An aspect of lifetime value that is often neglected but could mean the difference between the ability to advertise (or not), are the costs associated with your game (or product for those outside the gaming space). As I have discussed in detail in the first seven posts on customer lifetime value (LTV), your lifetime value has to exceed to cost per install of a new user (CPI) to justify advertising. The LTV is a formula incorporating retention, virality and monetization. The other areas, though, that you need to look at are costs that lower the revenue stream from the user. These costs include hosting, commissions, royalties, support and credit card fees, though they do not include the actual user acquisition costs (since you are using LTV to determine whether you should make an ad spend)
The cost drivers
- Running costs. The first bucket of expenses you need to incorporate into your LTV formula are tied to running the game and the marginal increase in those costs from a new user. The expense most frequently incorporated into LTV in this bucket is hosting expense. These costs generally scale with the number of users. Since you are probably calculating revenue on a daily user basis, you should look at hosting as the cost a player incurs in a day, which is your daily hosting cost divided by your daily active users. You may also want to incorporate support costs, since you can estimate the support overhead per user. If this cost is fixed (or you do not provide support), then you can drop this factor. Overall, you are trying to ascertain how your expenses will increase with a new player and deduct that cost from the players LTV.
- Payment processing. You must deduct the revenue share (some would say tax) that the platform keeps from your LTV. This would be the 30 percent payment for Facebook credits or equal payment to Apple for the App Store. It becomes more variable on platforms like Android where you may use different monetization tools that carry different fees. Fortunately, this is usually the expense most often already incorporated into LTV calculations.
- Software royalties. The third type of expense you need to account for are software costs and royalties tied to users or revenue. Many game engines, such as Epic’s UDK, are free to use but then charge a royalty on your revenue. Other software packages also cost more as usage increases. That royalty needs to be deducted from the lifetime value of your player, since you do not see the revenue.Many analytic packages, such as Kontagent, base their cost on the number of daily or monthly users. Others, such as Mixpanel, charge based on the number of events that go through the system. The variable element of these costs also need to be deducted from the lifetime value of your player.
- IP licensing. The cost of any third party IP also needs to be incorporated into your LTV formula. If you license the Star Wars IP and pay Disney/Lucas a 50 percent royalty, you need to deduct the payments due to Disney from your LTV. When calculating this expense, it is also crucial to understand and calculate using the revenue basis that you are paying the royalty on. There is a huge difference whether the royalty is paid on all revenue you receive, or revenue after you can deduct certain costs (such as the ones listed above or advertising).
Why care about these expenses?
A lot of game companies do not look at the above expenses and that could be a fatal mistake. As I have discussed in detail in the past, you should be using LTV to determine whether or not an advertising spend is profitable and what the expected ROI is. If you are not including your costs, you might be enticed to acquire a user who is actually not profitable after you deduct your payments to Epic and Disney.
It is also crucial to understand the impact of these expenses when deciding which software to use for development and / or operations and whether to incorporate a license. Too often, the impact of no initial fee or advance royalty gives the impression that there is no cost. When you launch your game, however, it may turn out that the cost is so high even a good product will not be successful. Thus, you need to war-game the expense in both your P&L and LTV estimates and see which software and software as a service (SaaS) are actually optimal.
Incorporate expenses into negotiations
You need to understand these costs before entering into agreements. Will the value of a property (such as Star Wars) lower your user acquisition costs enough to justify its expense?
Also, you should structure your deal in a way that minimizes the impact on LTV (which is in everyone’s benefit). For example, by paying a licensor a royalty on your net revenue after advertising, the royalty will never be the sole reason that a product that normally would justify advertising. For example, you are paying a 25 percent royalty and if the LTV outside the royalty is $2 and the CPI of acquiring a new user is $1.75, you would not advertise if the royalty is calculating on the gross revenue. However, you would advertise if the royalty is calculated on the revenue after deducting advertising. This is also an example of a win-win scenario, because the licensor does not receive any royalties in the first scenario, but is getting 25 percent of $0.25 in the second scenario, which over millions of users for months could be significant.
And vice versa
One last consideration is to remember this logic when you are on the other side of the table. If you are negotiating an agreement with a publisher or licensing your IP (maybe for another platform), keep in mind your future partner also must deduct your costs from LTV. You do not want to put a publisher in a situation where it would be profitable to keep advertising your game except the deal you negotiated turns it into a loss. Rather than negotiating a potential lose-lose, keep their needs in mind and perhaps negotiate a higher royalty on a different basis.
Remember the costs from Day 1
Just as with the other elements of LTV, costs should be incorporated at the point of the greenlight decision. Building to control hosting fees, choosing the right SaaS and development tools and deciding on licensing IP should all be examined for the impact on your LTV. By understanding and optimizing your expenses, you increase the profitability of your company and the chances of having a successful game.