This is a powerful metric that can help you make smart spending decisions for your business, so it’s well worth the effort to dig into your numbers and figure out the CAC for your current business model.
What is customer acquisition cost, exactly?
As an entrepreneur, you know that you have to spend some money to make money. Even if you have an incredible product that the market desires, you still have to find ways to get in front of your target audience and convert them into paying customers.
Although there are some great ways to market and advertise for free or at low cost, capturing new customers typically comes at a price. In a healthy, sustainable business, the income you earn from the new customer will more than offset the cost of acquiring them.
The customer acquisition cost (CAC) is a measure of how much your business spends over a given time period to attract one paying customer. It takes into account all that your business spends on acquiring new customers, and how many new customers are actually gained over a given period of time.
Why is calculating CAC so important?
Knowing your cost of acquisition can help you make sure that you aren’t spending an unsustainable amount of money to acquire new customers. In the worst case, spending too much on customer acquisition can lead to a business having to shut down since they will not be recouping their cost.
However, even if your current CAC is sustainable, you might be able to improve the profitability of your business by reducing your cost of acquisition.
By calculating your customer acquisition cost you’ll be able to see just how much it costs you to gain a new customer, where the majority of that cost is coming from, and how you may be able to reduce your CAC and become more profitable. Below, we’ll discuss the different ways you can use your CAC to make decisions about your business.
It is also important to understand your customer acquisition cost if you plan to seek out business funding, such as a bank loan or venture capital. Your lender will want to know your cost of acquisition so that they can judge if your business has the potential to grow without running out of capital.
How to calculate customer acquisition cost
To calculate your CAC, you will need to add all of the costs associated with sales and marketing for a given period and divide this by the number of new customers gained over that period. The calculation is as follows:
CAC = sales and marketing dollars spent on acquiring new customers/number of new paying customers acquired over a given time period.
For example, if you spent $5000 this month on sales and marketing efforts, and managed to land 2000 new customers, your cost of acquisition would be $5000/2000, or $3.
In order to calculate the number of sales and marketing dollars spent over the relevant time period, there are a few different categories of spending that you should add together. These include:
- Advertising spend, such as money spent on pay-per-click ads, social media ads, email marketing spend, and paid influencer campaigns
- Sales-related costs, including salaries for inside or outside sales staff if applicable, bonuses and commissions, POS systems, and any software you may use to support your sales efforts
- Cost of travel associated with generating sales
- Office space for sales staff
- Content production costs, such as product photoshoots
The best way to calculate sales and marketing costs for your business is to look at all of your receipts for a given period and include all of the expenses that can be filed under sales and marketing in your calculation.
When it comes to identifying the number of new customers acquired, that is a more straightforward number to calculate. Take a look at all of your sales for the period in question, and make sure to subtract any repeat business. When calculating your customer acquisition cost, you’ll want to make sure you’re only taking into account new customers gained over that period.
In the example above, you may have made 2200 sales over the given period. If 200 of those customers are repeat customers, your CAC calculation will remain the same because you would only include the 2000 newly acquired customers in your calculation.
A cost of acquisition example
Imagine an ecommerce business that sells kitchen appliances. They are a direct-to-consumer brand, or B2C, so all of their sales are online rather than through retailers. Since this is their business model, they do not have sales staff. However, they may have to spend a lot on targeted Google ads and on campaigns with food influencers.
They could choose to calculate their cost of acquisition for a period of one month, one quarter, or even more. In our example, let’s say they are calculating their CAC on a quarterly basis so that they can compare it to the previous quarter and try to make incremental improvements. A simple customer acquisition cost calculation for them may look like this:
Website hosting and maintenance fees for ecommerce store – $1000
Email marketing fee – $4000
Google ad spend – $10,000
Facebook and Instagram ad spend – $10,000
Paid partnerships with food and cooking influencers – $5000
Ad campaign in upscale food magazine – $5000
Salary for employee handling all marketing – $15,000
Marketing employee’s expenses for their home office – $1000
Photographer, videographer and studio rental fee for product shoot to create images and video for web and advertising purposes – $5000
Total: $56,000
Over this quarter, they acquired 250 new customers. This means that the customer acquisition cost is $56,000/250, or $224.
That may seem like a high cost of acquisition, but whether this is a good cost of acquisition for this business will depend on how much revenue each new customer brings the company. This is why CAC is usually discussed in conjunction with customer lifetime value, or LTV.
Calculating the ratio of customer acquisition cost to lifetime value
As is the case with most business metrics that entrepreneurs take into consideration, CAC is most valuable when considered in relation to another metric. The ratio of CAC to lifetime value (LTV) is a far more valuable piece of information than just CAC alone.
So, what is your customer LTV? To calculate, go through the following steps for a given time period. Usually, a year is used:
- Calculate your average purchase value, or average order value (AOV). To do this, simply divide your total revenue for the period and divide it by the number of purchases.
- Next, calculate your average purchase frequency rate by dividing your total number of purchases by the number of customers for that time period.
