The priority for any marketer is to bring long-term growth to their clients. However, even the best marketers can fall victim to the collective wave of insanity where they lose focus on the long-term part of the equation instead of chasing growth at any cost. Whether due to excitement, ignorance, or inattention, markets are prone to making less profitable decisions.
Understanding customer acquisition cost (CAC) allows you to combine the roles of a world-class marketer with a world-class business person. It identifies the needed resources for a company to bring in new customers to continue to grow.
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Customer acquisition cost measures how much it costs to convert a possible lead into a customer. Businesses use this metric to identify their profitability by comparing how much money gets spent on attracting a new customer against how many customers the company acquires. If companies can reduce their CAC, it shows they are spending money more efficiently, resulting in higher returns of total profit.
If the inbound marketing program is successful, businesses don’t need to allocate as many resources to various ad spends generating poor-fitting leads if your content marketing results in high-quality organic leads throughout the day. Successful inbound marketing programs provide your sales team a healthy pipeline of leads to nurture and eliminate the need to hire more reps to achieve your quarterly quota.
A high-quality sales team can cultivate and retain relationships with satisfied customers, which can help generate new customers via written testimonials, reviews, case studies, and word-of-mouth to family and friends. If you can convert these leads to customers, you will obtain them without spending any money, allowing you to decrease your CAC further.
To create a plan for lowering your customer acquisition cost, you first need to understand the CAC formula used to calculate your existing customer acquisition cost.
The following formula applies for calculating CAC: Customer Acquisition Cost = Cost of Sale and Marketing / Number of New Customers Acquired. Consider the following expenses when calculating your cost of sales and marketing:
Ad spend refers to how much your business spends on advertising. For some companies, advertising is an excellent way to bring in new customers, but you must be investing in campaigns that will attract your target audience.
To determine if your marketing campaigns are getting a good return on investment (ROI), divide the revenue advertising produces by spending on the campaign.
Creative costs relate to expenses for generating your promotional content, including money spent on bringing in talent to promote your business or funds to buy lunch for a team meeting.
It’s tempting to look at employee salaries being too high. However, a great employee is always worth the investment. Alternatives to consider when trying to reduce salaries other than layoffs and pay cuts may include marketing automation and chatbots to improve overall productivity and supplement your existing workflow.
Even SaaS (Software as a Service) businesses need to spend money on upkeep and maintaining their products. If your company provides software, inventory upkeep includes funds spent on patches and updates to the user experience.
Production costs include any costs associated with physical content creation. For example, if you plan on producing a video in-house, you will need to purchase a camera, props for set creation, software for editing the video, and more. You would also include fees paid to a third party for video production.
Money spent releasing marketing campaigns to the public falls under publishing costs and can include magazine or newspaper ads, social media ads, and TV air time.
Technical costs include any technology your sales and marketing teams use. For example, a reporting tool that tracks the progress of open deals would go under technical expenses.
The first step in calculating customer acquisition cost identifies the period (month, quarter, or year) you want to evaluate. Identifying this period helps narrow down the scope of data you will use. Once you’ve determined your period, you will need to add all of your marketing and sales expenses. You will then divide this sum by the number of new clients you acquired during the stated period. The resulting value is your company’s approximated costs of acquiring new customers.
For example, say your business spends $600K on sales and $400K on marketing to generate 1,000 new customers during the first fiscal quarter. If we use the customer acquisition costs formula from above, the CAC for the quarter would be $1,000 ([600K + 400K]/1,000 = 1,000).
Once you calculate your customer acquisition cost, you will compare that value against other significant metrics. In doing so, you’ll uncover valuable insights about your customer service, marketing, and sales campaigns.
Let’s say you’ve been conducting ad experiments to identify which generates the highest revenue leading up to your company’s busiest season of the year. You are circulating three ads, and each ad resulted in 15 new customers. If you want to optimize customer acquisition, you may think each of these ads is an equal creation and continue to budget accordingly.
While simple customer acquisition metrics are easy and popular, they aren’t exact tools for scaling and calibrating your business for growth. To grow in a profitable and scalable way, you need to look further than simply customer acquisition and consider the following:
Let’s review our three ad examples closer. They all resulted in the same number of new customers, but looking at other metrics, we can see they aren’t producing similar results.
If you purchased 200 clicks per ad but paid various amounts for these clicks, you may start to see different results. Multiplying the number of purchased clicks by the CPC shows that:
While this information is helpful, it’s still easier for most marketers to look at per-customer costs. When we divide the total cost by the number of customers, we get a more accurate look at customer acquisition cost.
Closely reviewing these ads shows that while all the ads produce the same number of new clients, Ad #1 is doing so at a much lower cost. Simply by adding the cost metric into the mix, we understand which ad we should use more aggressively and which we should pause or stop entirely.
Simply focusing on the CAC can cripple your business if it’s not looked at as part of the whole equation. Spending money isn’t always a bad thing. In fact, for a growing business, this spending should be viewed as an investment. The revenue your company makes from a customer over the lifetime of them being your customer is called the customer lifetime value (LTV).
Many businesses look at LTV over one, three, or five years. Determining lifetime value for digital or newer companies without a great deal of historical data is more challenging. Still, it’s essential to understand this critical metric to use in decision-making as your company matures. A few variables are needed to calculate LTV:
Calculate this number by averaging out how many years a customer purchases from your business.
