This post originally appeared on neilpatel.com
Customer acquisition cost (CAC) is a metric that has been growing with the emergence of Internet companies and web-based advertising campaigns that can be tracked.
Traditionally, a company had to engage in shotgun style advertising and find methods to track consumers through the decision-making process.
Today, many web-based companies can engage in highly targeted campaigns and track consumers as they progress from interested leads to long-lasting loyal customers. In this environment, the CAC metric is used by both companies and investors.
CAC, as you probably know, is the cost of convincing a potential customer to buy a product or service. In this article, we will explain the CAC metric in more detail, how you can measure it, and what steps you can take to improve it.
What Goes Into Customer Acquisition Costs?
- Advertising costs
- Cost of your marketing team
- Cost of your sales team
- Creative costs
- Technical costs
- Publishing costs
- Production costs
- Inventory upkeep
What the CAC Metric Means to You
As mentioned above, the CAC metric is important to two parties: companies and investors. The first party includes outside, early-stage investors who use it to analyze the scalability of new Internet technology companies. They can determine a company’s profitability by looking at the difference between how much money can be extracted from customers and the costs of extracting it.
For example, in terms of the upstream oil market, if an oil supply is in an area requiring heavy infrastructure investments, the amount applied to extract the oil may be greater than its market price per barrel.
Investors view Internet-based companies through the same lens. They are concerned with the current relationship, not on future promises of improving the metric unless they can be justified.
The other party interested in the metric is an internal operations or marketing specialist. They use it to optimize the return on their advertising investments. In other words, if the costs to extract money from customers can be reduced, the company’s profit margin improves and it makes a larger profit.
Investors are more interested in providing the company with the resources it needs, partners are more committed to growth, and the company can use the improved profit margins to pass the value to its customers for a greater market position.
How You Can Measure CAC
Basically, the CAC can be calculated by simply dividing all the costs spent on acquiring more customers (marketing expenses) by the number of customers acquired in the period the money was spent.
For example, if a company spent $100 on marketing in a year and acquired 100 customers in the same year, their CAC is $1.00.
There are caveats about using this metric that you should be aware of when applying it.
For instance, a company may have made investments on marketing in a new region or early stage SEO that it does not expect to see results from until a later period. While these instances are rare, they may cloud the relationship when calculating the CAC.
It is suggested that you perform multiple variations to account for these situations. However, we will provide some examples of calculating the CAC metric in its most pragmatic and simple form with two examples. The first company (Example 1) has a poor metric. The second (Example 2) has a great one.
Example 1: An E-Commerce Company
In this example, we take a fictitious e-commerce company that sells organic food products. The company spent $100,000 on advertising last month, and its marketing team says 10,000 new orders were placed. This suggests a CAC of $10, a figure that has no meaning in itself.
If a Mercedes-Benz dealer has a CAC of $10, the management team will be delighted when looking at the year’s financial statements.
However, in the case of this company, the average order placed by customers is $25.00, and it has a markup of 100% on all products. This means that on average, the company makes $12.50 per sale and generates $2.50 from each customer to pay for salaries, web hosting, office space, and other general expenses.
While this is the quick and dirty calculation, what happens if customers make more than one purchase over their lifetime? What if they completely stop shopping at brick and mortar grocery stores and buy from only this company?
The purpose of customer lifetime value (CLV) is specifically designed to resolve this. You can find a CLV calculator by simply searching in your favorite search engine. In general, this metric helps you form a more accurate understanding of what the customer acquisition cost means to your company.
A $10.00 customer acquisition cost may be quite low if customers make a $25.00 purchase every week for 20 years! However, in this ecommerce company, they are struggling to keep customers and most of the customers make only one purchase.
Example 2: An Online CRM (SaaS) Software Company
The company in this example provides an online system for managing sales contacts for customer relationship management. The cost of distributing the software is low since it is cloud-based, and customers need little support.
It is also able to easily retain customers because of the pain customers would experience uploading all the contacts, tasks, and events they are tracking onto a new CRM software.
The company has worked its way up the search engines and has an expert sales support team working for minimum wage, based out of their call centers in a rural Midwestern town.
The company also has many strategic partnerships that provide a steady supply of customers. In fact, they spend only $2.00 acquiring a new customer with a lifetime value of $2,000. Here is the calculation:
- Total cost of new customer sales support call centers: $1,000,000/year
- Total cost paid to strategic alliance partners per customer: $1.00
- Total monthly spending on search engine optimization: $20,000/year
Total new customers generated in the year: 1,020,000
Customer acquisition cost: ($1,020,000 / 1,020,000 customers) + $1.00 per customer = $2.00
As in our previous example, the amount is worth only the money extracted from customers. This company has used a customer retention calculation to determine its customer lifetime value (CLV) is $2,000.
