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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.
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LTV equals one divided by gross churn time 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
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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.
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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
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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 revenu.
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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.
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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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