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Factoring in COGS4:38 with Michael Watson
We highlight an important consideration when calculating LTV, Cost of Goods Sold, also known as COGS.
In the previous video, we introduced a flawed LTV model. 0:00 LTV equals one divided by gross churn time ARPU. 0:04 The problem with this formula is that not every dollar of revenue 0:09 has the same value to the business. 0:13 The calculation is simply reporting a gross revenue LTV number, but 0:15 we have to take into account how much it costs us to create that product. 0:20 In other words, we have to factor in what an accountant typically refers to as 0:26 costs of goods sold, or COGS. 0:31 In some businesses these are called cost of revenue, right, COGS, 0:35 what's all that about them? 0:40 Well, when we buy a cup of coffee the coffee shop is 0:41 going to incur some costs specific to that cup of coffee. 0:45 The water and the coffee used to brew the contents of our cup, the actual cup that 0:49 the coffee comes in, any milk we take, etc, those are COGS. 0:54 The salary of the barista, 1:00 the rent of the shop, those are generally not considered COGS because 1:02 they would've happened regardless of whether we sold the coffee or not. 1:07 Often, these costs, not directly related to the cup of coffee, 1:11 are referred to as overheads, they are usually fixed costs. 1:15 You may have heard people refer to variable and 1:20 fixed costs, but we're not gonna cover that in this course. 1:22 Indeed, I want to acknowledge that accounting is a massive topic area, 1:27 and we could create several courses on calculating COGS alone. 1:31 Now, as thrilling as that sounds, especially to me, 1:36 maybe not to you just yet, this is sadly beyond the scope of this current course. 1:40 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 1:48 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 1:56 through an example. 2:01 Here we are looking at some financial information on a hypothetical software 2:02 business. 2:07 We see we have the inputs for our flawed LTV formula, 2:08 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 2:17 then we have the LTV that those inputs output of $495. 2:21 As we said, some people talking about LTV will just leave it at that, 2:27 our LTV is $495. 2:31 Really though we should be thinking at the cost we know of effectively guaranteed 2:34 just to service that revenue, think back to the coffee example. 2:39 For every cup of coffee we sell there is cost associated with that product, 2:44 the same applies to a software here, there is a merchant process fee. 2:49 Our customers pay us online and 2:54 pretty much everywhere in the world we use a vendor to collect our customer's funds. 2:57 Then, our customers have to use our software, 3:02 which is all cloud based and store a lot of data. 3:05 We've calculated these costs to be about 10% of revenue on average 3:08 over the past several years, and we expect that to remain at 10%. 3:13 Then there's also our support costs, 3:17 we know these are usually about 2% of revenue. 3:20 So we know that just to provide our 3:24 service it's going to cost us 15% of revenu. 3:27 When we talk about our LTV, it's more accurate and 3:32 responsible to use an LTV minus COGS figure, in this case, it'll be $420.75. 3:36 I've heard people refer to this as LTV, 3:44 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. 3:57 When we're new to a team or when people are sharing LTV numbers with us, 4:02 make sure we clarify whether or not those have expenses removed from them, 4:07 or are simply based on gross revenue. 4:12 It's always better to double check and 4:15 make sure we known how the LTV data we are being given is calculated. 4:17 That is because, as with many things in life, 4:22 there are a lot of different ways people go about doing things. 4:25 Giving an LTV number that doesn't have COGS factored in it, 4:29 can lead to some very detrimental behavior. 4:32 We'll learn why in the next video. 4:35
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