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Customer Acquisition Cost: Why You Need to Calculate This Illuminating Financial Metric

Posted by Stephen King

Customer Acquisition Costs

"You can't manage what you can't measure."

This well-worn business saying attributed to Peter Drucker, the veritable father of modern business, holds truer than ever when it comes to the cost of gaining new customers, known in financial terms as Customer Acquisition Cost (professional service firms can substitute 'client' for 'customer').

Your business's Customer Acquisition Cost (CAC) represents the total price you pay to convert a lead into a sale, including the cost of research, lead generation and sales personnel.

Measuring and tracking CAC has gained popularity among businesses. Essential to predicting the imminent success (or failure) of new and established enterprises, understanding CAC and how to adjust yours will allow you to measure the amount your company can afford to spend on new customers.

Operating in the Numerical Dark

Online businesses can monitor CACs with the click of a button. Their owners have long understood the importance of tracking this metric. Although slightly more complicated to calculate, all businesses – regardless of type – will benefit from actively managing CACs.

According to the CMO Survey's February 2017 results, businesses on average spend 11% of their total budget on marketing. When considering CAC, marketing is only a thin slice of the pie. When you add several expense categories that come into play to acquire a customer, the price of each customer easily skyrockets.

Failing to measure CAC limits management's insight into the profitability of customer acquisition methods and, as a result, hinders business sustainability.

Do you know what your company spends per customer acquisition or how much revenue you gain from each customer acquired?

You can answer these important questions by determining your company's Customer Acquisition Cost (CAC) and Customer Lifetime Value (CLTV) and then putting the knowledge into action. Thoroughly answering these questions means more than calculating a couple of business metrics; you must also understand how the numbers you calculate are related and how they translate to active business decisions.  

You need to find a successful balance between the two metrics: how much your company spends to acquire each new customer and how much each customer's business is truly worth.

If you can calculate each customer's lifetime value and how much gross profit you make from each customer, then you can take an actionable approach to track your CAC. This ensures that you are spending enough to continue attracting new customers, while not over-spending. Learning to calculate these valuable key performance indicators and understanding the relationship between them will become invaluable to your company's success.

The Perfect Pair: Calculating Customer Acquisition Cost and Customer Lifetime Value

In order to manage your company's customer acquisition spend, you must be able to calculate the cost of current customers and how much you can truly afford to spend in order to ensure each new customer remains a profitable acquisition for your business.

Customer Acquisition Cost = Total Dollars Spent on Acquisition / Number of Customers Acquired

Measure CAC by calculating the total spent on acquiring new customers. This figure should include everything – not just marketing expense. Consider the total spend on items including:

  • Sales staff and training
  • Marketing Research Expenses
  • All Advertising: Pay Per Click, SEO, Social Media Marketing, Billboards, Radio, Television and Print
  • Overhead Sales and Marketing Expenses: Salesforce Salaries, Commissions and Onboarding
  • Trade Shows and Events
  • Marketing and Sales Software Expense

Every penny which could be considered necessary to convert new customers from leads to sales should be included in your total dollars spent on acquisition.

To gain a firm CAC value, look at the calculation over a period of time which makes sense for your company: weekly, monthly, quarterly or annually.

You can also look at these expenses by category to determine the effectiveness of separate advertising campaigns. To do this, calculate the total spent during that time interval (or ad campaign) divided by the total new customers acquired over the same period.

Monitoring your CAC on a set schedule will provide you with the most meaningful, easily applied numbers and enable you to spot trends and changes which you can use to indicate the success of your sales strategies and the health of your business.

Customer Lifetime Value = (Gross Profit / Number of Customers) x Years Customer Remains with You

Calculating your CLTV shows you the average amount your company can expect to bring in per customer. Determining this provides you with an actual dollar value per customer. Depending on your company's structure, it can be more or less difficult to determine CLTV. For example, companies which charge subscription-based fees can easily determine how much a customer will spend and how long the customer will remain a subscriber. Point of purchase companies, however, may have a more difficult time estimating these values and will need to look at averages over a period of time and several customers to determine a reasonable estimate.

Helpful Hint: When calculating CLTV, it is extremely important to remember to use your company's gross profit – not its revenue; calculating CLTV with revenue instead of gross profit will result in a greatly over-estimated CLTV.

Finding Financial Success in the Relationship between CAC and CLTV

Looking at the relationship between your company's CAC and CLTV will tell you whether you are spending too much, too little or just the right amount on customer acquisition.

Example 1 - Too Little:

If you have $30,000 in total company gross profit and 100 customers, and the average customer remains with you for five years, then CLTV = ($30,000/100) x 5, and your customer lifetime value is $1500.

Over a year, this company only spent $15,000 to acquire its 100 customers. In this scenario, CAC = $15,000/100, which equals a CAC of $150.

When comparing numbers, you can see this company only spends one percent of a customer's lifetime value on acquisition, which leaves a hefty 90% margin. This means that this company can probably afford to spend more on customer acquisition to increase it's customer base and profitability.

Example 2 - Too Much:

A campus coffee cart, with $10,000 in gross profit and 1000 customers who remain for four years, has a CLTV of $40. If the owner spends $50,000 in advertising, sales wages and promotions over the four year period to get those 1000 clients, this equals a $50 CAC, more than the CLTV. This coffee cart is losing money and will go out of business if it fails to reduce its CAC.

A successful company should have a CLTV which is significantly greater than its CAC in order to remain profitable. If your CAC is greater than the CLTV, this means you are losing money on every customer and you must lower acquisition costs to become profitable and stay in business. Monitoring these two numbers on a regular basis will help you measure the health and success of your business.

Operate Like a Business Guru, Enlist Expert Advice

If like most business owners, you are more of a problem solver, people person, product person or idea person, then you probably do not have time to also be the numbers person. If, however, you fail to measure your business operations, then how will you be able to manage it and continue doing what you love?

Our professionals at GrowthForce are here to be your number experts. We can help you establish and maintain a management accounting department that works for your business by calculating, tracking and measuring all of the most important key performance indicators, such as job costing, gross profit and, of course, customer acquisition cost and customer lifetime value. To start managing your company by measuring the numbers, contact us today!

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