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August 24, 2022

How your D2C can shorten payback period while increasing profitability

Farhana Rahman
Senior Content Manager

If a tree falls in a forest, and there is no one to hear it—does it make a sound? That famous philosophical question similarly extends to growth teams, albeit in a slightly different way. If you pay for a customer, but it is taking an excessively long time for their subscription revenue to exceed their cost of acquisition—are they being beneficial towards your company’s growth?

What I am referring to is the payback period. The longer the payback period (which refers to the time it takes for the customer to pay back their cost of acquisition), the longer it would take for profitability to kick in. The opposite also applies here—the shorter the payback period, the faster your company will grow.

With that in mind, we figured now would be a good time to go over how market changes have placed importance for D2C’s to shorten payback periods, which would naturally increase profitability much sooner.

These are the challenges being faced

Up until just a few years (months even) ago, companies thrived on the growth-at-any-cost approach. The numbers looked good, and investors were quick to give companies high valuations based on that growth that they saw on paper. It was like a lot of hype, which ultimately didn’t lead to profitability as customers would be quick to churn (ahem Peloton). Because of this both public and private investors pretty much universally decided that enough was enough, and focus needed to be placed on profitability instead of growth. Okay, cool. But what does that mean for growth teams?

{{banner}}

Well, the quick answer here is that marketing and growth teams have to perform the same or more with smaller marketing budgets. This calls for maximizing each marketing channel’s performance (in terms of ROAS and ROI). But here’s the catch—investors aren’t only interested in profits alone. I mean, obviously they made their investments with the educated understanding that big money will eventually be made. The question is… when will the ROAS and ROI kick in???

That. That right there demonstrates the need for growth teams to revamp their strategies, in a manner that would facilitate shorter payback periods, while also increasing profitability. Alternatively, we at least want to significantly improve the confidence in knowing what that period would be, for each marketing effort. This is all the more important when you consider the correlation of the scale and growth of companies, with their marketing cash flow. Time is money, and more emphasis needs to be placed on the payback period.

The importance of the payback period

The payback period has recently become more than just another metric to measure. In fact, it became an important metric for growth teams to optimize for—with the goal to have as short a payback period as possible. Granted, LTV to CAC ratios are also important. For some companies, depending on the industry and their stage, payback periods are critical because the faster the payback period, the less the need to raise money, and the more runway they have.

I know I’m going all out here, talking about the importance of the payback period, and it’s not for nothing. I mean, if you pay for a customer, you don't benefit from the acquisition until the customer's subscription (net!) revenue exceeds their cost of acquisition. Beyond that, the payback period determines the efficiency of your acquisition model.

That whole element of efficiency within acquisition models is also particularly important because misinformed campaign decisions get really pricey, really fast. 

How to calculate payback period

The most basic way of calculating the payback period is to divide the cost of acquiring a customer by the revenue they generate over a period of time. For instance, if it costs $100 to acquire a customer, and their subscription is worth $10 per month—that means  in 10 months they will have generated enough revenue to cover the cost of their acquisition: $100 / $10 per month = 10 months

Additionally, there is also the question of what it is that your company is wanting to diagnose and improve. Based on that you can calculate the payback period either with, or without the gross margin. The image below shows the respective formulas, and I’ll further elaborate right after.

Calculating payback without gross margin

It is simpler to calculate payback without the gross margin. 

CAC Payback Time = CAC ÷ MRR

Sometimes, figuring out the exact gross margin of a campaign is just operatively hard, as the data about margin's is often lagging (as it comes from a different finance system, and not in the data lake), as well as because companies often only track and record their average margins, and not per transaction/customer.

Calculating payback with gross margin

The biggest benefit to adding a gross margin into the equation here is that while it does increase the payback period, it also shows a more realistic number in terms of the profitability of your company’s customer acquisition efforts.

The equation for calculating gross margin is: GM = (ARR – COGS) ÷ ARR

And the formula to calculate the CAC Payback Time = CAC ÷ (ARR*GM%)

So what’s the best payback period for different verticals? This is not one-size fits all. After all, B2B’s have significantly longer funnels than D2C’s, which need to be accounted for. But to be honest (and this applies across the board), the best payback period is the shortest payback period possible. Based on our work with many D2Cs we can say that payback periods of two years were considered acceptable in the U.S. That later shifted down to one year, and now it is nine months. This is directly impacted by the cost of capital and rising interest rates.

Ways you can reduce your payback period

There are a few ways for D2C companies to reduce their payback period, with some approaches being a little more manageable than others. 

Reduce customer acquisition costs

You can start off by reducing your customer acquisition costs. That can be done by reducing marketing and sales figures. 

Increase average revenue per user

Another option is to increase the average revenue per user, per month (up sales/cross-sales, etc). If you decide to go this route, it would need to be done with lifecycle marketing, which can significantly boost ARPU and contribute to customers “repaying” your company sooner. And don’t forget—improving the ARPU directly affects MRR and ARR.

