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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.
0:04
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,
1:00
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.
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,
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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
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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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