the world we use
a vendor to collect our customer's funds.
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Then, our customers have
to use our software,
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which is all cloud based and
store a lot of data.
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We've calculated these costs to be
about 10% of revenue on average
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over the past several years, and
we expect that to remain at 10%.
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Then there's also our support costs,
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we know these are usually
about 2% of revenue.
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So we know that just to provide our
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service it's going to
cost us 15% of revenue.
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When we talk about our LTV,
it's more accurate and
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responsible to use an LTV minus COGS
figure, in this case, it'll be $420.75.
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I've heard people refer to this as LTV,
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gross profit LTV,
LTV after COGS and net LTV.
3:48
The chief point I want you to
internalize is that we need
3:53
to factor any cogs-related expenses
in to our LTV calculations.
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When we're new to a team or when people
are sharing LTV numbers with us,
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make sure we clarify whether or
not those have expenses removed from them,
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or are simply based on gross revenue.
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It's always better to double check and
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make sure we known how the LTV data
we are being given is calculated.
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That is because,
as with many things in life,
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there are a lot of different ways
people go about doing things.
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Giving an LTV number that doesn't
have COGS factored in it,
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can lead to some very
detrimental behavior.
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We'll learn why in the next video.
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