- Now you can calculate your average customer value by multiplying the average purchase value by the average purchase frequency rate.
- Calculate your average customer lifespan by adding up the lifespans of all your customers and dividing this by the number of customers.
- Now you have all the information you need to calculate your customer LTV: just multiply your average customer value from step 3 by your average customer lifespan in step 4.
Your lifetime value tells you how much revenue, on average, each customer will bring your business over the course of the time that they are customers. The reason this is such a helpful metric when calculating customer acquisition cost is that a higher lifetime value can justify a higher customer acquisition cost.
Let’s go back to our example of a kitchen appliances ecommerce business. Their LTV calculation might look something like this:
- Average purchase value = $50,000/250 customers = $200.
- Average purchase frequency rate = 500/250=2. This means each customer made an average of 2 purchases per year.
- Average customer value = $200×2=$400 annually.
- Let’s say the average customer lifespan for this company is five years, with the same average customer value annually.
- Based on this information, the LTV is $400×5=$2000.
The ratio of LTV:CAC for this company, based on our example, is $2000:$224, or 8.9:1.
Since an LTV:CAC ratio of 3:1 or higher is considered healthy in most industries, this company has an excellent ratio. It is also generally considered important that a business can recoup its CAC within one year. This might not apply to some rare businesses with a very long sales cycle that can take more than a year, such as certain types of software businesses.
If a company that sold a $20 product with an average customer value of $60 per year and a lifetime value of two years, the CAC of $224 would be way too high, and they would go out of business. This is why the ratio of LTV:CAC is so important. It communicates whether or not your sales and marketing spend is justified by bringing in revenue and growing your business.
What affects my customer acquisition cost, and how can I make sure I have a healthy LTV:CAC ratio?
Many factors impact both your CAC and your LTV, so you can manipulate parts of your business to try to boost your LTV while lowering your CAC for a better ratio.
Reduce your CAC
When it comes to your customer acquisition cost, you can examine your sales cycle from beginning to end to see if there are parts that are costly and perhaps unnecessary. Look at all of the expenses that you included in your CAC calculation, and see if any of that money can be better spent or reduced.
For example, if you have an outside salesperson who is on the road visiting potential clients, you might be able to reduce that cost by switching to inside sales. This way, you save on travel costs and other expenses, such as trade show attendance, incurred by outside sales.
You can also break down your advertising spending by channel and examine your analytics to see which channels are most effective. You might be surprised that, for example, Instagram is providing a better return on ad spend, or ROAS, compared to Google Ads. In this case, you could transfer some of your Google Ads dollars to Instagram, which may boost your sales and reduce your CAC.
A/B testing, such as showing website visitors two different landing pages with two unique offers and seeing which page converts better, can help you make regular changes that lead to more sales conversions. Improving your website’s SEO may also make a significant improvement to your cost of acquisition.
Looking at no- or low-cost ways to get in front of more customers is another great way to reduce your cost of acquisition. If you don’t already have a customer referral program, this can be an excellent way to reduce your CAC.
Depending on the type of product or service you provide, you may even be able to provide free trials at low or no cost to you, which can be a great way to land new customers. Alternatively, offering free products to influencers may greatly boost the exposure of your brand to potential buyers.
Increase your LTV
Since we are talking about a ratio, you can also take action to impact the LTV side of your LTV:CAC ratio. If you increase your customer lifetime value, your overall ratio will improve.
If you have high churn rates, meaning customers only buy from you once and don’t repurchase your product or service, that may be a clue that you can take action to improve their lifetime value. Perhaps your customer satisfaction is low, and there are steps you can take to improve your product so that they want to remain loyal customers.
Alternatively, they may love your product but do not have choices for other things to buy from you. In the example of the kitchen appliances ecommerce company, if their only product is a high-end electric kettle, their customers might love the product but have no reason to buy from them again because the kettle will last them for many years. In this case, that company might greatly improve their customer LTV by expanding their product line.
They can also try to increase their average purchase value by up-selling and offering add-ons, such as specialty filters for the kettle or a mug set that can be purchased with the kettle. These add-ons increase the value of each purchase, increasing overall LTV.
As you can see, calculating your customer acquisition cost and your CAC:LTV ratio can empower you with information that lets you make smart decisions about your business. You might be wondering how you can apply this information if your business hasn’t launched yet, so you don’t have sales data.
In that case, you can still gather data to come up with reasonably informed guesses of your CAC and your sales data. When you write your business plan, you may already be collecting lots of data that is relevant to calculating a realistic potential CAC and LTV. Doing this in the early stages of setting up your business will give you better chances of maintaining a good CAC:LTV ratio from the beginning.
Keeping an eye on important business metrics such as customer acquisition cost is a key part of the job of any entrepreneur, no matter what industry you’re in. These metrics provide actionable data, information that can help when seeking access to funds, and warning signs in case there are changes that need to be made to your business model. Now that you know how to calculate your own cost of acquisition, you can arm yourself with the information you need to make the best choices for your business.
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