A conversation with an investor this week brought out that Customer Acquisition Cost is a key to his investment decision-making process. It occurred to me that many new entrepreneurs may not consider how important such a metric is for their venture, whether or not they are seeking investment. Customer Acquisition Cost is not just a measure to determine the average cost to acquire a customer; it is also used to determine the overall health of the business, the marketing budget, and the effectiveness of marketing and sales programs. For an investor, it will demonstrate the short- and long-term viability of the venture.
Let’s examine Customer Acquisition Cost in a little more detail.
CUSTOMER ACQUISITION COST
Calculating the customer acquisition cost (CAC) is not difficult. Start by totaling all of the marketing and sales costs for a period, and then divide those costs by the number of new customers acquired for the same period. Easy enough, right? Except that many entrepreneur’s—myself included—may miss costs in the calculation and do not get an accurate number against which to measure the customer acquired.
For a more detailed analysis of CAC, I think about spend and acquisition by channel. For example, in the chart below, I list the number of channels and further categorize them in measurable and non-measurable buckets. Measurable channels are those from which a customer’s purchase is trackable to the marketing or sales campaign, either through a link, a promo code, a special call-in number, or a sales order tied directly to a salesperson.
Non-measurable channels are channels which do not provide for an easily trackable source for a specific sale but are likely to contribute in some way to sales in general and should be calculated as part of the overall CAC. Brand campaigns might fall into this category, as would most promotional activities such as an entrepreneur’s speaking engagements, and networking events, to name a few. By adding the costs together and then dividing by the number of customers acquired for the period we arrive at an Average Customer Acquisition Cost.
One of the advantages to tracking spend and acquisition by a channel is the ability to determine which channel is most effective in generating customers. If, as in the example above, Inbound CAC is lower than PPC CAC, one might look more closely at the PPC campaigns to determine how and where improvements may need to be made if it appears those costs are out of line with expectations. But, how to do we determine what is reasonable? We need to calculate the lifetime value of a customer.
CUSTOMER LIFETIME VALUE
The Customer Lifetime Value (CLV) helps us determine the value of a customer over time. This helps us determine how much we can spend to acquire a new customer, and how much we could spend to retain that customer. The CLV estimate considers several key things: The average order value, the average number of purchases, and the average customer lifespan. The customer retention rate, average margin per customer, and a “discount rate” which adjusts the future profits from the campaign for the uncertainty of performance vs. investing instead in other business operations.
In the chart below, we estimate that a customer will have three purchases per year with an average order size of $35. We anticipate that the average customer lifespan is three years and we will have a 75% customer retention rate. Based on the particular product we have an average of 70% profit margin per customer. The discount rate in the example chart below is set to 10%; however, the longer future customer revenue is expected, the higher the discount should be to factor the greater possibility of inaccuracy.
We use three different LTV calculations in the chart above: A simple LTV which calculates the sales over the customer’s lifespan, a more customized LTV based on the average gross margin on sales over the customers lifetime, and the more traditional LTV calculation which incorporates the discount rate. Then we average the three methods to arrive at an Average Customer LTV. Using the data in the above chart, the Average customer has a value of $316 over his or her lifespan.
Now that we know our Customer Acquisition Cost and Customer Lifetime Value, we can determine whether our cost of acquiring a customer is reasonable given our assumptions, or if we’re using actual numbers, whether we may be over-spending or under-spending to gain a customer.
CUSTOMER ACQUISITION SUMMARY
Our CAC calculations indicate the average cost of acquiring a customer is $100.00. Our CLV calculations suggest that the average customer spends $105 per year. For most business types, an entrepreneur would want to limit the cost to acquire a new customer to approximately 30% of what an average customer spends in a year. Considering that the customer spends $105 per year, the target expenditure to acquire a new customer should approximate $35.00 as shown in the chart below.
The numbers used in this scenario suggest overspending on customer acquisition by about 186% more than necessary.
As a result of the overspending, the average customer is unprofitable the first year and reduces the overall profitability during his or her lifespan assuming the customer is retained as shown in the next chart. If the customer is not retained, the loss would be much greater.
In the scenario outlined here, the cost of acquisition is much too high and the possibility to recoup the investment over time is suspect. These factors would likely be a red flag for an investor.
Remember, Customer Acquisition Cost and Customer Lifetime Value will vary from venture to venture and industry to industry. Benchmarks are difficult to find, but using models such as these, a baseline can be established from which to work forward. As with all financial analysis, each entrepreneur should develop his or her own CAC and CLV models so that the specifics of the business are incorporated. To assist, I have attached the spreadsheet model to download and explore below.
Understanding the Customer Acquisition Cost is critical to business operations. Every entrepreneur should know what it costs to acquire a new customer and how those costs flow through the business in particular to the impact on marketing budgets, the effectiveness of marketing and sales expenditures, and overall business profitability. Spending too little for customer acquisition will result in missed opportunities, but spending too much will decrease profitability. Keeping track of Customer Acquisition Costs is a good first step in ensuring profitability, and it will likely play a role in a prospective investor’s decision-making process.
A few notes on this model:
- This model is an example and is for use as is. It is not supported in any way. It is not intended to be a tool to use without customization based on the specifics of an entrepreneurial venture.
- This model is only an example to give the reader an idea of how such a tool can be developed. It is not based on a real business. I compiled this model for a graduate class, but I have developed similar models for entrepreneurial ventures. Each business venture is different, and so is the CAC and CLV that are prepared for that venture.
- Most CAC and CLV calculations are done annually using actual numbers. This model can be used in that way. It can also be used for estimating and creating variations in the start-up phase of a venture. In the later situation, “what if” scenarios might be deployed to determine the outcome of different of customer acquisition costs or levels of lifetime value.
- This model is set up for annualized numbers; however, one could create a similar model with monthly numbers to track improvements over time.
- All of the “Bold Blue” text areas can be changed to demonstrate how the interactivity might work. No other data can be changed.
- Formulas can be seen in each of the cells (mouse over it), but only the values in the “Bold Blue” text area can be changed.
- By downloading you acknowledge this is for personal use only. It is not to be sold or distributed in any way.
Featured Image Source: Getty Images/Martin Dimitrov