As a business owner, you understand the importance of bringing in new customers, but do you know the actual cost of acquiring those customers and the actual value to your business they represent? The concepts of Customer Acquisition Cost, or CAC, and its close cousin, Customer Lifetime Value (CLTV), are critical to understanding whether the money you spend to attract new customers is ultimately a good investment for your business.
There are three calculations needed to understand the impact of CAC and CLTV:
1. The CAC Itself
In its simplest form, your CAC is the total cost of your sales and marketing activities divided by the number of customers you acquire during a specified period. Note that sales and marketing costs include more than just the obvious things, such as commissions paid to your sales team and spending for online ads. It includes travel expenses incurred when calling on prospects, the fees paid to have a booth at a trade show, the cost of conducting customer surveys, and so on.
Sales costs + Marketing costs / Number of new customers
For example, if your business spends $200,000 per year to support your sales efforts and $100,000 on marketing, and you gain 50 new clients per year, your CAC is $6,000 = ($200,000 + $100,000)/50.
To understand the impact of spending that money to acquire each new customer on your business, compare your CAC to the new recurring revenue that new customers bring to your company.
2. Customer Lifetime Value (CLTV)
This calculation, equal in importance to your CAC, captures how much recurring revenue you expect from new customers over the duration of their association with your company. The CLTV calculation requires only simple multiplication:
Average sale x Number of repeat sales x Average lifespan of a client relationship
The following example illustrates this concept. Assume your company provides IT services, your average signed contract generates $10,000 per month, and you retain clients for an average of five years. The CLTV calculation shows that the average client generates $600,000 in total, over the life of the relationship.
$10,000 x 12 Months x 5 Years = $600,000
How does your CLTV relate to your CAC? After estimating the lifetime value that a new customer will bring to your business, compare that to the cost of acquiring that customer. Your CLTV should be much larger than your CAC (usually by a ratio of 3:1, if not more). If not – in other words, if the CLTV does not justify the cost of bringing in that new business (CAC), you may need to rethink your pricing, sales and marketing costs, customer retention strategy, or whether your new customers are a good fit for your business.
3. Churn Rate
The third calculation you need in order to gauge the impact of your CAC is your churn rate. In business, you will always lose some customers, sometimes for reasons that are truly beyond your control. However, retaining as many customers as possible is usually in your best interest. Measuring churn gets at this notion because as the CAC number shows, it is costly to replace lost customers by acquiring new ones. There are two churn metrics you will want to track.
This first is your customer churn rate, which shows how well (or poorly) your company is doing at retaining customers. The customer churn rate is calculated for a specific period of time – one month is reasonable for many businesses and allows you to spot trends in time to fix problems before they become disasters. You do not want to let an entire year go by without measuring customer churn. The calculation is:
Number of customers lost that month / Number of customers at the start of the month
For example, if you start the month with 50 customers and lose five during the month, your customer churn rate is 10% (note that customer retention = 1 minus customer churn, so the retention rate in this example is 90%). Keep in mind the time period you use to calculate churn. While 10% may not sound terrible by itself, if you lose 10% of your customers per month, after a year only about 28% of your original customers will still be with you.
Note that despite having some level of customer churn, you would have negative dollar churn (that’s a good thing) if upsells exceed the revenue lost from customers who left. A renewal analysis will show whether the types of customers you lost are worth focusing on in the future. You can often learn more from customers who leave than from the ones you retain, so be sure to analyze lost customer profiles, along with any operational issues that contributed to recent customer churn, when developing your strategy for targeting new prospects.
In addition to customer churn rate, calculate your revenue churn rate. Recurring revenue is critical to business stability, so monitoring revenue churn is important in evaluating the impact of customer churn. Calculating a revenue churn rate mirrors the customer churn rate formula:
Amount of recurring revenue lost that month / Original amount of revenue for the month
For example, if your company has $500,000 in recurring revenue at the beginning of the month and loses customers representing $50,000 of that total, the revenue churn rate for the month is 10%.
Customer Acquisition Metrics: The “Best” Numbers
Tracking these three metrics—CAC, CLTV, and Churn Rate—provides insight into key aspects of your business, including the success of your sales team, pricing strategy, and customer service. It also allows you to gain a deeper understanding of your finances, helping you to forecast and budget for future spending.
Is there a “magic” or “best” number” for a company’s CAC? As with so many things, that depends – on your industry, your margins, and the stage of your business or product. Startups must spend money before they make money. In the early stages of a business, a CAC might be high as you invest in your sales team and marketing efforts, and those investments may take time to pay off in the form of CLTV.
Having said that, you should target a high CLTV, a low CAC, and a low customer churn. For many companies, a 3:1 ratio for CLTV to CAC is ideal. There are a number of ways to decrease CAC and increase CLTV—including shortening the sales cycle, improving marketing strategies, and working on customer support. Measuring all three metrics is critical to understanding the impact of CAC.
Do you need help calculating your Customer Acquisition Metrics? G-Squared Partners can thoroughly analyze these critical measures based on your specific circumstances, providing important insights for your business. For a no-obligation phone consultation, contact us today.