Whoever said, it takes money to make money couldn’t be more accurate. According to a survey, businesses spend over 11% of their total company revenue on marketing.
But here’s something you need to know — Marketing is just one part of the customer acquisition puzzle. The actual customer acquisition costs (CAC) are even higher. You don’t just have to attract interested leads but also give them a reason to make a purchase and turn them into loyal customers.
Many brands have understood how to reduce their overall customer acquisition costs and set themselves up for long-term success. Lucky for you, we have put together the ultimate guide that can help you take your acquisition game to the next level.
In this article, we will be discussing what is CAC and how and how you can calculate CAC for your business.
What is Customer Acquisition Cost (CAC)
CAC is the cost of acquiring one potential customer. In other words, it is the total marketing and sales cost that is required to earn a new customer over a specific period of time.
Your company’s goal should be constantly reducing the CAC, not just because it leads to higher revenue, but also because it is a sign of good health for your marketing, sales, and customer service teams.
After all, if your inbound marketing program is working efficiently and you are able to generate high-quality organic leads then you wouldn’t have to dedicate extra resources and spend more money on running paid ads just to generate a few ill-fitting leads.
Finding the ‘ideal’ acquisition cost for your business
Of course, after understanding CAC, your first question would be — What is the ideal customer acquisition cost?
Well, there is actually no correct answer to that question. But we can help you in understanding what the CAC for your business will depend on:
- Monthly recurring revenue of a single customer (MRR)
- Lifetime value of a single customer (CLTV)
The CAC for your company will also depend on your business model.
Freemium: Companies like Spotify, Dropbox, and Trello offer freemium products or services. There is a free version of their product which is used to acquire and attract new users. There is usually a separate a paid version with extra features, that generates revenue for the company.
For a company working on a freemium business model, their free product is the main method of customer acquisition. So what you need to decide is whether you would want to include product, engineering, and support efforts in the CAC.
While your product engineers and support staff may be helping out with the free product, but they are still expenses that are necessary for new customer acquisition, which is why, you should take that into consideration when evaluating the CAC.
SaaS: If you have a SaaS company that offers digital products online, with or without free trials, then you need to consider how much you are willing to invest in your customer success teams.
When clients are paying for your online products from day one, they expect great service and even better customer support. Whether your customer success teams are more focused on acquiring new customers or winning back lost customers, you should include those expenses into your CAC.
Ecommerce: Ecommerce business don’t just need to consider the manufacturing or wholesale cost of their goods, but they also need to consider the packaging, shipping, and warehousing costs. If you are hosting your own website or listing products on marketplaces like Amazon, then it’s crucial to not forget about those expenses as well.
Understanding the difference between CAC and CPA
Before you go into calculating your Customer Acquisition Cost (CAC), you have to remember that it is not the same as Cost Per Acquisition (CPA). While CAC measures the cost of acquiring a paying customer, CPA measures the cost of acquiring something that isn’t a customer. That ‘something’ can be anything from registrations to trials or leads.
CPA is actually used to measure the leading indicators of CAC.
For instance, for a freemium SaaS product like Dropbox, CAC could be the cost to acquire a paying customer through any of its paid plans.
CPA, on the other hand, would be used to measure other factors like cost per registration or cost per free activated user. These are non-paying factors which signal that a visitor has become the user of the product.
Evaluating Customer Acquisition Costs
1- Calculate how much a customer is worth to your business
The first thing that you should evaluate is how much revenue on average does a customer generate for your business throughout their lifetime, which is also called customer lifetime value (CLTV).
Though you have to remember that the revenue every customer generates goes beyond the first sale. While a customer may bring in $20 of revenue by making their first purchase, but many customers will also go on to make more purchases in the future, which you need to consider as well.
So if a customer ends up buying five product on average, then each customer is worth $100 and that is CLTV for your brand.
To calculate CLTV, you need to know about two parameters:
- What is the total number of customers who have bought your products or services
- What is the total revenue generated
It’s best to choose a data range of over 12 months to analyse this data. Though, if you don’t have enough data, you can just go back 3 months as well
For example, if over the last 12 months, you made a revenue of $150,000 and you had over 1000 customers, then your CLTV will be:
$150,000/1000 = $150
While the above method is helpful when you have historical purchase data with you, if your business hasn’t started selling products yet, you can roughly estimate your CTLV as two to eight times the price of your initial conversion value.
So if your brand’s initial conversion value is $30, then a good benchmark for the CLTV would be anywhere between $60-$240.
2- Subtract refunds and cancellations
Now the next step is to evaluate how many of the customers ask for refunds or cancellations and subtract that from your calculated CTLV. If you have your CRM data with you, then you can accurately calculate refunds and cancellation rate from it. Though, in case you don’t have that data, you can consider 10% of the CLTV as the benchmark.
So, from our previous example, if the CLTV is $150, then the refund rate per customer will be 10% of CLTV, which is $15
3- Subtract the cost of goods sold
With this step, you need to deduct the cost of manufacturing and delivering your products from the CTLV. Of course, this will be different for online services and actual physical products.
If you offer online services, then you are paying for the servers to store and maintain your data. In the case of physical products, you should consider the warehousing and shipping costs.
For the sake of our example, we can consider the cost of goods sold as 10% of the CLTV calculated above, which will be $15.
4- Subtract Overhead Costs
Next step is to consider all the overhead costs that your business has to pay, apart from the costs of the products you are selling. These overheads can include accounting fees, the software you use for your business, payroll for employees, and other utilities.
You need to subtract your overhead from your CLTV. On an average, you can consider the overhead cost as 30% of the CLTV. For our example, the overhead costs would be 30% of $150, which would be $45.
5- Subtract profitability
At this point, we have subtracted refunds, cost of producing goods, and other overheads from the total revenue earned from a single customer (CLTV).
Let’s stop for a second here and calculate where we are at:
CLTV – refunds and cancellations – the cost of goods – overheads
$150 – $15 – $15 – $45 = $75
So, half of the revenue that you generated from a customer goes into creating and delivering the products to them.
But does that mean you can spend the other half in acquiring a new customer? Sure, only if you want to make no profit at all and break even for every customer.
That is why, the last step is to evaluate how much of a profit margin you want to earn per product. The correct profit margin will depend on your industry, current cash flow situation, and your business model.
While for physical products, your profit margin will depend on the manufacturing costs, for digital products, an ideal profit margin would fall anywhere between 20-40% of the CTLV.
For our example, if we consider, 30% of the CLTV as the profit margin, then we would make $45 from every customer and that would leave $30 from the CLTV which we can use to acquire a new customer. Going by the industry standards, $30 is a more tolerable and realistic customer acquisition cost.
Note that, while you might be inclined to increase your profit to 40% of the CLTV, but that would be $65 which would only leave you with $15 to spend on acquiring a new customer. It is not enough and that is why it’s important to come up with a realistic number when doing these calculations.
By now, you should know how to calculate CAC and figure out how your business can afford to acquire a new customer. Though, you should remember that CAC doesn’t have to be accurate. You can start with an estimated CAC value and then modify it with time.