Reduce churn

Churn reduction is another way to reduce your payback period. I know I know, churn is inevitable. However, if you have enough customers who successfully cover their CAC payback in time and stay long enough afterwards, you will be able to maintain a positive revenue. As we mentioned in one of our previous posts, many D2C brands have updated their strategies, in an effort to ensure users would yield high LTV and loyalty to reduce their churn.

Optimize for high LTV users

There’s a ton of business value that comes from optimizing for high LTV users. This includes the discovery of audience potential, identification of the highest value customers, and ultimately—the optimization of revenue forecasts. We dove deeper into this in one of our previous blog posts

Now there are two ways you can optimize for high LTV users: either in-house, or with the additional help of an AI-based predictive growth platform. Ahem. 😇😉

There are few formulas that come into play should you decide to do this in-house. We thoroughly went over them in this post, courtesy of our very own data science team.

Now if you decide to turn to the assistance of a codeless predictive AI solution for greater efficiency, it will be quite the time saver for your growth team. With the backing of a predictive growth platform, you will be able to appeal to users who are less likely to churn, and that are expected to have a higher lifetime value—all based on your LTV data. In the case of one of our globally recognized D2C clients, predictive AI helped improve their ROAS by 30 percent, and retention by 81 percent, all through LTV-optimized campaigns.

With the assistance of a predictive AI platform, growth teams can optimize their campaigns based on LTV data, combined with the payback they want, and when they want it—all for more significant and sustainable results in the long term. You can basically target more customers that align with the persona of your most loyal base, stemming from insights gathered from your zero-party data. 

Upon acting on futurespected insights gathered from the newly strengthened internal data operation, you will not only increase your ROI—you will also shorten your CAC payback period. That is because you’re acquiring users that are less likely to churn, and will be far more likely to purchase the premium subscription. These users will be more inclined to add products outside the subscription each month.

Check out the graph below. It demonstrates how a cohort’s ARPU affects the payback period. The light pink line is the original campaign - the month over month (MoM) retention is 75% (assuming it’s constant over months) - by focusing on high LTV users, who are less likely to churn - improving MoM retention to 77% (bright pink line) or 80% purple line - the payback period shortens from 9 months (light pink) to 6 months (purple) or 7.2 months (bright pink). The dashed line is at the CAC. This is just with a small improvement in retention.

So we established that shortening your payback period is important, and it is totally doable while also ultimately increasing your profitability. It’s basically a win for everyone—your team, your company, your investors, heck even your customers. If you haven’t already set things in motion internally, to shorten your payback period, believe me, you must, because going forward— it will be the only real way to drive sustainable growth.

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How your D2C can shorten payback period while increasing profitability

August 24, 2022
4 mins
Farhana Rahman

If a tree falls in a forest, and there is no one to hear it—does it make a sound? That famous philosophical question similarly extends to growth teams, albeit in a slightly different way. If you pay for a customer, but it is taking an excessively long time for their subscription revenue to exceed their cost of acquisition—are they being beneficial towards your company’s growth?

What I am referring to is the payback period. The longer the payback period (which refers to the time it takes for the customer to pay back their cost of acquisition), the longer it would take for profitability to kick in. The opposite also applies here—the shorter the payback period, the faster your company will grow.

With that in mind, we figured now would be a good time to go over how market changes have placed importance for D2C’s to shorten payback periods, which would naturally increase profitability much sooner.

These are the challenges being faced

Up until just a few years (months even) ago, companies thrived on the growth-at-any-cost approach. The numbers looked good, and investors were quick to give companies high valuations based on that growth that they saw on paper. It was like a lot of hype, which ultimately didn’t lead to profitability as customers would be quick to churn (ahem Peloton). Because of this both public and private investors pretty much universally decided that enough was enough, and focus needed to be placed on profitability instead of growth. Okay, cool. But what does that mean for growth teams?

{{banner}}

Well, the quick answer here is that marketing and growth teams have to perform the same or more with smaller marketing budgets. This calls for maximizing each marketing channel’s performance (in terms of ROAS and ROI). But here’s the catch—investors aren’t only interested in profits alone. I mean, obviously they made their investments with the educated understanding that big money will eventually be made. The question is… when will the ROAS and ROI kick in???

That. That right there demonstrates the need for growth teams to revamp their strategies, in a manner that would facilitate shorter payback periods, while also increasing profitability. Alternatively, we at least want to significantly improve the confidence in knowing what that period would be, for each marketing effort. This is all the more important when you consider the correlation of the scale and growth of companies, with their marketing cash flow. Time is money, and more emphasis needs to be placed on the payback period.

The importance of the payback period

The payback period has recently become more than just another metric to measure. In fact, it became an important metric for growth teams to optimize for—with the goal to have as short a payback period as possible. Granted, LTV to CAC ratios are also important. For some companies, depending on the industry and their stage, payback periods are critical because the faster the payback period, the less the need to raise money, and the more runway they have.

I know I’m going all out here, talking about the importance of the payback period, and it’s not for nothing. I mean, if you pay for a customer, you don't benefit from the acquisition until the customer's subscription (net!) revenue exceeds their cost of acquisition. Beyond that, the payback period determines the efficiency of your acquisition model.

