In the previous video, we introduced a flawed LTV model.

LTV equals one divided by gross churn time ARPU.

The problem with this formula is that not every dollar of revenue

has the same value to the business.

The calculation is simply reporting a gross revenue LTV number, but

we have to take into account how much it costs us to create that product.

In other words, we have to factor in what an accountant typically refers to as

costs of goods sold, or COGS.

In some businesses these are called cost of revenue, right, COGS,

what's all that about them?

Well, when we buy a cup of coffee the coffee shop is

going to incur some costs specific to that cup of coffee.

The water and the coffee used to brew the contents of our cup, the actual cup that

the coffee comes in, any milk we take, etc, those are COGS.

The salary of the barista,

the rent of the shop, those are generally not considered COGS because

they would've happened regardless of whether we sold the coffee or not.

Often, these costs, not directly related to the cup of coffee,

are referred to as overheads, they are usually fixed costs.

You may have heard people refer to variable and

fixed costs, but we're not gonna cover that in this course.

Indeed, I want to acknowledge that accounting is a massive topic area,

and we could create several courses on calculating COGS alone.

Now, as thrilling as that sounds, especially to me,

maybe not to you just yet, this is sadly beyond the scope of this current course.

So just be aware that as you grow your understanding of finance and

accounting, I encourage you to think critically about what you are doing and

the nuances of the situation you are analyzing.

All right, let's dig in to how COGS impact our LTV calculations by walking

through an example.

Here we are looking at some financial information on a hypothetical software

business.

We see we have the inputs for our flawed LTV formula,

we have our monthly churn, we have our ARPU We have our

average customer life based on the inverse of our monthly churn, and

then we have the LTV that those inputs output of $495.

As we said, some people talking about LTV will just leave it at that,

our LTV is $495.

Really though we should be thinking at the cost we know of effectively guaranteed

just to service that revenue, think back to the coffee example.

For every cup of coffee we sell there is cost associated with that product,

the same applies to a software here, there is a merchant process fee.

Our customers pay us online and

pretty much everywhere in the world we use a vendor to collect our customer's funds.

Then, our customers have to use our software,

which is all cloud based and store a lot of data.

We've calculated these costs to be about 10% of revenue on average

over the past several years, and we expect that to remain at 10%.

Then there's also our support costs,

we know these are usually about 2% of revenue.

So we know that just to provide our

service it's going to cost us 15% of revenu.

When we talk about our LTV, it's more accurate and

responsible to use an LTV minus COGS figure, in this case, it'll be $420.75.

I've heard people refer to this as LTV,

gross profit LTV, LTV after COGS and net LTV.

The chief point I want you to internalize is that we need

to factor any cogs-related expenses in to our LTV calculations.

When we're new to a team or when people are sharing LTV numbers with us,

make sure we clarify whether or not those have expenses removed from them,

or are simply based on gross revenue.

It's always better to double check and

make sure we known how the LTV data we are being given is calculated.

That is because, as with many things in life,

there are a lot of different ways people go about doing things.

Giving an LTV number that doesn't have COGS factored in it,

can lead to some very detrimental behavior.

We'll learn why in the next video.