Many businesses know that there are at least three key operational elements that determine success: a solid team, a quality service or product and a need in the market. While all three are vitally important to having a successful business, there is another element that is often overlooked. Customer acquisition cost, or CAC, can have a direct impact on how a marketing plan is executed or how much it really costs to product signature services or products.
Failure is not a willing option for businesses, but it is definitely a possibility when leadership misunderstands how much it really costs to turn prospects into customers. Therefore, calculating CAC is essential before a marketing plan is developed.
It is crucial for businesses to understand the costs of acquiring customers and the direct link to growing a business. This single – but significant – number will guide marketing efforts and other strategic plans. Questions of whether to move forward with a new product or upgrade are answered if the costs to bring the product to customers exceeds production costs. Additionally, time is not wasted on non-effective marketing efforts.
Generally, acquisition costs apply to direct costs and fixed costs used to support gaining new customers. Businesses will know the actual expenses related to maintaining customer accounts.
There are many businesses that fail to consider the customer acquisition cost metric, but rather, will spend time scrambling for more customers. The amount of money being spent to reel customers in is not just overlooked, but it is not even part of the equation. The result leads to significant losses when the return on investing onto winning new customer accounts bears no fruit. Ignoring CAC metrics is bad business.
In addition, calculating CAC, businesses must determine customers’ worth to the organization. This involves projecting the amount of revenue each customer will generate throughout the business relationship. Known as lifetime value or LTV, this could equal a single transaction or multiple transactions.
Successful businesses will have CACs that are less than the lifetime value of their customers. Obviously, spending more to acquire customers than what is generated in revenue is not good financially for these businesses.
Likewise, different methods of acquiring customers may reflect different costs. Each method employed could lead to decreasing returns during any given period. Prospects are eventually converted to customers, which forces businesses to target more prospects that may be less inclined to buy the product or service. For this reason, businesses should utilize a cohort analysis to measure which marketing efforts are most productive by tracking CAC and LTV.
For the most part, this will depend on the established cost structure and strategic goals. Some businesses could have higher acquisition costs in the early stages of the business. Eventually, acquisition costs and revenues level off as businesses grow. There are no hard and fast rules to determine an ideal customer acquisition cost. Average ratios and formulas need to be flexible because there are many variables based on industry and nature of the business.
While rules are flexible, customer acquisition costs can be broken down into two categories: direct and fixed. Direct costs are attributable to the development of a product or service. These may include labor, materials and equipment that benefit specific projects. It is easier to trace these costs because each one is linked to a specific item.
Fixed, or indirect, costs are the opposite of direct costs. Generally, these costs will not neatly rise or fall with sales and production volumes. Fixed costs may include overhead expenses that must be paid whether the business is successful at selling millions of products or just one. The rigidness of fixed costs is a major factor in determining whether the business breaks even with acquiring customers.
Basically, businesses will need to list employee-related expenses such as:
Operational expenses that are considered include:
Contribution per customer is another important aspect to understanding acquisition costs. A sophisticated approach is first to recognize that different customer segments will have substantially different contributions to consider. How much each customer contributes annually will most likely change during the life of the relationship. Businesses may increase prices over time or gather information about customer preferences and tailor product or service offerings based on those preferences.
Businesses need a reliable formula to calculate the costs of acquiring new customers. The first part to factor is general overhead expenses for the product or service. How much expense is required to pay employees to facilitate the service, if applicable? Pricing units of products sold will also need to be part of the calculation.
This is a relatively simple process for well-established businesses. Basically, the costs of sales and marketing over a given period are divided by how many customers were acquired during the same period. Marketing budgets and salaries are included in these costs.
To illustrate, let’s look at how much it would cost a business to market and sell a new and improved widget. Total direct and fixed costs equal $500,000 during a 12 month period. The business gained 500 new customers during the same time, which cost $1,000 each to acquire based on total expenses to produce and market the improved widget.
$500,000 ÷ 500 new customers = $1,000 to acquire each customer
Calculating the lifetime value that each customer brings to the business employs a slightly different formula. Essentially, LTV includes gross revenues the business expects to earn from each customer over the course of the customer relationship. This amount includes supporting costs and the cost of goods sold. Actual amounts will vary based on the customer, but businesses should be able to track how much revenue is being generated. The key is to keep track of repeat business.
The formula used to calculate customers’ LTV includes:
A simpler formula to use is LTV = Net Profit ÷ Number of customers over a given period
Finding the right balance between CAC and LTV will let determine how well a business is doing in terms of investing in acquiring new customers. If the cost to acquire a customer is $1,000, a LTV of $10,000 is a good tradeoff. However, if profits for each customer are barely $100 during the 12 month period, this is obviously bad news for business.
Fortunately, a business has options in having a balanced relationship. One option is to increase LTV with customer retention efforts. Improving marketing and support services can create repeat customers and minimize efforts to find more customers.
Another option is to lower the CAC through a number of ways. The first way would be to decrease budget allocations for sales and marketing. For some businesses, this might seem like an easy way to change the balance. However, this could be the least effective approach. Cutting a marketing budget in half, for example, gives the business less money to acquire new customers. The end result could be acquiring only half the number of customers without really changing the CAC:
$250,000 ÷ 250 new customers = $1,000 to acquire each customer
This is a common mistake that many businesses make without even realizing nothing has changed. A better solution would be to redirect marketing dollars to more effective areas such as increasing web advertising since print ads generate very little business. Eventually, redirecting dollars could bring in more customers and effectively lower acquisition costs:
$500,000 ÷ 1,000 customers = $500 to acquire each customer
Businesses that operate solely over the Internet may see these numbers shift gradually over time. As the business continues to grow and gain more traction through its web advertising, the marketing budget can remain the same. More prospects are reached, which eventually leads to an increase of new customers. If human touch is required to sustain growth for a web-based business, overhead expenses will grow as the customer based increases.
Measuring customer acquisition costs is important for businesses because it can aid in strategic planning. Future capital allocations are easier to plan when marketing budgets and customer discounts are not a mystery. Generally, businesses should also consider prospects for customer loyalty and determine which customers are easiest to retain.
For the most part, businesses can depend on a specific number of customers to spend the same amount of money each year. Acquiring new customers is important, but it is not always enough to replace established relationships with loyal customers who come around year after year.
Differentiating between the two groups is the sweet spot that every business should try to achieve. Medium and long-term decisions about how much it costs to acquire new customers depend on these calculations. By using customer acquisition cost and lifetime customer value formulas, businesses can determine how much a customer is worth and whether that worth is enough for the investment.
Businesses cannot put a price tag on each customer, but they can assign a value. Doing so with careful precision can give businesses a tangible edge in a customer-based, technology intensive economy.