That whole element of efficiency within acquisition models is also particularly important because misinformed campaign decisions get really pricey, really fast. 

How to calculate payback period

The most basic way of calculating the payback period is to divide the cost of acquiring a customer by the revenue they generate over a period of time. For instance, if it costs $100 to acquire a customer, and their subscription is worth $10 per month—that means  in 10 months they will have generated enough revenue to cover the cost of their acquisition: $100 / $10 per month = 10 months

Additionally, there is also the question of what it is that your company is wanting to diagnose and improve. Based on that you can calculate the payback period either with, or without the gross margin. The image below shows the respective formulas, and I’ll further elaborate right after.

Calculating payback without gross margin

It is simpler to calculate payback without the gross margin. 

CAC Payback Time = CAC ÷ MRR

Sometimes, figuring out the exact gross margin of a campaign is just operatively hard, as the data about margin's is often lagging (as it comes from a different finance system, and not in the data lake), as well as because companies often only track and record their average margins, and not per transaction/customer.

Calculating payback with gross margin

The biggest benefit to adding a gross margin into the equation here is that while it does increase the payback period, it also shows a more realistic number in terms of the profitability of your company’s customer acquisition efforts.

The equation for calculating gross margin is: GM = (ARR – COGS) ÷ ARR

And the formula to calculate the CAC Payback Time = CAC ÷ (ARR*GM%)

So what’s the best payback period for different verticals? This is not one-size fits all. After all, B2B’s have significantly longer funnels than D2C’s, which need to be accounted for. But to be honest (and this applies across the board), the best payback period is the shortest payback period possible. Based on our work with many D2Cs we can say that payback periods of two years were considered acceptable in the U.S. That later shifted down to one year, and now it is nine months. This is directly impacted by the cost of capital and rising interest rates.

Ways you can reduce your payback period

There are a few ways for D2C companies to reduce their payback period, with some approaches being a little more manageable than others. 

Reduce customer acquisition costs

You can start off by reducing your customer acquisition costs. That can be done by reducing marketing and sales figures. 

Increase average revenue per user

Another option is to increase the average revenue per user, per month (up sales/cross-sales, etc). If you decide to go this route, it would need to be done with lifecycle marketing, which can significantly boost ARPU and contribute to customers “repaying” your company sooner. And don’t forget—improving the ARPU directly affects MRR and ARR.

Reduce churn

Churn reduction is another way to reduce your payback period. I know I know, churn is inevitable. However, if you have enough customers who successfully cover their CAC payback in time and stay long enough afterwards, you will be able to maintain a positive revenue. As we mentioned in one of our previous posts, many D2C brands have updated their strategies, in an effort to ensure users would yield high LTV and loyalty to reduce their churn.

Optimize for high LTV users

There’s a ton of business value that comes from optimizing for high LTV users. This includes the discovery of audience potential, identification of the highest value customers, and ultimately—the optimization of revenue forecasts. We dove deeper into this in one of our previous blog posts

Now there are two ways you can optimize for high LTV users: either in-house, or with the additional help of an AI-based predictive growth platform. Ahem. 😇😉

There are few formulas that come into play should you decide to do this in-house. We thoroughly went over them in this post, courtesy of our very own data science team.

Now if you decide to turn to the assistance of a codeless predictive AI solution for greater efficiency, it will be quite the time saver for your growth team. With the backing of a predictive growth platform, you will be able to appeal to users who are less likely to churn, and that are expected to have a higher lifetime value—all based on your LTV data. In the case of one of our globally recognized D2C clients, predictive AI helped improve their ROAS by 30 percent, and retention by 81 percent, all through LTV-optimized campaigns.

With the assistance of a predictive AI platform, growth teams can optimize their campaigns based on LTV data, combined with the payback they want, and when they want it—all for more significant and sustainable results in the long term. You can basically target more customers that align with the persona of your most loyal base, stemming from insights gathered from your zero-party data. 

Upon acting on futurespected insights gathered from the newly strengthened internal data operation, you will not only increase your ROI—you will also shorten your CAC payback period. That is because you’re acquiring users that are less likely to churn, and will be far more likely to purchase the premium subscription. These users will be more inclined to add products outside the subscription each month.

Check out the graph below. It demonstrates how a cohort’s ARPU affects the payback period. The light pink line is the original campaign - the month over month (MoM) retention is 75% (assuming it’s constant over months) - by focusing on high LTV users, who are less likely to churn - improving MoM retention to 77% (bright pink line) or 80% purple line - the payback period shortens from 9 months (light pink) to 6 months (purple) or 7.2 months (bright pink). The dashed line is at the CAC. This is just with a small improvement in retention.

So we established that shortening your payback period is important, and it is totally doable while also ultimately increasing your profitability. It’s basically a win for everyone—your team, your company, your investors, heck even your customers. If you haven’t already set things in motion internally, to shorten your payback period, believe me, you must, because going forward— it will be the only real way to drive sustainable growth.

Farhana Rahman
Senior Content Manager

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