Customer acquisition cost explained by a CFO

Peter Sharkey in Marketing automation on 13th of Jun 2017
how to measure customer acquisition cost

Customer Acquisition Cost

Customer acquisition cost (CAC) is the metric companies use to calculate the spend required to win a new customer. It’s calculated by adding up your marketing and sales costs, then dividing that by the number of new customers acquired within that spending period. The metric isn’t limited to one type of company. SaaS and eCommerce companies, startups and enterprises, and even brick-and-mortar retailers benefit from knowing their customer acquisition cost. In this post, you’ll learn the ins and outs of this metric, which makes or breaks a business:

  • Why customer acquisition cost is important
  • How to accurately measure customer acquisition cost
  • Customer acquisition cost benchmarks
  • The biggest mistakes companies make with CAC
  • How to reduce customer acquisition cost

I’ll share from my experience as an interim, part-time CFO for eight different early and mid-stage SaaS businesses - including Autopilot - over the past eight years.

Why customer acquisition cost is important

Customer acquisition cost answers a simple question: “How much does it cost your business to win a new paying customer?” Your business could:

A) Spend more to acquire a customer than you earn from that customer

B) Earn more from a customer than you spend to acquire that customer

C) Spend and earn the same amount from the acquired customer, also known as break even

B is where you want to live. If you spend $1,000 to acquire a new customer, you want to be certain that the customer will deliver at least $1,001 over the duration of the relationship. Achieving this ratio, in which earnings from a customer are greater than the cost to acquire that customer means you have a profitable customer acquisition strategy and positive unit economics. On the flip side, if you only make $500 from a customer that cost you $1,000 to acquire, you have an unsustainable business model on your hands. Investors won’t want to join in your next funding round, and no matter how many customers you acquire, you’ll keep losing money. With that said, there are exceptions to the rule, which we’ll cover in the customer acquisition cost milestones section. For now, let’s crunch the numbers.

How to accurately measure customer acquisition cost

Here’s the formula to figure out your CAC:

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Marketing and sales costs include salaries, software tools, marketing programs and paid marketing spend. That new SDR you hired a few days ago? Add their pay to the equation. Recently bought customer journey marketing software? Count it. Some companies make the mistake of only factoring in what they spend on Facebook, AdWords, etc., but that doesn’t show the true cost of customer acquisition.

To accurately measure your CAC, you must factor in all of your marketing and sales costs. Once you add up your total costs, divide that by the number of new customers won. Say you want to measure your CAC for March. The equation implies that you should take your March marketing and sales costs, then divide that by the number of new customers won in March. This makes sense at first glance, but the reality can be more nuanced depending on your sales cycle.

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Let’s assume you have a 30-day sales cycle. To accurately measure your March CAC, total up your marketing and sales costs from March, then divide that by the number of new customers won in April. This approach factors in the amount of time it takes to acquire a customer.

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Your sales cycle may be 30, 60, 90, or even seven days long. Whatever it is, account for this variable in your CAC equation. Here’s a spreadsheet to speed up your calculations (hat tip to Brian Balfour).

Customer acquisition cost benchmarks

There’s no one-size-fits-all customer acquisition cost benchmark. Success depends on your particular business model and, more specifically, the ratio between your CAC and customer lifetime value (LTV). David Skok, a VC with Matrix Partners, suggests that “your LTV should be at least 3x the CAC, otherwise you need to raise prices or reduce costs.” I’ve seen companies raise their next round of funding with an LTV at least 2x the CAC, but 3x is a great target.

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With that said, early-stage companies can expect a high CAC as they are a) searching for product-market fit and b) building brand awareness. What’s important is whether your CAC is trending towards a sustainable target. Let’s say your long-term target is a $1,000 CAC, and you’re spending $5,000 to acquire each customer. If your CAC is trending down, you can start to model assumptions and test acquisition strategies to reach that long-term goal. Unfortunately, you won’t know what your CAC is going to be at the outset. You’ll have to tweak your model and assumptions along the way. In my experience, once you hit an annual run rate of $1-2 million, you’ll have better visibility into where your CAC will land.

The biggest mistakes companies make with CAC

There are two common CAC mistakes:

  1. Being too aggressive in what you think it’ll cost to acquire a customer. Say you structure a model where you plan on spending $1,000 to acquire a customer, but after a few months, you discover it actually costs you $1,500. You’ll run out of money faster than you anticipated. As a rule of thumb, lean toward a conservative CAC estimate.
  2. Running marketing activities without paying attention to the metrics. Pretend you’re about to launch a marketing campaign to a new audience based on attributes of existing customers that have a tendency to convert at higher rates. You have a $10,000 budget. Before you launch, you should set target metrics and determine a time period or intervals in which to measure the campaign’s success or failure.

After the time period passes, go back to the customer acquisition cost and lifetime value relationship. Is the lifetime value of the new customers the campaign brought in more than the amount spent on the campaign? Is it reaching 3x the CAC? Assess the success of that particular campaign based on the answer.

Use this same lens to evaluate your existing marketing programs. Consistently test your assumptions around where you’re investing to acquire customers.

How to reduce customer acquisition cost

Go back to the CAC equation: total cost of marketing and sales divided by new customers won. The way to reduce your customer acquisition cost is to adjust the variables of the equation, with the end goal of acquiring customers more efficiently. With that in mind, you have a few different options:

  • Reduce costs
  • Hold costs flat
  • Increase costs

Reduce costs by eliminating marketing and sales expenses but continue to acquire the same number of customers. You could cut ties with your PR agency, choose not to sponsor Dreamforce this year, stop using overpriced all-in-one marketing automation tools, or eliminate the AdWords program you launched last month. The risk here is that eliminating these costs could result in fewer customers. If both costs and customers decrease in tandem, your CAC may wind up the same.

Hold costs flat but focus on increasing funnel efficiency to acquire more customers out of what you’re already doing. Perhaps you could launch a lead nurturing program to re-activate cold leads? Or refine the targeting criteria on existing paid advertising campaigns? Or publish an on-site message to increase visitor-to-lead conversion rates? You have options that can increase customer wins.

Increase costs if there’s a brand-new marketing program you think will give extraordinary returns on the number of customers you acquire. This is the most risky out of the three. I recommend starting with holding costs flat while increasing funnel efficiency. Companies typically have holes in their customer journey that can be patched with a little time and attention. Want to learn more about customer acquisition? Here are 10 low-cost, actionable customer acquisition tips.

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