Customer acquisition and retention are important for any business, however, they are crucial for companies that operate on a subscription-based model. What makes their case different, is that it takes much longer for them to start making profit from a customer.
These companies invest resources in attracting leads, nurturing, and converting them, the same way as any other organization. However, with subscriptions, the ROI of this process is not immediate. There is a customer acquisition cost (CAC) payback period, and it’s length, along with other factors, is critical for the business’s revenue and overall success.
In this article, we will talk about the various ways to efficiently calculate, reduce, and optimize CAC payback period. So read on and take notes!
What Is the CAC Payback Period and Why Is It Important?
The CAC payback period refers to the time it takes for a company to recoup the money they spent on acquiring a new customer. In other words, it marks the moment the clients “pays off” their acquisition cost and the business starts making profit from them.
The costs involved in attracting new customers include marketing and sales budgets, employee salaries, software and tools costs, ads, PR expenses, affiliate fees, and so on. As these usually add up to a significant amount, to make an actual profit from the customer, the company has to be able to retain the client for long enough for them to exceed their “debt” and start contributing with revenue.
The CAC payback period depends on the industry, type of product, type of clients, and company specifics, and there is no universal benchmark. For SaaS, where the metric is most commonly used, the longest acceptable payback time is considered to be 1 year. However, this number can vary and be affected by different factors, including the way you calculate it.
For example, large enterprises that operate in the B2B sphere, can’t be put on par with small and medium businesses catering to B2C clients. The sales cycles for these two types of businesses are completely different, therefore,so is the payback time.
However, let’s look at some tactics that apply to most subscription-based businesses.
How to Calculate CAC Payback Period?
Depending on what businesses want to diagnose and improve, they can use two ways of calculating CAC payback time – with gross margin in the equation or without it.
Calculating CAC Payback Period Without Gross Margin
This calculation shows how efficient the customer acquisition process is both in terms of velocity and cost. It also allows companies to monitor the business’s growth.
The equation here is simple:
CAC Payback Time = CAC ÷ ARR
We already mentioned what qualifies as customer acquisition costs (CAC), however, make sure to add any other costs that apply to your business. If you want to learn more on how to calculate customer acquisition costs, here is another article on the topic.
The other value, annual recurring revenue or ARR, includes the overall number of subscribers multiplied by the average revenue per user (ARPU).
Calculating CAC Payback Period With Gross Margin
Adding a gross margin to the equation increases the payback time but provides a more realistic number. It shows the profitability of the company’s customer acquisition efforts.
The equation here is the following:
CAC Payback Time = CAC ÷ (ARR*GM%)
Business’s costs don’t end with acquiring the client – once they are on board, you have customer service expenses, product maintenance, and development. By adding a gross margin to the formula, you can understand how these affect CAC payback time, and obtain a more realistic overview of your revenue.
The equation for calculating gross margin is:
GM = (ARR – COGS) ÷ ARR
GM is estimated in percentages. The cost of goods sold (COGS) should include the already mentioned service and development expenses, as well as any other specific costs that apply to your business.
How to Reduce CAC Payback Period
Once you’ve done the math, you may find out that your CAC payback period is less than ideal. Even if you hit the 1 year benchmark, there may still be room for improvement. Reducing the numbers will enable you to boost revenue and increase your overall profits.
Also, better customer acquisition ROI means that you will be able to reinvest resources sooner and power up your business.
Here are some actionable ways to do it:
Reducing the CAC
The first step you can take is to reduce customer acquisition costs. If the expenses of convincing a new client to sign up drop, so will the CAC payback period. However, this is easier said than done.
There are, generally, two ways to accomplish it – by reducing marketing and sales figures, or by increasing customer lifetime value. One efficient way to work on both issues at the same time is to implement customer segmentation. Choosing this approach will enable you to better understand where your marketing dollars go to waste, and find out how to encourage customers to spend more and stay longer with your brand.
For example, most businesses use omnichannel customer acquisition strategies. By segmenting and analyzing your customers based on the type of channel and type of plan, you can identify which streamlines attract the best clients. You may find out that customers from some channels are easier to acquire and sign up for high-tier contracts, thus costing you less with shorter payback periods.
Improving the ARPU
The average revenue per user is an important metric for subscription-based companies. Improving it directly affects MRR and ARR, and can optimize the CAC payback period. If you make more money from your customers you will recoup your expenses quicker.
One way to do this is by revising your pricing. Companies often neglect the importance of how much they charge their customers, and skipregular strategy adjustments. However, as the marketplace constantly evolves, so does the customer’s perception of products. This can affect how much they are willing to pay, and if your company doesn’t respond to the changes, you may start losing money.
In addition, you can consider developing an efficient upselling strategy. This can significantly boost ARPU and contribute to customers “repaying” you sooner.
Encourage Annual Plans
Annual plans are probably the best way to handle CAC payback time. By encouraging customers to choose an annual subscription rather than a monthly one, you’ll receive what they’ll spend over a year in advance. Even if this doesn’t cover the complete CAC (although you should make sure it does) this will improve your working capital and enable reinvestments.
Furthermore, annual plans give customers enough time to familiarize themselves with your product, get used to it, and fall in love with it. You, on the other hand, have more time to understand their needs and deliver on them. This reduces the chances of them leaving once the year is over, and ensures that they will continue to contribute to your revenue.
Work on Retention
If too many customers leave before they manage to repay their acquisition cost, the company will be operating on a loss. That’s why it’s vital to take action to battle churn and work on your retention strategy.
A certain amount of churn is inevitable. However, what’s important is that you have enough customers who successfully cover their CAC payback in time and stay long enough afterwards. This way you will still be able to maintain a positive revenue.
Active communication with your clients will allow you to understand what makes people leave and what encourages them to stay. By keeping track of this, as well as monitoring usage behavior, and customer feedback, you may be able to improve retention.
Furthermore, you should invest the time and effort into improving the customer onboarding process. By ensuring that users understand your product well and take full advantage of its features, you will reduce the chances of them leaving for the wrong reasons.
Design Your Product for Viral Growth
Although viral growth can easily be named every business’s number one dream, the concept is often misunderstood. Virality doesn’t happen by accident – it has to be built-in into the product.
If you are designing a new product or revamping an existing one, building virality into the project can help your business grow fast and for a minimal cost.
The beauty of the viral model and the reason why we are mentioning it here, is that it costs companies almost nothing to acquire new customers. Existing clients introduce the product to their friends, and encourage them to try it. If the model is calculated well, the business can grow exponentially until it exhausts the market. And even then, the company can try to penetrate a new market and continue growing.
In this type of business model, the CAC payback time is minimal, because, as mentioned, it costs the company next to nothing to attract new clients. They still have to take care of customer service, maintenance, development, and other costs relevant to their gross margin, but with a low CAC, the numbers should remain in their favor.
Although it is really hard to achieve virality nowadays, it’s not impossible, and if your product calls for it, it’s worth the shot.
The CAC payback period is an important metric that can be used to estimate the overall health and growth potential of a business. Tracking it enables businesses to obtain a better overview of the customer acquisition process and whether it’s paying off or not.
Although there is no universal recipe to reduce customer payback time, there are a myriad of strategies that businesses can consider. Successfully implementing them will enable growth and increase the company’s working capital.