Are you starting a new business or launching a new product? Then you should know what your customer acquisition cost (CAC) is. Simply put, the definition of CAC is the cost of acquiring a new customer to your business. Regardless of your industry, acquiring customers underscores the success of your business. The metric is used in a variety of industries, but is most commonly used among SaaS and other subscription-based organizations.
Creating a loyal and growing customer base is an essential factor in safe-guarding your business health and longevity. This is why truly understanding the costs associated with acquiring a new customer has massive implications on operational decisions.
CAC vs. CLV: What They Are and How to Calculate
Both CLV and CAC metrics measure the relationship between the cost of acquiring a customer and the lifetime value of the customer. While both help drive business decisions, it’s the relationship between the two metrics that provides insight into whether the company is operating efficiently and profitably. The customer acquisition cost refers to how much a company spends to entice a customer to purchase the products or services offered. CLV, on the other hand, is the total amount of money expected from the purchase of products and services over the customer’s lifetime.
When your CAC is consistently lower than your CLV or conversely your CLV is consistently higher than your CAC, it’s a positive sign that your business model is successful. Alternatively, if your CAC is consistently higher than your CLV, it’s a red flag that your marketing and customer retention strategies may need to be reviewed and modified. Let’s look at how CAC and CLV are calculated and the metrics needed to ensure accurate figures.
Metrics Behind CAC
There’s some ambiguity about what metrics to use when calculating CAC, the two main metrics are sales and marketing expenses, and the number of customers acquired. The following provides a more comprehensive list of metrics commonly used to calculate CAC.
- Number of new customers: This figure should only include newly acquired customers.
- Cost amortization: While some customer acquisition costs are simple and straightforward, others are more difficult to attribute to a specific period of time. For example, long sales cycle times or acquiring customers from a conference or trade show that took place months before the prospect became a customer. A good rule of thumb in these circumstances is to amortize the cost over a 12-month period so that it accurately reflects the cost of acquiring the customer.
- Total sales and marketing costs: Explicit to the amount spent to acquire new customers, it typically includes program and advertisement spend, marketing campaigns, bonuses and sales commissions, employee salaries, etc.
- Time period: Used to narrow the scope of the data, choose a time frame for your customer acquisition cost calculation, such as month, quarter, year.
- Sales performance: This typically includes annual recurring revenue (ARR) and monthly recurring revenue (MRR) figures.
- Inventory upkeep: For SaaS companies, this would include product updates and for organizations that sell physical goods, the inventory cost would encompass storage, product handling, and shipping costs.
- Miscellaneous costs: These can include creative costs, e.g. hiring consultants/agencies, buying lunches, conducting training sessions, etc.; proof of concepts (PoC), publishing costs such as costs incurred to create a video or podcast; and costs associated with creating/developing the products or services you sell.
Metrics to Calculate CLV
- Average purchase value: The average amount spent in an individual transaction on your product or service.
- Average purchase frequency: This metric is the average number of purchases made over a defined period of time, such as one month or one year.
- Customer value: Consists of the average purchase value times the average purchase frequency.
- Average customer lifespan: The average number of days between the first order date and the last order date of all customers.
- Average revenue per user: This metric is the average revenue per user (ARPU) for your customer base over a given time period.
- Gross margin: This figure is net sales minus cost of revenue.
- Churn or attrition rate: Alternatively, referred to as customer retention rate.
- Additional metrics or key performance indicators (KPIs): Customer acquisition cost, average days between transactions, net promoter score (NPS), time to first response, time to resolution, etc.
Calculating Your Customer Acquisition Cost
Let’s now look at the various ways to calculate CAC and CLV. We’ll look at two calculations, the first being the most simplistic and the second a bit more complex.
Simple CAC calculation
CAC = (Cost of sales + cost of marketing) / (# of new customers acquired).
For instance, we’ll assume that in the previous quarter the company spent $75,000 on sales and $50,000 on marketing and during the same quarter, the company acquired 500 new customers.
The company’s CAC would be ($75,000 + $50,000) / 500 = $250.
Complex CAC calculation
In this quarterly CAC example, we will use the following metrics:
[wptb id="8209" not found ]We will also assume that the number of new customers acquired during this period of time was 300.
The CAC for the specified quarter would be: $1,320 ($396,000 total spend / 300 new customers).
Calculating CLV
There are several ways to calculate CLV, such as historical, predictive, and traditional. For the purpose of this blog, we will use one of the more straightforward formulas, but keep in mind you need the ability to predict future customer retention rates.
In this scenario, we will use three metrics – ARPU, gross margin, and churn.
CLV = ARPU x Gross Margin
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Churn
Let’s assume that for the specified time period:
- ARPU: $150
- Gross margin: $ 75
- Churn: 5
The CLV for this calculation period would be $2,250 ($150 x $75 / 5).
The CLV to CAC ratio provides a quick view of how much value customers are bringing to the company compared to their acquisition costs. With both CAC and CLV in hand, you have the foundational information needed to determine sales, marketing and customer service spend.
CLV:CAC Benchmarks
These figures are then used to calculate the CLV:CAC ratio, which provides a comparison between what it costs to acquire a customer vs. how much money the company will receive from the customer. So, what is a good ratio? Ideally, CAC should be equal to or less than the CLV of each acquired customer. If your ratio is 1:1, it means you are spending as much on acquiring customers as the money you will receive. However, if your ratio is higher than 3:1, you’re not spending enough on sales and marketing and could be missing opportunities to attract new customers. To stay competitive and profitable, SaaS companies should aim for a CAC ratio of less than 3x their CLV.
