April 14, 2020 (Updated: May 4, 2023)
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There are a lot of costs associated with owning and running a business, especially when it comes to generating new customers. It’s important that you understand the expenses associated with customer acquisition as well as the return that you see on these investments so that you can grow your business in a way that is both profitable and sustainable. Read on to take a deeper look at customer acquisition costs and why they matter, how to measure them, and some strategies for improving and reducing them.
An acquisition cost is the amount of funds that a company needs to buy out a competitor or take over another firm, acquire a new customer, or purchase fixed assets. Here’s a closer look at the two main types of acquisition costs:
At its most basic meaning, an acquisition cost, sometimes called the cost of acquisition, is the final cost for purchasing an asset after accounting for any necessary expenditures, such as:
Though the cost of acquisition accounts for the all-in cost to buy an asset, it does not include the sales tax for the purchase. These assets could include anything from a piece of equipment to a piece of property. The finalized number assigned as the acquisition cost is often called the original book value of an asset because it gives companies a much more realistic view of the figures they’ll find on their financial statements compared to other methods.
Customer acquisition costs, commonly referred to as CAC, are the funds needed to increase brand awareness and introduce more customers to the services and products that a company offers. Some of the more traditional expenses that are associated with customer acquisition costs are:
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Customer acquisition cost is a metric that is growing in popularity among many web-based companies and advertising campaigns because it can be used as a direct reflection of your business’ future success. Investors and organizations alike use CAC to engage customers and track their progress through the buyer’s journey. Though both parties are using the same metric, they adopt it for different reasons:
It’s important to note that for most businesses, there is a period of time in the early stages of a company where money and time are being spent, but there is little return on this investment. Eventually, as brand awareness grows, companies are able to make this money back. That is when customer acquisition costs are the most useful.
There are three main reasons why understanding your customer acquisition cost is important:
LTV, otherwise known as the lifetime value, refers to the overall average revenue that a customer is expected to generate throughout their life (or duration of their account). When this number is compared to the customer acquisition cost, it helps you figure out how much money you should be spending to acquire new customers. It’s a good idea to calculate this ratio each quarter so that you are able to accurately and quickly determine if you’re missing marketing opportunities because you’re not spending enough or if you’re overspending per customer.
The formula for calculating the lifetime value to customer acquisition cost is:
LTV to CAC ratio = [(individual customer revenue – direct expenses per customer) / (1 – the customer retention rate)] / (the number of customers acquired / amount spent on direct marketing initiatives)
In most cases, if a company has an LTV to CAC ratio that is less than 1.0, than it is losing value. A ratio that indicates a company that is positioned for sustainable growth should usually exceed 3.0. Let’s calculate the lifetime value to customer acquisition cost ratio in an example to clarify its usefulness:
An eCommerce company has spent $10,000 on a marketing campaign that has helped them acquire 1,000 new customers. On average, each customer brings in about $50 of revenue and the direct costs associated with filling each order is around $30. The company is able to keep 75% of its customers each year. Here’s the math:
Customer contribution margin = $50 – $30 = $20
Lifetime value = $20 / (1 – 75%) = $80
Customer acquisition cost = $10,000 / 1,000 = $10
Lifetime value to customer acquisition cost ratio = $80 / $10 = 8.0x
The customer acquisition cost payback period is the amount of time that it takes for your business to earn back the money that was spent on acquiring new customers. The primary benefit of calculating the CAC payback period is that it serves as an indication of how much money and time your company needs in order to become profitable and continue to grow. Additionally, if the payback period is especially long, it helps you determine the need for reducing marketing expenses until you are able to earn back the initial investment.
Companies usually have a CAC payback period of about 12 months. You can use this metric to pinpoint what is and isn’t working in your company’s marketing strategy. Before you can calculate the payback period for your CAC, you need to know the average revenue per account (ARPA) and your gross margin percent. You can use this formula to calculate your company’s CAC payback period:
Customer acquisition cost payback period = CAC / (ARPA * gross margin percent)
A deeper look at your company’s customer acquisition cost usually requires that you determine your CAC ratio. This metric helps you calculate your profit margins instead of just your revenue. To effectively calculate and use your CAC ratio, you take your company’s gross margin, compare it to the costs of customer acquisition, and then track these numbers over time. You can calculate your CAC ratio by using this formula:
CAC ratio = [(the gross margin for quarter two – the gross margin for quarter one) * 4] / the marketing and sales expenses for the second quarter period
This formula focuses on producing an annualized number for your records.
There are several different variations for using customer acquisition costs as a metric, but the most basic form can be accomplished by simply dividing the entire cost associated with getting more customers (marketing expenses) in a specific period of time by the number of customers that were acquired during that same period. For example, if a company spent $1,000 on marketing over the course of a year and gained 100 customers over that period of time, their customer acquisition cost would be $10.
