There are many financial and marketing KPIs that allow you to track the overall health of your business. They can give you the full picture of what you are doing well, and what can be improved. However, there’s one metric that can show you whether your business is going to make it or not, and that’s customer acquisition cost (CAC).
In this article, we’ll discuss how to calculate customer acquisition cost, and what measures you can take to reduce it, improve profits, and keep your business afloat.
What Is Customer Acquisition Cost?
Customer acquisition cost tracks the amount of money a company spends to successfully attract a new customer. The goal of measuring this KPI is to identify whether the price you are paying in order to stay in business and achieve growth is not higher than the return on investment.
Monitoring CAC over set periods of time allows you to understand how your sales and marketing initiatives are performing. For example, if expenses are rising or remaining the same, but the number of new customers is dropping, this means your CAC rates will also increase. This also means that eventually, it will cost you more to acquire new customers than the profits you’ll gain from them.
Thus, your company will be operating at a loss, and if this trend continues, you will be out of business soon.
You can technically measure the CAC of any firm, although it does vary on the industry and business model, product pricing, customer lifecycle, and customer lifetime value among other factors.
However, the companies that rely heavily on digital marketing can measure it more accurately since it’s easier to monitor the performance of communication channels and to credit them for conversions. This enables you to track every dollar as well and know if it was well-spent. Furthermore, you can monitor the conversation path of leads and customers and gain insight on how to optimize and reduce costs.
Customer Acquisition Cost Formula
Calculating customer acquisition cost is simple.
First, you have to decide what period of time you’d like to monitor. Traditionally, you should calculate CAC for a month, a quarter, or a year, and track the results regularly to identify any fluctuations. However, if you are just starting out, it’s best to do all three calculations. This will allow you to compare the results and look for clues on what changes cause the differences.
The formula for CAC is as follows.
You have to first add up all your sales and marketing expenses for the period of time you’d like to monitor. These include any resources you’ve invested in:
- PPC Campaigns.
- Offline Advertising.
- Social Media, etc.
Any other marketing and sales costs should be added up as well.
Once you have the total, you have to divide it by the number of new customers you’ve acquired over the same period.
The equation will look like this:
For example, if your expenses are $1000 and you have signed 100 new clients, then your CAC is $10.
Now, here is where it gets a little more complicated. This number alone doesn’t mean anything. One business can thrive with a CAC of $10, while another can be as good as dead.
That’s why there are other factors and metrics you should take into account and that will help you in deciphering the results.
Factors and Metrics Affecting Customer Acquisition Cost
Tracking KPIs can rarely tell you much without context. As with other metrics, how you calculate customer acquisition cost and what it means for your company depends on more than one factor.
Customer Lifetime Value
Customer lifetime value (CLV) refers to the profits you expect to make from a customer over their lifetime with your company. That’s what makes it so definitive to CAC – in order to know how much is reasonable to spend on a customer, it’s vital to know how much you can expect to make from them.
It’s commonly accepted that the golden ratio of CLV:CAC is 3:1. This means that your expected profits should exceed the investment in landing the customer three times.
If the ratio is lower, you’ll need to optimize your acquisition costs so that you remain profitable. If it is much higher, this means that you may be missing out on an opportunity to grow your business.
Calculating CLV is complex and involves other relevant KPIs, such as average customer lifespan, average revenue per user, profit margin per customer, average gross margin per customer, etc.
Business Model and Pricing
Businesses that operate on a subscription-based model can usually afford a higher CAC, because their customers pay smaller sums over a longer period of time. Once the customer “pays off” their CAC, they continue to bring in profits. Moreover, the profits may exceed the cost to attract them many times over.
Furthermore, it’s important to take into account how much your products cost. If your products are expensive, it’s acceptable to have high CAC rates, because it takes more effort to convince people to buy an expensive product. In addition, this may prolong the lead-nurturing process and increase your costs.
However, once the customer converts, the price they pay should make up for the investment.
On the other hand, if the products are inexpensive, it will become more expensive to acquire new clients than not to.
