Investor Tip: Customer Acquisition Cost is Key

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 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 of 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 the 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 overspending 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.

RECAP

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.

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Featured Image Source: Getty Images/Martin Dimitrov

How to Develop a Sales Plan for Your Entrepreneurial Venture

Sales planning is a combination of both strategies and tactics necessary to achieve sales revenue growth within the company. The purpose of sales planning is to determine the expected volume of future sales to support business operations. A sales plan should be based in part on historical performance, but also factor a stretch or performance goal that considers new products, new territories, and changes in the marketplace.

A sales plan is direct and straightforward and focuses on how to identify and develop new customer sales opportunities as well as how do grow revenue opportunities from existing customers. Typically, the following four steps are used to frame the sales planning process:

  1. Establish a realistic revenue goal (What do you desire to achieve?)
  2. Identify sales opportunities (To whom are you selling?)
  3. Determine outreach approach (How will you engage and what will you say?)
  4. Set clear and measurable metrics (What will you measure and how frequently?)
Establish a realistic revenue goal

Sales planning must begin with a revenue goal. The annual revenue goal is this segmented and assigned to broad customer segments, such as new acquisition vs. existing or returning). Among the factors considered when determining how to apportion the revenue goals are historical sales performance for new customers vs. existing customers as well as customer satisfaction and customer churn rate (Gallo, 2014). Factors such as new product launches, the lifetime of a product, product or service pricing, and other similar things will often influence which segment gets the most substantial proportion of the revenue goal.

Identify sales opportunities

Once the revenue goal is established and the segmented by new vs. existing customers, the next step would determine how to identify sales opportunities within those segments. For both segments, an analysis of the customer’s needs, values, and expectations (NVEs) are essential, as is a review of the competitive landscape. The outcome of the analysis will shape the products and services offered, as well as the price position of those offerings.

With existing customers, the goal is to create deeper customer loyalty and increase retention. To do this, start with how to strengthen the relationship by meeting or exceeding the customer’s NVEs. Often this involves creating new insights for customers that support long-term goals and objectives. Usually, this means brainstorming new ideas and identifying new solutions and projects before the customer realizes or understands the need (Selling Power Editors, 2014). Determine if there are cross-sell (offering similar products) or upsell (offering an add-on or next-level product or service) opportunities with existing products or services, or if something different needs to be provided to strengthen the relationship. Then, create a sales goal for each customer based on those identified opportunities. These customer sales goals should roll up into the existing customer sales revenue segment.

For new customers, first, determine what an ideal customer might look like using the parameters of the current best and most profitable customers. Sometimes it’s helpful to create “buyer profiles” or “personas” to help identify what that best customer will look like in the marketplace. Then, identify prospective customers that align best with the products and services offered. Next, consider what would cause those potential customers to switch and whether the products and services provided will create enough value. Finally, establish realistic sales goals for new customers considering the market conditions and competitive landscape. These sales goals should roll up into the new customer sales revenue segment.

Determine Outreach Approach

Also known as the strategies and tactics of the sales plan, the outreach approach defines when, how, and the message used to reach each of the target customers and prospective customers. Given social media and online engagement have changed prospecting, some argue an excellent way to connect with potential customers be present in their communities (Haden, 2017). Identify the company first, if the prospective customer is a company, and then identify prospective buyers within the company. According to Inc.com contributing editor Jeff Haden, questions to consider when determining outreach approach include:

  • Are they on social media?
  • What’s their network of choice?
  • Are they involved in social media groups (e.g., LinkedIn or Facebook)?
  • Do they ask questions on Quora or Reddit?
  • Do they listen to podcasts? Which ones?
  • What blogs are they reading?

Gaining a better understanding of the prospective customers and their media consumption habits will help to define the strategies and tactics used to engage those prospects.

For example, considering the lists above, a strategy might be to provide value to prospective customers by becoming a trusted resource. Then, the tactics might be to engage in non-selling activities (i.e., conversation and Q &A) in social media groups, and answer questions on Quora and Reddit. Other tactics might be to develop a sponsorship program for the target prospects that includes the blogs they are reading (if possible) or the podcasts to which they listen. And, of course, some prospective customers do not engage with online media or do so sparingly.

Another strategy might be to incent the sales staff or offer customer incentives to increase sales. If a strategy is to increase sales by 20% during a calendar quarter using incentives, for example, tactics might include referral programs, price discounts or promotions, sales team bonus, or increased commissions for the period (Frost, 2018).