Here’s a closer look at the CAC formula:
CAC = (total cost of marketing and sales) / (the number of customers acquired)
Though the calculation is simple, there are certain caveats to consider before using it, such as when companies make investments in marketing initiatives that may not show immediate results. For example, a company could make an investment in early-stage SEO or market themselves in a new territory. Though these scenarios are fairly uncommon, they could result in unclear relationships when calculating customer acquisition costs. To address these types of situations and get more accurate numbers, it’s usually suggested that you perform multiple versions of a CAC.
There are two main elements that make up a customer acquisition cost:
In most cases, it’s unnecessary to add customer success costs to your customer acquisition cost calculations. This is largely due to the fact that the primary purpose of customer success costs is to expand revenue instead of acquire new customers. Because customer success is more of an aspect of sales, it is usually handled as a separate variable that can be used to optimize other equations, such as the CAC ratio. It is helpful here because it allows you to measure each independent acquisition team’s efficiency.
When it comes to determining the customer acquisition cost for individual marketing channels, there are essentially two theories:
For most marketers, it’s extremely important to find out the customer acquisition cost associated with each marketing channel. This allows you to identify the channels where you could stand to devote more marketing spend because they have the lowest CAC. The more of your marketing budget that you can allot to lower CAC channels, the more new customers you will be able to generate for a fixed budget amount.
The simplest way to do this is to create a spreadsheet where you list all of your marketing expenses for the month, quarter, or year (depending on how you’d prefer to do it) and then add these numbers up based on each marketing channel. For example, you could create columns for pay per click (PPC), SEO, and blogging.
Once you have determined how much you spent on each marketing channel, you can use a simplified formula, guess that each channel was equally effective, and assume that the same amount of customers were acquired through each channel. Though this method of averaging can be generally helpful, it is difficult to pinpoint which channel attracted which specific customers.
The ineffectiveness of this approach is made clear when you compare a marketing strategy that is relatively inexpensive to other, more costly marketing strategies, such as pay per click advertising. Using this method, you would see the cost to customer ratio on your spreadsheet for your pay per click efforts and unwisely assume that you should be funneling more money in this area. This isn’t really an issue for companies that sell physical products online, known as eCommerce companies, because conversion tracking on the platform shows which of the pay per click ads resulted in direct sales.
This tracking information can help you determine the value of the effort. To use it to compare the success of your pay per click campaign, make note of it in your spreadsheet. You can also use other tools, like customer analytics, to trace the buyer’s journey of paying customers back to their last impression and then attribute it to the sale. In other words, these tools allow you to identify which channel the customer interacted with before making the first purchase with your online business.
For instance, if a customer originates from an organic search result, you can infer that effective SEO led to that customer acquisition.
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Regardless of how effective your marketing efforts currently are, there are always things that you can do to improve your customer acquisition cost. Here are some methods that you can use to improve your company’s CAC:
You can increase the number of returning customers to your company by establishing some form of a CRM that increases customer loyalty, such as a:
User value really refers to a company’s ability to create or provide something that the user finds pleasing. This notion is grounded in the simple fact that customer satisfaction tends to have a positive correlation with a company’s retention rate. Essentially, you accomplish this by generating new ways to encourage existing customers to spend more money with your company. Some strategies for enhancing user value are:
In order for your company to have sustainable profitability, you need to have a customer acquisition cost that is lower than your customer lifetime value. It is generally believed that you should try to spend a maximum of 33% of your customer’s lifetime value on customer acquisition costs. Here are a few strategies for minimizing your CAC and maximizing your profit:
Producing quality content for a blog, site, or social media channel is a low-cost and extremely effective way to generate leads. Additionally, this marketing technique provides real value for your user and bolsters your credibility in the industry. Some examples of successful inbound marketing strategies are:
You can create cheaper customer acquisition costs by reducing the amount of time that it takes a prospective customer to engage with your product. Creating quality content has a lot to do with this, but it needs to be paired with effective follow-up strategies. For example, collect email addresses before allowing visitors to download an eBook, and then send an email connecting with the individual about your brand and products.
Evaluate your marketing and sales efforts to see which channels have the best return on investment (ROI). From there, you can take a more lean approach by focusing your funds on the channels that work best for you and your target audience.
Customer acquisition costs require you to spend money upfront, essentially operating at a loss until you’ve made that money back. Because of this, it’s important that you create value-based pricing models that allow you to recover your CAC as quickly as possible. This ensures that you can expedite your company’s profitability.
In order to create marketing channels and strategies that are effective, it can be helpful to break them down by each step in the process. This allows you to understand how each visit or interaction results in a lead, how many of those leads become opportunities, and which of those opportunities lead to customers. With this information, you can better understand where costs can be cut or reallocated.
There are a lot of variables involved with customer acquisition costs. In order to create and maintain a business that is both sustainable and profitable, it’s important that you understand all of these elements and how they affect your bottom line. Invest some time to evaluate how much money you are spending to acquire each new customer, and which marketing channels are showing you the highest return on this investment.
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