Calculating customer acquisition cost and understanding it

While setting up a new business, entrepreneurs are more inclined towards acquiring new customers by any means possible. The most important insight they can gain for a successful business venture comes after understanding and calculating customer acquisition cost.

• Revenue is the lifeline of every business today.
• Loyal customers help businesses survive and generate referrals.
• Without these loyal customers, success will always elude businesses.

In the long run, however, such an outlook makes customer acquisition costs unpredictable and overinflated.

Calculating customer acquisition cost against customer lifetime value helps a business know the individual earning from their customers.

What is the customer acquisition cost (CAC)?

Customer acquisition cost includes sales and marketing costs incurred while acquiring a new customer for the business.

• Ideally, the less a business has to spend on acquiring a new customer, the better.
• Customer acquisition cost varies from business to business.
• Every business has its own niche and a distinct target audience.
• Customer acquisition cost is an important metric.
• It helps business owners determine if their business model is a viable one.
• If the business is having higher profits after deducting all the expenses, it’s a very good sign.

Businesses must match up to the acquisition cost against customer lifetime value. It helps in determining the overall costing of the business.

• Every business must understand their CAC as it helps them in investing wisely and scale their business.
• Determining expenditure is important for businesses.
• They get an idea of how much revenue is needed for better sustenance and growth.

What is customer lifetime value (LTV or CLV)?

As a business, how much revenue are you earning from a single customer?

• When business owners average out this figure across their customer database, the outcome becomes the customer lifetime value.
• It’s better to have a higher customer lifetime value.
• Longer a customer stays with a company, the more valuable that customer becomes.

LTV (Lifetime value) vs CAC (Customer acquisition cost) Ratio

• Speaking in general terms, the customer acquisition costs of a business should be at or less than 33 percent of their customer lifetime value.
• Comparing customer acquisition cost and customer lifetime value is important.
• It helps them in understanding the viability of the customer acquisition model.
• If customer acquisition cost of any business exceeds expected customer lifetime value, it is using a non-sustainable acquisition model.
• While calculating the LTV: CAC ratio, business owners must simplify the ratio.
• The lifetime value and customer acquisition cost will likely be large and uneven numbers, hindering the achievement of simplified ratios.

Important note: The costs associated with retaining customers must be evaluated later and compared against this LTV: CAC ratio.

How to calculate customer acquisition cost?

A simpler way for business owners to calculate customer acquisition cost:

Dividing the total cost of sales and marketing by the number of customers acquired after that expense.

For instance:

• Let’s say as a business you are spending $7,500 on acquiring 200 customers.
• Thus, the cost of acquisition $37.5 per customer.
• Customer-lifetime value is easy to calculate.
• Business owners have to add up the revenue earned from each customer and divide it by the total number of customers.
• Customer-lifetime value and customer acquisition cost ratio higher than or equal to three depict viable business model.

Customer acquisition cost formula

In this section, we will be showing how to calculate customer acquisition cost.

Mistakes in customer acquisition cost calculation

By now it must have become clear that there is no universal method that can help business owners calculate the customer acquisition cost.

• There is no standard method for calculating CAC across all industries which leaves a lot of room for errors.
• Most business owners underestimate the expenses necessary for acquiring a new customer.
• Overlooking certain expenses for a lower CAC is also a tempting error that business owners frequently commit.

Many freemium products or service providers avoid the cost of maintenance of such services while calculating customer acquisition cost.

A hypothetical customer acquisition cost case study

We are going to use a hypothetical productivity app called Beaker as an example for explaining customer acquisition cost.

• The Beaker team has a unique business model.
• The majority of their app contributions comes from other users.
• The exception of their special service research which is a paid subscription service.
• The team subsidizes the freemium content model with an advertising revenue model.
• We will be using round figures for easy calculations.

Beaker has around 1,000,000 free monthly users and 40,000 paid subscribers and growing. The paid subscription brings in recurring monthly revenue of $20 per subscriber.

Beaker: How to calculate customer acquisition cost

• For providing freemium content the costing comes to $2 million per year with annual ad revenues of $3 million.
• In the last quarter, sales and marketing expenses, excluding salaries, were $80,000.
• The sales and marketing team is comprised of 5 full-time employees with total salaries of $400,000.
• In the latest fiscal quarter, Beaker acquired 40,000 new paid subscribers.

With sales and marketing expenses of $200,000, the customer acquisition cost is calculated as:

Beaker: Calculating the customer lifetime value

• The Beaker team has an average premium subscriber that has continued to pay $20/month over the course of 3 years.
• Special service research is rather expensive to be done on a monthly basis.
• That leaves their profit margin at 5%.

The customer lifetime value for Beaker would be calculated as follows:

Beaker: (LTV: CAC)

• The Beaker team wants to calculate its LTV: CAC ratio.
• They have a customer acquisition cost of $5 and a customer lifetime value of $36.
• The LTV: CAC ratio would be expressed $36: $5.

In order to simplify this ratio, the Beaker team would need to divide the antecedent and consequent by a common factor, in this case, 5:

• 5/5 = 1
• 36/5 = 7

In this example, the LTV: CAC ratio for Beaker is 7:1.

• The common benchmark for LTV: CAC is 3:1.
• A higher ratio will mean the customer lifetime value exceeds the customer acquisition cost.
• An LTV: CAC ratio of 7:1 means Beaker generating 6 times the amount they are spending on customer acquisition cost.

Hence, maintaining a healthy business model.

How can businesses improve customer acquisition cost?

Businesses can improve their cost of customer acquisition by increasing the LTV: CAC ratio to more than 3:1. We are suggesting some of these strategies businesses can work on for improving their customer acquisition cost:

Investing in conversion rate optimization 

• Businesses must work on making the purchasing process smooth for their website visitors.
• They must make sure the process is simple for visitors to get converted into leads, and into paying customers.

Optimizing the website for mobile form submissions and shopping will help create a touchless sales process for the website visitors.

Adding customer value

• Increasing customer retention by providing value to their purchase.
• Businesses must collect customers feedback.
• They must fix their product and add new features to their service.
• Businesses must do their best for providing customers with what they ask for.

This helps in making the customers stick around longer.

Implementing a better customer referral program

• Have a loyal customer base that refers its contacts to you that proves to be a warm prospect.
• This is an excellent opportunity to lower their CAC as the CAC value on such customers is $0.

Building a better customer referral program for their loyal customers is a better idea.

Streamlining your sales cycle

• By decreasing the length of the typical sales cycle, businesses can effectively decrease their CAC.
• The faster they are able to generate revenue the faster they will cover their CAC.
• Using a CRM properly helps in prospecting and connecting with more qualified prospects.

It also helps in converting these prospects into paying customers in lesser time.

Wrapping it up

• We hope that this article will allow you to understand the importance of understanding and calculating customer acquisition cost.
• After getting the CAC, marking your business model as a viable one becomes easy.
• It has the potential for growth over time.
• The trick lies in understanding the customer acquisition cost formula. 
• There are ways and tools mentioned in this article that can be used for curbing the customer acquisition cost of business.

One such tool mentioned was the CRM (customer relationship management) software. Salesmate CRM is one such sales intelligence tool that can allow businesses to understand their entire sales process in a single glance.

The intuitive reporting can help them understand where the prospects in the current sales pipeline are, how many deals are on the verge of closure, and how many are stalled.

With all the smart features available at their disposal at a budget-friendly price, it becomes easier for the small and mid-size business owners to scale their business and handle their CAC. If you want to know more about the features of Salesmate, get in touch with us anytime and we will be more than happy to help you.

Learn how to maximize your LTV from Neil Patel in this infographic.