Using Gross Profit Instead of Revenue
At 20 months and $100/month, our LTV would be $2000. This is quick, easy, and problematic.
First, due to payment processing and bank fees, you never actually receive the full revenue value. And second, there are direct costs associated with generating that revenue.
You want to account for these direct costs before calculating LTV, so that you do not overstate the amount of cash that you have available. Not including these direct costs will also make your payback period and LTV-to-CAC ratio look stronger than they really are.
Thankfully, accountants have already solved this problem. The costs directly attributed to generating revenue are called cost of goods sold (COGS) and you should already have these amounts tracked in your accounting software.
Instead of using revenue in your LTV calculation, we recommend using gross profit.
Gross Profit Formula: Revenue – COGS
There are several ways of calculating COGS, some people have a strict interpretation and others a loose one. But for a SaaS company, our rule of thumb is to include hosting costs and payment processing fees at a minimum.
Let’s assume Acme Inc. uses Amazon Web Services (AWS) for hosting and Stripe for payment processing. For a quick hosting cost per customer, you can take your previous month’s bill and divide by the total number of accounts from that month.
As a result, a $5,000 AWS bill for 1,000 accounts would be $5/month in hosting per account. We can also assume Stripe charges a flat 3% to accept payments for another $3/month.
Acme Gross Profit: $100 Revenue – $8 COGS
Acme Gross Profit: $92
In the simple calculation of 20 months times $100 per month, LTV was $2000.
By removing the cost of hosting and payment processing, we are able to get a better sense of the actual cash that will be usable by our company. The revised LTV calculation is 20 months and $92/month for an LTV of $1840.
Our example only has an 8% cost of goods sold, which leaves a 92% gross profit margin. This is an ideal case and only a handful of companies have a gross margin at or above 90%.
It’s more typical to see an 80-85% gross margin, which makes the difference even more pronounced between using revenue or gross profit in your LTV calculation.