A new business or startup will immediately unfurl a “mission accomplished” banner and declare victory if you are able to market and sell your product, regardless of the costs.
But if your customer acquisition cost (CAC) is greater than the customer lifetime value (LTV or CLV) for your business, then you are on a slow path to failure.
So when you spend $2 per click on SEM and you get your first $99.98 sale, it feels great…Until you realize that you spent $200 to get 100 click-thrus that generated five leads and eventually a single sale. So you end up with one paying customer and a $100 loss.
But it could still work out nicely, if this one customer ends up buying more stuff from you and eventually generates more than $200 in sales for your business. In any case, the important thing here is to know how much you are spending to acquire a customer, and how much that customer is worth to you in terms of sales.
How to Calculate Customer Acquisition Cost
The simple math is that you can add the total cost of lead acquisition (CPL x No. of leads) and the total sales touch costs (sales team salaries, travel allowances, etc.) for a selected period, and divide the sum by the number of customers converted from leads during the same period.
CAC = [Lead Acquisition Costs + Sales Costs] / Number of lead conversions
In reality, it’s a bit more complex since each business has its own unique costs and marketing plans at every stage. For instance, you may be laying out a budget now for a search marketing strategy, but the ROI may start reflecting in the books only after 6-8 months. In that case, you have to apply this formula for costs and leads converted over the duration of a whole year in order to get an accurate CAC.
What you can do to make this whole thing easier is focus on what your CAC should be. Ideally, your CAC needs to be at or less than LTV/5 in order to sustain strong long-term growth, and you can survive as a startup even if your CAC is as high as LTV/3. We’ll get to the part about how to reduce your CAC, but it’s likely that the question now on your mind is – what’s my customer lifetime value?
How to Calculate Customer Lifetime Value
For new startups without past customer data that can be analyzed, the customer lifetime value is obviously going to be a projected figure. Specifically, the definition of CLV or LTV is the projected revenue that a customer will generate for your business over their lifetime.
If you want to keep this simple too, use our online CLV Calculator. Just input the values of the required variables, and it will give you your customer lifetime value.
If you want to do it yourself, use the spreadsheet. You can download it for free and modify it to match your requirements. The CLV formula used in the spreadsheet and calculator is explained below.
You need a selling price, which is the price customers are paying for a single unit of your product or service. If you have multiple or variable selling prices, then divide the estimated annual revenue by the projected annual units of products sold. This will be your average selling price (asp).
The second variable value you need is the purchase frequency (pf), which tells you how many times a customer is buying your product in a given period. This value you can calculate by dividing the total number of units sold by the number of unique customers you have sold the products to in that period.
Now all you need is the projected period for which you expect a customer to stay with you. Let’s say this will be n number of years.
LTV = (asp * pf * n)
Note that there may be upsell opportunities present that might unlock some more value with the same CAC, but that’s beyond the scope of our simple calculator. Another question you may have at this point is that you have no idea how long you can expect your customer to stay with you. This is where you need to know the churn in your customer pipeline. So the formula now becomes a little bit more complex. If you have a retention rate of 89% (which means your churn is at 9%), then you can calculate “n” as follows:
n= 1/(1-retention rate)
So with an 89% retention rate, your n would be = 1/(1-0.89), which is 1/0.11, or 9 years.
Continuing the aforementioned SEM sale, you start with a $200 CAC for a $100 sale. If the purchase frequency is once a year, you end up with an LTV that is ($100 x 1 x 9) = $900. This means that your ideal CAC would be LTV/5 = $180. But you spent $200 instead.
How to Reduce CAC
The issue now is about how to bridge the gap between your present and ideal customer acquisition cost. The two key issues you need to address to bring down your CAC are about targeting the right segments, and reducing churn.
Reduce Churn – Customer churn in a business means you have to acquire more new customers, which is always a more expensive proposition. So your CAC increases and the LTV goes down. In order to reduce churn, you need to allocate more resources to customer support, outreach, loyalty programs, etc. to ensure that existing customers are satisfied and engaged.
Buyer Personas – It’s a waste of resources if you are contacting and trying to convince people who are not in need of your product and unlikely to buy it. You need to identify and target the right audience to generate qualified leads, and this in turn requires you to create a buyer profile or persona.
It’s a process where you create a detailed description of the attributes of one or more ideal customer types, so that you know exactly what segments your marketing campaigns need to target. Doing this will reduce your CAC, and these ideal customers will also be the ones who will be more loyal and increase your LTV.
The bottomline here is that in order to reduce your CAC, you need to calculate and know your current cost of customer acquisition. Create buyer personas, and target the right prospects with a new and improved customer acquisition strategy to increase lead conversions, and then focus on reducing churn.
Understanding both you CAC and your LTV is crucial in setting your marketing budget as you need to know how much to spend to acquire customers. Check out these 3 easy steps in controlling your marketing budget.