That said, if you are scaling your SaaS business the CLV:CAC ratio should fall between 3 – 5. A lower ratio may be an indicator that your product-market fit is lacking. A higher ratio – above 5 – points to an opportunity that you can and should invest additional funds in marketing and sales. A ratio of less than 1 means that your company is losing revenue on every customer and won’t be sustainable over the long run.
Common Mistakes in Calculating CAC and Best Practices
With so much at stake, it’s important that calculations are accurate. To this end, we’ve listed the top four most common errors made when calculating CAC.
- Including only marketing and sales expenses: While many websites cite CAC = marketing and sales expenses / number of new customers, it is a simplistic equation that doesn’t provide the entire picture. By not including other metrics such as sales performance, inventory upkeep, miscellaneous costs associated with acquiring customers, etc., you may be putting your company in jeopardy of operating under misleading financial information.
- Including costs associated with existing customers: Whether a new customer or existing customer, there are associated costs. The costs associated with customer maintenance or growing usage should not be included in the CAC calculation. Doing this will provide a higher than accurate CAC which may prompt you to decrease spend on marketing and sales initiatives.
- Including costs associated with new vs. existing customers: Let’s assume that your sales and marketing teams work on both new customer acquisitions and expanding usage of existing customers. If you include 100% of costs associated with both new and existing customers, your CAC will be higher than if calculated for just new customer acquisitions.
- Including cost amortization in a single time period: Some costs are more difficult than others to attribute to a specific period of time. For instance, leads from an industry tradeshow may take months to convert to paying customers. If you attribute the entire cost of the trade show to a specific month, your acquisition cost would be high compared to the number of customers acquired for that month.
CAC Best Practices
Designed to measure and maintain profitability, CAC is an important metric to consistently and accurately measure. To optimize the process, you need to:
- Streamline the purchasing funnel from both a marketing and sales perspective.
- Know how many leads move up the funnel to become opportunities.
- Know how many opportunities become customers.
- Hone your SaaS pricing strategy to ensure the shortest CAC payback period, while ensuring profitability.
- Achieve a CAC ratio of less than 3x the CLV.
- Consistently track, analyze, and optimize your CAC ratio.
Although measuring, analyzing, and optimizing the CAC metric can be challenging, there are some proven strategies to help you reduce CAC.
Strategies to Reduce CAC
It would be nice to have a silver bullet answer, but each industry has specific needs. Several of the most common ways you can reduce CAC and optimize profitability include:
1) Streamline the sales cycle
By shortening the sales cycle you can connect with qualified leads more quickly and effectively.
2) Reduce marketing spend
This can effectively be accomplished by:
- Reviewing previous campaigns and implementing the ones that captured the most leads.
- Optimizing existing campaigns to ensure they are effectively communicating with your target market.
- Leveraging social media platforms such as LinkedIn, Twitter, and Facebook for low to no cost marketing.
- Keeping websites, landing pages, etc. up to date for maximum search engine optimization (SEO).
3) Using content marketing
Lower cost marketing initiatives like blogs, videos, infographics, website copy, etc. can help reach your target market and convert them to paying customers.
4) Incorporating technology
By automating marketing functions with technology like artificial intelligence (AI) and machine learning (ML), your marketing team will be able to create more precise definitions of the ideal customer base, develop and deploy tailored messaging campaigns, track customer behaviors, including upgrades and churn, and be able to quickly scale to meet growing needs.
5) Offer free trials
While free trials don’t guarantee that a prospect turn into a customer and conversion rates vary between industries, it’s an effective way to onboard new customers while reducing CAC. Some of the top “free trial” conversion rates include Netflix (93%), Vimeo (60%), and Slack (30%).
4) Create a customer referral program
Referral programs increase brand awareness and strengthen existing customer relationships while allowing you to significantly lower your CAC.
5) Participate in events and conferences
While pricey, they provide the opportunity to interact with a multitude of potential customers who are already interested in your products or services.
6) Engage with prospects and customers quickly
By reducing the time it takes to get prospects and new customers engaged with your product, the lower the acquisition cost is per customer.
7) Review and modify your pricing strategy
Regardless of the industry, pricing is in a constant state of flux. Effective pricing strategies are even more critical for SaaS organizations where you need to maximize revenue and provide customer value, while effectively managing subscriptions. For example, you can offer usage-base pricing, tiered pricing plans, per-user/per-unit plans, volume-based pricing plans, or a combination. By offering pricing plans that provide different levels of service, additional functionality, product add-ons, etc., you’ll not only increase the overall value of the product but gain the opportunity to increase revenue received from customers and reduce CAC.
Optimize CAC and Achieve Higher Profitability
You want and need to get the most out of every dollar spent in acquiring customers. CAC and CLV provide the metrics needed to gain insights that will enable you to reduce churn, manage enterprise pricing, improve customer retention, and increase customer acquisitions – all at the lowest CAC possible. However, doing this requires a platform that automates revenue lifecycle processes.
BillingPlatform delivers the agility needed to easily adapt to any business requirement and any billing need. Our cloud-based revenue management platform supports any business model with any combination of one-time charges, subscription, consumption/usage, or hybrid-based billing all on a single platform, gives you the power to support simple to the most complex recurring revenue relationships, and monetize any revenue opportunity – all while delivering a frictionless customer experience.
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