This means this particular company is able to turn a $2.00 investment into $2,000 of revenue, which is attractive to investors and a signal to the marketing team that an effective system is in place.
What About CAC Per Marketing Channel?
Knowing the CAC for each of your marketing channels is what most marketers want to know.
If you know which channels have the lowest CAC, you know where to double down on your marketing spend. The more you can allocate your marketing budget into lower CAC channels, the more customers you can obtain for a fixed budget amount.
The simple approach is to break out your spreadsheet and gather all your marketing receipts for the year, quarter or month (however you want to do it) – and add up those amounts by channel.
For example, how much did you spend on Google Adwords and Facebook advertising? In this case, you might put this in a column called “PPC” or “Pay-Per-Click”. How much did you spend on SEO and blogging? This might go into a column called “Inbound Marketing Costs“.
Now that you know how much you spent on each channel, you can apply a simplistic formula and assume each channel “worked” to get the same amount of customers as the next channel. This would be an averaging method.
The only issue is that it can be difficult to know what channel is responsible for which customers. You can easily see where this approach becomes futile.
Say you only ran one Pay-Per-Click advertisement on one day – just as a test. You spent $10 total and that’s all. When you look at your spreadsheet, it will appear Pay-Per-Click would be the best marketing channel because of its extremely low CAC. It would be unwise to double down on Pay-Per-Click because you know you really didn’t utilize it all for that period of time.
For e-commerce companies that sell physical products, it’s easy to know what Pay-Per-Click advertisements lead to direct sales because of the conversion tracking the advertising platform provides.
In this case, you can determine that value and note this in your spreadsheet. This will give you a better idea of how your Pay-Per-Click campaigns are doing relative to the rest of your marketing spend.
Also, with tools like customer analytics, you can trace paying customers back to their “last touch” attribution source. This means you can see the last channel the customer visited before doing their first sales with your online business.
For example, if a customer came from an organic search result, you would know that SEO would be responsible for that customer acquisition.
Now, this is where marketing gets philosophical.
One school of thought is that each marketing channel supports the next channel – it’s a combined effort. Your blog posts reinforce your Pay-Per-Click ads, and all channels work together to bring in customers.
This is a common notion in outdoor advertising. Billboards reinforce T.V. campaigns, which reinforce radio spots, and so on. Ultimately it comes down to your own company’s philosophy on how to attribute customer acquisition.
If you feel that last touch is “good enough,” you can use that model for your CAC calculations.
However, you may have wildly popular viral videos (think Dollar Shave Club) or a blog that drives a lot of word-of-mouth referrals. These obviously support your overall marketing efforts and tend to be more difficult to track and attribute to customer acquisition.
How You Can Improve CAC
We all wish customer acquisition cost margins are like Example 2. The reality is that our advertising campaigns can always be more effective, customer loyalty can always be improved, and more value can always be extracted from consumers. There are several methods your business can use to improve its customer acquisition costs in its industry:
- Improve on-site conversion metrics: One may set up goals on Google Analytics and perform A/B split testing with new checkout systems in order to reduce shopping cart abandonment rate and improve the landing page, site speed, mobile optimization, and other factors to enhance overall site performance.
- Enhance user value: By the highly conceptual notion of “user value,” we mean the ability to generate something pleasing to the users. This may be additional feature enhancements/qualities that consumers have expressed interest in. It may be implementing something to improve the existing product for greater positioning, or developing new ways to make money from existing customers. For instance, you may realize that customer satisfaction ratings have a positive correlation with retention rate.
- Implement customer relationship management (CRM): Nearly all successful companies that have repeat buyers implement some form of CRM. This may be a complex sales team using a cloud-based sales tracking system, automated email lists, blogs, loyalty programs, and/or other techniques that capture customer loyalty.
Customer Lifetime Value
In addition to knowing your customer acquisition costs, you should also be interested in knowing your customer lifetime value. This infographic will help you.
Want to learn more about LTV? Check out this video:
Measuring and tracking customer acquisition costs is important for both investors and your company.
Investors can use CAC to help them decide whether or not they think your company is, and will continue to be, profitable.
Businesses can use it to allocate resources and funds, strategize marketing campaigns, and guide them in their hiring and salary process.
About the Author: Chase Hughes has six years of experience working in the consulting sector and three years in the private equity sector for large multi-nationals and emerging startups. He is the founding partner of a service that writes business plans for debt and equity capital for startups.
The post Customer Acquisition Cost: The One Metric That Can Determine Your Company’s Fate appeared first on Neil Patel.