Another important and often overlooked factor is the customer payback period. This is the time that it takes for the profits gained from the customer to exceed the expenses of attracting them.
The payback period length depends on the type of business you are running, the pricing model, the industry, the customer lifecycle, and so on. However, it is generally accepted that the maximum payback period for most businesses is 1 year.
Again, this depends on outside factors. For example, in the automotive industry, life cycles are long, because the investment is a substantial one. However, the payback should be an immediate one, because it’s doubtful that the customer will make another purchase in the next few years. And although the company may upsell accessories and other add-ons to the initial product, these are not expensive enough to make a significant change in the equation.
How to Reduce Customer Acquisition Costs
Generally, there are two ways to lower customer acquisition costs. You can reduce how much you invest in gaining a new client, or increase their lifetime value.
Reduce CAC By Limiting Sales and Marketing Expenses
One way to reduce how much acquiring a customer costs, is to limit your expenses on sales and marketing. However, this doesn’t mean that you should stop your efforts. Your goal here is to minimize unnecessary spending and to improve ROI.
- Adjust Your Targeting. Well-defined buyer personas are the foundation of efficient customer acquisition. If you are targeting the wrong audience, you will be wasting money and your customer acquisition costs will only increase. Knowing your ideal customer’s profile can improve the quality of the leads you generate and cost less time, money, and effort to move through the funnel.
- Improve Your Funnel. If your funnel is not optimized for conversions, you will be losing money and failing to nurture leads You should analyze how many prospects convert into clients. If the numbers are not satisfactory, perhaps you should improve your lead generation and lead-nurturing efforts.
- Eliminate Poorly Performing Channels. Digital marketing attribution modeling allows you to identify which channels contribute to a conversion. You can leverage this information to improve the ROI of campaigns, redistribute resources, and, ultimately, reduce CAC.
- Optimize Your Website for Conversions. By tracking the customer’s journey and analyzing the performance of pages, you can identify any weak points. Issues should be adjusted to provide a frictionless experience and accelerate conversions.
- Invest in Market Research. If you understand your customers, you’ll be able to improve your targeting, convert them more easily, and satisfy their needs more successfully.
Conducting market research is an additional marketing cost, and may increase your immediate CAC. However, it will help you reduce expenses by making your sales and marketing efforts more productive.
Reduce CAC By Increasing Customer Lifetime Value
The other approach you can take towards reducing your customer acquisition costs is to increase the lifetime value of your customers. This way, you will profit more from each customer and this will make up for any expenses involved in landing them.
- Provide More Value. By improving the quality of your products you can increase the amount of time a customer remains loyal to your business.
- Adjust Pricing. Many companies underestimate the role of pricing in growing a business and increasing CLV. However, even a small adjustment in the cost can have a significant effect on your revenue and the attitude of your customers. Conducting pricing research will allow you to find the most optimal way to charge your clients and improve their CLV.
- Segment Your Audience. By segmenting your customers, you can focus your efforts on those customers who deliver higher profits. This will also help you improve your high-end customer persona profile. Customers who pay more and stay longer with your brand have better CLV and can, thus, improve your CAC.
- Upsell and Cross-Sell. Customer lifetime value can be improved by upselling and cross-selling to happy clients. Explore ways that people can benefit from new features and additional products, and encourage them to upgrade.
- Improve Customer Satisfaction. Happier clients stay longer and spend more money. In fact, in a marketplace flooded with similar products, customers often choose the brand that delivers a better customer experience and will make them feel valued and cared for. You can consider using a CRM solution to optimize the way you manage customer communication and improve your relationship with your clients.
While CAC is not a stand-alone metric, at the end of the day, knowing how to calculate the price of landing a new customer may be the difference between staying in business, and not.
It’s vital to work on bringing in new leads and new clients to your business. However, this should be done in moderation and with certain factors in mind. Striving for growth at any cost may be a dangerous practice and can jeopardize your long-term strategy.
By regularly tracking your customer acquisition cost, customer lifetime value, and other related KPIs, you can ensure that your business remains balanced and healthy.