Sample Article: How cost of acquisition impacts the growth of your company

by Nov 28, 2022Uncategorized

The cost of acquiring a new customer (CAC) is critical for any business owner to measure and manage. Simply put, the CAC is the amount of money that a business spends to convince a new prospective customer to make a purchase. An excessive CAC can lead to decreased profitability, slower growth, and a serious cash shortage.  

In this article, we'll discuss how to calculate your cost of acquiring a customer and how it drives the health of your company.

The cost of acquiring a new customer

In general, any expenses associated with the sales and marketing process for acquiring new customers are included in the cost of acquisition. Expenses include:

  • Marketing, advertising, and lead generation.  
  • Personnel such as a marketing manager, sales reps, and respective management. 
  • Supporting costs such as sales tools, materials, samples, and marketing collateral. 

The simplest method of calculating CAC is to divide the total cost of sales and marketing for a period by the number of new customers acquired during that time. For example, a business spends $100,000 on sales and marketing over 12 months and acquires 100 new customers. Its average CAC is $1,000 ($100,000 / 100 customers). 

A more sophisticated approach with CAC is to segment sales and marketing costs by channel or campaign. Certain costs, such as management expenses, may be spread across all segments, while other costs, such as PPC, direct mail, or specific campaigns, can fall into particular segments. This type of attribution enables a business to identify high-performing channels for additional investment and low-performing channels to cut.   

Long sales cycles can make calculating and tracking CAC more difficult. A marketing campaign started in month one may not yield customers for a year or longer. Therefore, companies with long sales cycles should use more extended periods to calculate CAC. They can also measure and analyze the costs and results of specific stages of the sales process. For example, a business can measure the costs and leads generated by a one-month digital marketing campaign and compare the results to previous campaign results.

The cost of acquisition can also be segmented by marketing and sales costs. Marketing costs are typically focused on generating qualified leads and educating prospects at the top of the sales funnel. Sales costs are typically focused on converting prospects into new customers. The cost dynamics of marketing are very different from those of sales. For instance, increasing investment in marketing can drive up the marketing portion of CAC, while the higher volume of leads and sales can help reduce the sales portion of CAC.

Cost of Acquisition and Customer Lifetime Value  

Customer lifetime value (CLV) is the total gross margin a customer generates for a business over their relationship with the company. To calculate CLV, multiply the average gross margin per sale by the average number of purchases a customer makes over their lifetime. The calculation can also be based on time instead of the number of orders.

Customer attrition, the percentage of customers lost during a period, is key to calculating customer lifetime value. If a business loses 10% of its customers annually, the average customer lifetime is ten years. If a typical customer purchases $1,000 of goods each year, yielding $400 of gross margin, the CLV will be $4,000 ($400 GM x 10 YRS). 

Notice that gross margin is used instead of total sales to calculate CLV. Some businesses hold significant gross margins, whereas others are paper thin. Companies want to compare their gross margin to sales and marketing expenditures to understand the ROI. A CAC of $1,000 that results in a total spend of $10,000 may seem great, but not if that $10,000 spend only results in $500 of gross margin.    

Businesses typically don't want the cost of acquiring a customer to be higher than the lifetime value of a customer, at least in the long term. It would mean the business is losing money on each new customer. Therefore, companies should strive to widen the gap between CAC and CLV by either lowering customer acquisition costs or increasing customer revenue and gross margin.

Cost of Acquisition and Time to Payback

Sales and marketing can significantly drain cash, which is why Time to Payback is an important metric. The Time to Payback is the amount of time a customer must remain a customer to pay back the cost of acquisition. 

For example, a company's CAC is $1,000, the average annual gross margin is $400, and customer attrition is 10% annually. In this example, it will take 2½ years for the gross margin from a customer to pay back the cost of acquisition ($1,000 CAC / $400 GM). This time to payback may seem ok since the average customer lifetime is ten years. However, this scenario can quickly drain the cash of a growing company.

Let's consider a company that spends $10,000 each month to acquire ten new customers. Each customer generates a gross margin of $400 annually ($33/month). By the end of year 1, the company has spent $120,000 to acquire 120 new customers who are now generating $3,960 a month in gross margin (120 customers x $33/month). Only after 2½ years will the company reach 300 new customers generating ~$10,000 in gross margin each month. Even though the company reaches break-even at the 2½-year mark, it will be $145,000 in debt from the sales and marketing spend from months 1 through 30.  

In the above situation, the business could work to reduce the cost of acquiring a customer and increase the gross margin of the product or service to reduce the amount of cash tied up in sales and marketing. It could also lock customers into long-term contracts that can be financed or incentivize customers to prepay. While the first strategy helps to improve cash flow through profitability, the second helps through financing.  

The challenge of a growing business

Growing businesses face headwinds from both customer attrition and limited marketing channels. The larger a company grows, the more difficult it becomes to maintain the same annual growth rate.   

Customer attrition may not be a significant factor when a business is young and has a relatively small base of customers and revenue. However, once the customer base grows and matures, customers will begin to leave. If annual customer attrition is 10%, a business must replace the lost customers each year just to maintain the same revenue. If revenue growth is targeted at 15% annually, then the company must not only replace lost customers but sell an additional 15% on top of that. 

Maintaining growth in the face of customer attrition requires ever-increasing investment in marketing. Unfortunately, as a company increases its marketing budget, it will max out highly profitable channels and be forced to invest in less effective channels. For example, a company may purchase a monthly ad in the local business journal that produces several leads each month at a great cost per lead. Buying a second ad in the journal won't yield any additional leads - the channel is maxed out. The company still has available marketing budget and must generate additional leads to fuel growth, so it invests in the next best channel - radio advertising. As the company tries to allocate more budget, it invests in less effective channels, which drives up the marketing portion of CAC.

One solution is product-customer fit. As a business grows and improves its product-customer fit, more sales will be driven through word-of-mouth which helps to reduce the average cost of acquiring a customer. And as the product and service improve, customer retention should also improve, which increases the customer lifetime value and decreases the sales and marketing spend required to replace lost customers. 

It's difficult to justify significant expenditure in sales and marketing if the product-customer fit is weak because customer attrition will drive down profitability and customer lifetime value. However, businesses with a solid product-customer fit and strong CAC to CLV ratio should consider investing in sales and marketing to drive more revenue. 

Once a business begins investing more in sales and marketing, management should ensure CAC does not rise to an unacceptable level. They should also pay close attention to customer attrition to make sure that new batches of customers are a good fit for the product/service and do not have a higher attrition rate than existing customers. If CAC, CLV, or customer attrition gets out of line, it's time to stop and reassess the marketing channels and strategy.  

This article provides an overview of key sales and marketing metrics and is not a substitute for speaking with one of our expert advisors. Every business and market is unique, which is why it's important to meet with one of our advisors. If you would like to discuss how to track and improve your company's metrics, please contact our office.  

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