Calculate this number by dividing total purchases during the specified period by the number of distinctive customers buying items during the stated period.
Calculate this number by dividing a company’s revenue during the specified period (typically one year) by the number of purchases made over the same period.
Obtain this number by multiplying the average purchase frequency by the average purchase value.
Once you have identified all of these values, you will obtain the LTV by multiplying the average customer life span by the customer value. This number provides an estimate of how much revenue to reasonably anticipate the average customer will generate for the business during the lifetime of your relationship with them.
Thus, your LTV-to-CAC, or LTV-to-CAC ratio, is a quick indicator showing you the customer’s value relative to how much it costs you to convert them from a lead.
Companies use the LTV-to-CAC ratio to help guide their spending habits for customer service, marketing, and sales. A business needs to achieve the right LTV-to-CAC balance to obtain the most out of its investments. Ideally, you want to recoup CAC within one year resulting in a 3:1 LTV-to-CAC ratio. The LTV-to-CAC ratio shows your customers’ value as three times more than what you spent acquiring them.
When this value is closer to a 1-to-1 ratio, the ratio shows a company is spending the same amount of money acquiring customers as the customer is spending on their products. When the ratio is higher than the ideal 3-to-1 ratio, like a 6-to-1 ratio, it may indicate you’re not spending enough on marketing and sales and may be missing out on opportunities that may attract new leads.
When businesses understand what CAC and LTV are, including the individual components of each and how they relate to each other, they start to look at the three ads they once thought were performing the same.
Once you add lifetime value into the equation, you may understand which is the best ad and where additional money should be going. While Ad #1 may look like the initial winner with the value it adds to the company, it would be best to invest more money into Ad #2 as it contributes more value.
All this information may lead many businesses to wonder what a reasonable customer acquisition cost looks like, and the answer depends on your industry.
Once you understand the lifetime value, customer acquisition costs, and the LTV-to-CAC ratio, you can plan program budgets that best fit your needs. For example, it can help you decide when to spend more on acquiring new customers who are likely to stick around for a significant amount of time, and paying more during that time is an intelligent business decision.
Your allowable customer acquisition cost is the maximum amount acceptable to spend in acquiring a new customer. Your allowable CAC is essentially a pre-negotiated cap you agree upon with your finance team. When your LTV is higher, a higher allowable CAC is justifiable.
Explore some other dynamic ways of looking at the lifetime value and customer acquisition costs, along with some questions to ask yourself:
The possibilities are truly endless. However, don’t get caught up in too much micro-optimization. You could split your company into 80 dimensions looking for growth opportunities, or you focus simply on the larger ones and spend more time going out and doing your job.
While both lifetime value and customer acquisition cost are important components of your marketing plan, payback periods are another essential piece to consider. While many finance-focused individuals think about this metric many business-minded individuals, including marketers, make the mistake of hardly acknowledging it.
The payback period is simply the rate at which businesses get money from their paying customers and dictates how fast the company can reinvest back in the business. It should also be an essential component of calculating customer acquisition costs. Bottom line, it’s better to have money today, allowing you to scale and grow immediately rather than waiting for money five years from now.
Smaller companies typically grow with one channel or tactic, such as events. Using only one or two channels makes computing costs simple since everything is straightforward and visible. However, as your company grows and becomes more complex, you start to explore more channels and other ways for potential customers to interact with your business. You need to start thinking about customer acquisition costs in yet another way.
Larger, faster-growing businesses usually combine several tactics, each having its characteristics of customer acquisition costs, into a comprehensive marketing tactics portfolio. Some tactics will carry an extremely low CAC, such as a great blog or social post, while others can be quite expensive, such as bidding on competitor terms in Google Search.
When you understand customer acquisition cost marketing at a channel level, you are more likely going to balance budgets across various aspects of your company’s portfolio depending on the needs of your business.
Improving your CAC is one way to bring your LTV-to-CAC ratio close to the ideal 3-to-1 range. You can explore several ways to improve your CAC:
Work on increasing customer value by providing your customers with what they deem valuable. Collecting feedback from customers, whether it’s a free product, a product fix, or new features, are all ways to show you are doing your best to provide them with what they are looking for and why they continue to come back.
When an existing customer refers a warm lead to you from the individual’s network, the CAC will be $0 when the lead converts. Over time, these freebies help lower your customer acquisition costs. Building a referral program your current customers want to participate in is a win-win for everyone.
Your process of converting visitors into leads and leads into customers making purchases on your site must be straightforward and simple. Optimizing your website for mobile shopping and form submission, testing website copy, making sure it’s as clear as possible, and trying to establish a touchless sales process for your customers to use 24/7 are all important steps to take.
Decreasing the length of a typical sales cycle can help increase how many sales you can generate annually. Using prospecting tools and CRM (customer relationship management) software can help you connect with more warm leads.
Customer acquisition costs provide a great deal of information for your business. Adding LTV and payback periods makes the process more complex but provides a better comprehensive view of the process.
New businesses generally don’t simply choose to look at customer acquisition costs. After all, data tends to be inconsistent and messy since they’ve had limited time to accumulate quality data. It’s important to follow industry trends and add these components as soon as you can.
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