Editor's Note: Today's guest post comes from Asher Elran of Dynamic Search. This piece is a bit more complicated than some of our usual fare, but it's a great one. Put your math pants on because Asher's going to drop some formula knowledge on us. Take it away, Asher!
Many businesses, especially startups, focus on three key operation elements. They know they need the proper team, a product or service and a fit in the market. While these are all vitally important, another major cost of doing business is Customer Acquisition Cost, or CAC. Many businesses fail because they don’t accurately understand just how much it actually costs them to turn a prospect into a customer. To make sure that those dollars are directed in the best way possible, it is essential to calculate CAC before building a marketing plan.
In addition to the CAC, you must also determine what each of those customers is worth to your business, in terms of the amount of revenue generated during your business relationship. This is referred to as Lifetime Value, or LTV, of the customer. For some businesses, this may be a single transaction, while for others there is the possibility of a long relationship, with multiple transactions over a period of years.
For a business to be successful, the Customer Acquisition Cost needs to be significantly less than the Lifetime Value for that customer. If you are spending more on acquiring each customer than they generate in revenue, it is obvious that your business is headed for failure.
Take a deep breath, we are diving…
How to Calculate Customer Acquisition Cost (CAC)
Computing CAC is relatively simple for established businesses. You take all of the costs for your sales and marketing program over a given period. This would include marketing budgets as well as salaries for all the staff in your sales and marketing departments. This number would then be divided by the number of new customers you were able to acquire over that same period.
As an example, if your costs for a given year were $50,000 and you acquired 500 new customers, the math is very straightforward:
$50,000 ÷ 500 customers = $100 to acquire each customer
It is recommended that the CAC will be = > to 4 (Month Revenue Per Client)
How to Calculate Lifetime Value (LTV)
The LTV for each customer would be the amount of gross revenue you would expect from that customer over the course of your entire relationship. This amount would also need to take into account any costs for supporting your product or services, as well as the cost of goods sold. While this will obviously vary with each customer, any business should be able to track how much revenue they are generating versus how many customers are generating that revenue. The key here is to be able to track repeat business, and to know how much each customer averages over the lifetime of the relationship.
LTV = Margin r/[1+i-r (1+g)] - ACQ
|Margin||Product contribution margin|
|i||Discount rate (if any)|
|g||Growth rate of a client|
|ACQ||Cost of acquisition|
Or for rough estimate and to keep it simple:
LTV = Net Profit / Number of clients over a period of time (usually 1 year)
Balancing CAC and LTV
At this point, comparing the two numbers will let you know how well your business is doing. If it costs $100 dollars to acquire a customer, an LTV of $1000 would be a good tradeoff. However, if each customer is only generating $25 in profit, this is obviously a business destined to fail.
There are two ways to keep this relationship balanced favorably. First, increasing LTV will make each customer more valuable. Customer retention efforts can help create repeat customers through better marketing and support. The second way to change the balance would be to lower the CAC.
Lowering the CAC can happen in a number of ways. The most obvious would be to decrease the sales and marketing budget. While this might seem the easiest or most expeditious way to change the balance, it might not be effective. For example, if you cut your marketing budget in half, and as a result you only get half the number of new customers, you haven’t changed the CAC at all:
$25,000 ÷ 250 customers = $100 to acquire each customer
(Very common mistake)
A better approach would be to redirect the marketing dollars into areas where they are more effective. For example, if web advertising is highly productive, whereas print ads aren’t generating much business, shifting the dollars may mean more new customers, and a lower acquisition cost:
$50,000 ÷ 1000 customers = $50 to acquire each customer
(The shift many businesses are doing to improve CAC)
For a purely web based business, these numbers may gradually shift over time naturally. As the business grows and gains traction, the same marketing budget may begin to reach more people, and thus result in many new customers. However, if a human touch is needed for each customer, then the head count will need to grow along with the new customer base. In that case, CAC might remain nearly stagnant.
So how CAC is being calculated before you even accumulated data?
In most cases, CAC will be an important factor when you have an investor inquiring about your startup. Way before you are even accepting clients, they want to know your CAC, LTV, revenue, and the whole nine yards of the business projections. How is that even possible?
First, let’s understand why they are asking for these numbers and why you as the business owners should be even more curious about this important information. The owner, the investor, and anybody else involved are all sharing at least one objective. They all want the business to succeed. While the owner/founder could let his inspiration and confidence in their company lead them, the investor needs more hard evidence to ensure that his money is going to be well invested.