While the outreach tactics will depend upon the nature of the offering and the engagement preferences of the customers and prospective customers, ideally the engagement should include multiple channels. Creating a continuity of contact campaign or program that defines the frequency of contact, the channel of engagement (online, email, phone call, personal visit, trade show, podcasts, blogs, etc.), and the message strategy can be very useful in moving a customer through the sales cycle to purchase. Technology, such as sales force automation systems or CRM tools can be beneficial for tracking and keeping up with engagement campaigns and programs.

Set clear and measurable metrics

The sales plan must establish metrics and milestones against which to measure performance progress. Moreover, that progress needs to be measured frequently to ensure the plan is on target, and if it is not on target, what needs to be done to ensure any shortfalls are made up before year-end. While many things can be measured, the most important thing to measure in a sales plan is total sales because it provides the top-line cash flow for the business.

For example, let’s consider, and sales goal is 1 million dollars. Based on the historical sales seasonality of the business, $200 thousand is expected during the first quarter, $400 thousand is expected second quarter, $300 thousand third quarter, and $100 thousand in the fourth quarter. Because of the seasonality of sales, the majority of the sales come during the first three quarters of the year. If sales are off during any of those quarter, it becomes harder to make up sales to meet the goal. Therefore, monthly milestones should be established to monitor performance and enact new programs as may be necessary if sales fall short.

Sales planning is as much an art as it is a science. While revenue targets can be established that are built on a solid foundation of research, customer and market needs, product and service offerings, and historical performance, there remain many variables that can affect the ability to achieve those targets. Market conditions, new competitors, pricing and delivery factors, and sales team staffing are just a few of the factors that are difficult to predict and may influence sales performance. Regular performance monitoring will allow for quick plan corrections and revisions and minimize variances from the plan.

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Supplemental Articles Resources

In addition to the references and links within, here are a few more supplemental resources that might be of use to you as you consider how to develop your sales plan:

The Value of Keeping the Right Customers by Amy Gallo

What is Sales Strategy  by Hubspot Staff

The Hubspot.com Staff provides a good overview of sales strategy and planning and offers case studies of sales strategies for Hubspot, Salesforce.com, and Shopify.

How to Create a Sales Plan in 7 Steps by Allison Potts

Allison Potts offers a step-by-step approach to developing a sales strategy and plan, covering everything from the benefits of developing a sales plan, to examples and ideas for execution. The article also provides guides and templates to use in developing your own plan.

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References

Frost, A. (2018, January 9). How to Create a Sales Plan: The Ultimate Guide. Retrieved October 25, 2018, from hubspot.com: https://blog.hubspot.com/sales/ultimate-guide-creating-sales-plan

Gallo, A. (2014, October 29). The Value of Keeping the Right Customers. Retrieved October 25, 2018, from hbr.org: https://hbr.org/2014/10/the-value-of-keeping-the-right-customers

Haden, J. (2017, July 12). How to Create a Profitable Sales Plan for Your Business: 10 Steps. Retrieved October 25, 2018, from inc.com: https://www.inc.com/jeff-haden/how-to-create-a-profitable-sales-plan-for-your-bus.html

Selling Power Editors. (2014, August 21). The True Purpose of Account Planning. Retrieved October 26, 2018, from sellingpower.com: https://blog.sellingpower.com/gg/2014/08/the-true-purpose-of-account-planning.html

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Photo by Daria Nepriakhina on Unsplash

Introducing the Working Life Project Podcast

Since December, I’ve been putting a lot more time on my latest project, the Working Life Project podcast. As you might imagine, there’s a lot that goes into launching a new podcast and that, in part, explains the lack of content on my blog lately.

It’s also no surprise, then, that it took me a little while to put the finishing touches on the new website and work through some production issues. 

My goal with the Working Life Project is to capture the stories of America’s entrepreneurs and small business owners. It’s a conversational/interview podcast where I hope to find those things that make them tick and share, in their own words and sometimes with pictures.

On April 2, I launched the first full-length episode with Ahna Hendrix of Anahata Swimwear. I interviewed David Harris of David Harris Magic for episode two, and later this week I’ll launch release the third interview. New episodes will be released every other week throughout the first 10-episode season.

If you’re a regular reader of my blog, you may recall I interviewed several entrepreneurs for my graduate work in entrepreneurship. This was a catalyst for bringing my 2010 idea for this project into the 21st century with a podcast. So, a couple of those interviews will make it into this first season in some way.

I hope you’ll listen and share the podcast with friends. You can learn more and listen to the podcast online at workinglifeproject.com. You can also subscribe at iTunes, Google Play, Spotify, Stitcher, SoundCloud, or wherever you get your podcasts.