June 15, 2016
Customer Acquisition Cost
Customer acquisition is a powerful, repeatable way of growing your business. However talking about it, and actually pulling it off successfully are two very different things. Here is how to make the math work, with a few real-life examples and expert tips on getting started.
Lower customer acquisition cost, increase customer lifetime value
One-time traffic bumps from big PR features are nice. Getting a few thousand hits from Hacker News makes your traffic count look fantastic for a few days. But neither are going to systematically grow your business. The reason? Those tactics are extremely difficult to scale; to pull off repeatedly like a well-oiled machine that confidently delivers new leads and customers on an ongoing basis. The most reliable way to acquire new customers, consistently, is through some combination of paid acquisition and sales. This is different from typical big brand advertising because it obsessively emphasizes two key ingredients:
- Customer Acquisition Cost (CAC): The initial cost outlay (both hard and soft) used to successfully convert a single customer.
- Customer Lifetime Value (LTV): The total revenue derived (or expected) from a single customer over the lifetime of their purchases.
The magic happens when your customer lifetime value exceeds your customer acquisition cost. That means you’re breaking even, comfortably, and are able to take the profit to continually reinvest back into your business. This formula is how subscription based businesses like Netflix are able to grow, despite only charging $8 bucks a month. Their lifetime value of each customer is actually a more promising $291.25. Even one-off companies like Amazon can optimize this lifetime value though, with Prime members reportedly spending $1,340 each year (which ends up being more than double the spend of non-Prime members). Here’s how both companies are able to optimize those numbers so well.
How Netflix and Amazon increase customer lifetime value
Facebook gets you to keep using their service by personalizing your News Feed to friends and family, while also sending frequent notifications through channels to bring you back to their app. This objective is similar for subscription based businesses like Netflix, where the goal is to reduce churn (or the amount of people canceling their subscriptions). How? They can tailor your recommended movie selection based on your previous history, helping to surface new material that appeals to you and beckons you to keep watching. Squeezing a few extra months out of each subscriber raises that lifetime value metric, which has allowed Netflix to reportedly spend at least $16 to affiliates in the past (even though that number is double the initial revenue they make per user per month). Amazon isn’t a subscription business per se. But they’ve been able to use similar personalization and notification techniques to keep Prime customers loyal, happy, and shopping frequently. With perks like free two-day shipping, and their latest same day delivery, shopping on Amazon is now easier than getting in your car and running to the store for an extra trip. The numbers illustrate the impact of these customer-centric developments:
These two examples also highlight the path to making paid acquisition work for your business: 1. Increase revenue per user: Ideally, you want to keep people around longer, and/or purchasing more/expensive things (thereby increasing the average order value and customer lifetime value). 2. Decrease costs of acquisition: Find ways to better optimize how you’re acquiring new customers to bring down your customer acquisition cost. Sounds great. Except, how should you pull it off?
Customer acquisition math, step-by step
Here’s a simple step-by-step guide to calculating your customer acquisition math, with a few tips from experts.
Step 1. Calculate your customer acquisition cost (CAC)
Start by looking at your total spend on sales and marketing for a specific month, quarter or year, divided by the number of customers acquired during the same time period.
Step 2. Calculate your customer lifetime value (LTV)
Next you want to figure out how much each customer is worth to your business. You’ll need decent customer tracking enabled, or at least some point of sale data to view repeat customer purchases. Add up these numbers over that same time period, multiplying by a gross margin for each sale.
Step 3. Measure those metrics against these two profitability rules
David Skok is a VC with Matrix Partners and writes the popular For Entrepreneurs blog where he dispenses detailed, actionable advice on a regular basis. OpenView recently interviewed him, where they dove deep into his two rules of thumb for SaaS businesses (that could also apply to most companies looking to profitably scale customer acquisition).
- Your LTV should be at least 3x the CAC, otherwise you need to raise prices or reduce costs.
- Try to get your CAC back within 12 months (the less, the better).
Step 4. Set up a realistic budget based on customer value
Your total marketing and sales budget can be defined as a percentage of first-year LTV, or Annual Contract Value (ACV) for B2B companies. However the actual percentage depends largely on your own personal growth stage, and cash runway. Jason Lemkin of SaaStr explains to OpenView: “One thing I do know: the common metric of sales plus marketing expense equals first-year ACV is a useful yardstick for SaaS businesses that are truly in the scaling phase. But you’ll need to modify it to match the cash coming in, and the cash on your balance sheet, to make it really work for your SaaS business.”
Step 5. Systemize your tactics to scale
Once you’ve done all the legwork, begin to evaluate and systemize’ your process for aligning paid tactics like Google AdWords or renting a booth at the next big trade show, with more lead generating and nurturing tactics like inbound marketing, conversion optimization, marketing automation and more. And that’s exactly what we’ll dive into in the next article of this series.