1 00:00:00,550 --> 00:00:04,610 In the previous video, we introduced a flawed LTV model. 2 00:00:04,610 --> 00:00:08,870 LTV equals one divided by gross churn time ARPU. 3 00:00:09,900 --> 00:00:13,790 The problem with this formula is that not every dollar of revenue 4 00:00:13,790 --> 00:00:15,684 has the same value to the business. 5 00:00:15,684 --> 00:00:20,690 The calculation is simply reporting a gross revenue LTV number, but 6 00:00:20,690 --> 00:00:26,040 we have to take into account how much it costs us to create that product. 7 00:00:26,040 --> 00:00:31,050 In other words, we have to factor in what an accountant typically refers to as 8 00:00:31,050 --> 00:00:34,250 costs of goods sold, or COGS. 9 00:00:35,560 --> 00:00:40,110 In some businesses these are called cost of revenue, right, COGS, 10 00:00:40,110 --> 00:00:41,600 what's all that about them? 11 00:00:41,600 --> 00:00:45,220 Well, when we buy a cup of coffee the coffee shop is 12 00:00:45,220 --> 00:00:49,910 going to incur some costs specific to that cup of coffee. 13 00:00:49,910 --> 00:00:54,640 The water and the coffee used to brew the contents of our cup, the actual cup that 14 00:00:54,640 --> 00:01:00,750 the coffee comes in, any milk we take, etc, those are COGS. 15 00:01:00,750 --> 00:01:02,000 The salary of the barista, 16 00:01:02,000 --> 00:01:07,200 the rent of the shop, those are generally not considered COGS because 17 00:01:07,200 --> 00:01:11,430 they would've happened regardless of whether we sold the coffee or not. 18 00:01:11,430 --> 00:01:15,200 Often, these costs, not directly related to the cup of coffee, 19 00:01:15,200 --> 00:01:20,260 are referred to as overheads, they are usually fixed costs. 20 00:01:20,260 --> 00:01:22,950 You may have heard people refer to variable and 21 00:01:22,950 --> 00:01:27,000 fixed costs, but we're not gonna cover that in this course. 22 00:01:27,000 --> 00:01:31,350 Indeed, I want to acknowledge that accounting is a massive topic area, 23 00:01:31,350 --> 00:01:36,010 and we could create several courses on calculating COGS alone. 24 00:01:36,010 --> 00:01:40,240 Now, as thrilling as that sounds, especially to me, 25 00:01:40,240 --> 00:01:45,210 maybe not to you just yet, this is sadly beyond the scope of this current course. 26 00:01:45,210 --> 00:01:48,750 So just be aware that as you grow your understanding of finance and 27 00:01:48,750 --> 00:01:52,960 accounting, I encourage you to think critically about what you are doing and 28 00:01:52,960 --> 00:01:55,589 the nuances of the situation you are analyzing. 29 00:01:56,790 --> 00:02:01,597 All right, let's dig in to how COGS impact our LTV calculations by walking 30 00:02:01,597 --> 00:02:02,980 through an example. 31 00:02:02,980 --> 00:02:07,342 Here we are looking at some financial information on a hypothetical software 32 00:02:07,342 --> 00:02:08,340 business. 33 00:02:08,340 --> 00:02:12,780 We see we have the inputs for our flawed LTV formula, 34 00:02:12,780 --> 00:02:15,810 we have our monthly churn, we have our ARPU We have our 35 00:02:17,610 --> 00:02:21,920 average customer life based on the inverse of our monthly churn, and 36 00:02:21,920 --> 00:02:27,260 then we have the LTV that those inputs output of \$495. 37 00:02:27,260 --> 00:02:31,757 As we said, some people talking about LTV will just leave it at that, 38 00:02:31,757 --> 00:02:34,250 our LTV is \$495. 39 00:02:34,250 --> 00:02:39,610 Really though we should be thinking at the cost we know of effectively guaranteed 40 00:02:39,610 --> 00:02:44,540 just to service that revenue, think back to the coffee example. 41 00:02:44,540 --> 00:02:49,760 For every cup of coffee we sell there is cost associated with that product, 42 00:02:49,760 --> 00:02:54,830 the same applies to a software here, there is a merchant process fee. 43 00:02:54,830 --> 00:02:57,110 Our customers pay us online and 44 00:02:57,110 --> 00:03:01,080 pretty much everywhere in the world we use a vendor to collect our customer's funds. 45 00:03:02,140 --> 00:03:05,551 Then, our customers have to use our software, 46 00:03:05,551 --> 00:03:08,973 which is all cloud based and store a lot of data. 47 00:03:08,973 --> 00:03:13,416 We've calculated these costs to be about 10% of revenue on average 48 00:03:13,416 --> 00:03:17,820 over the past several years, and we expect that to remain at 10%. 49 00:03:17,820 --> 00:03:20,897 Then there's also our support costs, 50 00:03:20,897 --> 00:03:24,727 we know these are usually about 2% of revenue. 51 00:03:24,727 --> 00:03:27,826 So we know that just to provide our 52 00:03:27,826 --> 00:03:32,380 service it's going to cost us 15% of revenu. 53 00:03:32,380 --> 00:03:36,785 When we talk about our LTV, it's more accurate and 54 00:03:36,785 --> 00:03:44,384 responsible to use an LTV minus COGS figure, in this case, it'll be \$420.75. 55 00:03:44,384 --> 00:03:48,751 I've heard people refer to this as LTV, 56 00:03:48,751 --> 00:03:53,771 gross profit LTV, LTV after COGS and net LTV. 57 00:03:53,771 --> 00:03:57,477 The chief point I want you to internalize is that we need 58 00:03:57,477 --> 00:04:02,012 to factor any cogs-related expenses in to our LTV calculations. 59 00:04:02,012 --> 00:04:07,114 When we're new to a team or when people are sharing LTV numbers with us, 60 00:04:07,114 --> 00:04:12,473 make sure we clarify whether or not those have expenses removed from them, 61 00:04:12,473 --> 00:04:15,212 or are simply based on gross revenue. 62 00:04:15,212 --> 00:04:17,570 It's always better to double check and 63 00:04:17,570 --> 00:04:22,530 make sure we known how the LTV data we are being given is calculated. 64 00:04:22,530 --> 00:04:25,476 That is because, as with many things in life, 65 00:04:25,476 --> 00:04:29,493 there are a lot of different ways people go about doing things. 66 00:04:29,493 --> 00:04:32,490 Giving an LTV number that doesn't have COGS factored in it, 67 00:04:32,490 --> 00:04:34,740 can lead to some very detrimental behavior. 68 00:04:35,770 --> 00:04:37,600 We'll learn why in the next video.