If you ever built a business plan, you probably know what are financial projections. In order to project the revenue, expenses, payroll, etc., we need to make a series of realistic assumptions. Usually we need three of them to cover a wider range of possible scenarios.
Why CAC then?
It is very simple. CAC will help you understand if your business concept is strong enough to make money and enable growth. CAC would help you put things in perspective, estimate your marketing expenses, and help you estimate your revenue. Ask yourself, How much will it cost me to gain one client? And then ask, will X amount of clients cover 4 times the marketing expenses?
Suggested CAC = > 4(MRR)
CAC and Marketing Budgets
Web Marketing opens up whole new avenues to business marketing teams, but each of these approaches cost something. One of the biggest problems with starting a new enterprise is setting unrealistic expectations and goals. When the cost to implement marketing to reach these goals grossly outpaces the number of new customers generated, businesses fail.
Starting a new business takes a healthy dose of optimism. Many new business owners may have a great new product or service, but they wrongly think that people will be beating a path to their door to buy. Many times, a lengthy marketing effort is required before sales really get going. Many greatly underestimate the time, effort and expense that are involved. When this happens, marketing budgets can quickly outpace the value of the customers brought in.
Since a realistic idea of CAC is so vital, it is important that new companies not underestimate, or they may run out of money before they really get going. It would be better to overestimate expenses and have the CAC turn out to be less than expected than to have a marketing program run out gas due to lack of funds. For existing companies, there is a need to verify the CAC, maybe checking the calculations twice a year, at the very least. If there are real concerns, more often might be necessary, but avoid the trap of over analyzing.
CAC and Web Marketing
Fortunately, there are a variety of web marketing techniques that can help lower CAC. There has also been a change in buying patterns that can also work in favor of a web based marketing program.
Many people dislike dealing with salespeople. They would rather do their own research and make their own buying decisions. This can be leveraged to great advantage by a web marketing campaign, since each piece of your online marketing efforts can deal with many potential customers at the same time, as opposed to the one on one interaction of traditional sales.
Inbound marketing techniques can also be used to good advantage to get pre-qualified sales leads. Rather than having a team of salespeople making cold calls and reaching out to uninterested people, web marketing can make use of search engines and social media to identify and interact with people actually looking for your goods or services. By the time they actually get to you, they may already be set to buy.
However, this inbound marketing also comes at some cost. Businesses must provide good content, whether that is in the form of web pages, blog posts or white papers. They also need to do proper SEO to be sure that they are correctly indexed and displayed for key search terms. Having great content that other sites, including social media sites, want to link to will also extend marketing reach at little or no extra cost.
Social media is another avenue that shouldn’t be ignored. It is generally lower cost, but does require human interaction to set up, maintain and monitor. While the incidence of ads going viral is relatively small, there have been always a chance with well written and interesting content. In any event, by focusing on making content interesting and sharable, businesses can reach a far greater audience.
A note of caution is in order regarding social sites. It is vital for a business to realize that these are not the place people want to see a lot of blatant advertising. It does take some effort to join and participate, and businesses will do much better to listen first, and then share links to their non-sales oriented content as a way to help and inform.
Another avenue is to use paid search ads. These can be effective in the immediate term, but you need to pay for each click. This means that the cost of paid search programs grows as the scale of your business increases. They can be helpful to get started, especially when used in conjunction with proper SEO. SEO takes time to build and grow, but once that happens, increases in cost are minimal.
Other tips for reducing CAC
- Learn how to retain clients for a longer time. This will increase your LTV, which will help decrease your overall CAC
- Encourage referrals and within your existing clientele
- Learn what are your clients like about you and promote the same with new ones. It will help you gain new clients faster as you will be touching the exact pain point you current clients suffered from
- Utilize engagement with social influences – brand awareness
- Host a contents – brand awareness
- Conversion rate optimization
A web marketing program can be a great asset for virtually any business, but it needs to be carefully planned and monitored. The costs can quickly get out of control if they aren’t watched. You also need to be certain that you are getting your money’s worth, and that you aren’t paying more to acquire a customer than you are receiving in return. In order to properly plan, implement and maintain an effective web marketing program, it is vital to know and monitor your customer acquisition cost.