Marketing as an Investment
How much is the average customer worth to your business?
If you’re in the restaurant industry, for example, and the average diner spends $40.00 on their meal and tends to visit your establishment three times per year, then that customer is worth $120.00 per year, or $1,200.00 over the course of a decade. If you’re in the sporting goods business and the average customer spends $200.00 when they visit your store, if they only visit you once per year then over the course of a decade that customer is worth $2,000.00.
How much are you willing to spend in order to acquire that new customer? How much is your competitor willing to spend?
This is called your Customer Acquisition Cost (CAC) and knowing your CAC will help you to make critical decisions in many other areas of your business. In this article, we’re going to look at five steps to help you determine your CAC.
Whoever can spend the most to acquire a new customer wins.
It’s ugly, but it’s true. If you can afford to spend more than your competitors to gain new customers… then you’re going to have all of the customers! Look at what Walmart has done to the local department store. Look at what Best Buy has done in the online electronics retail market. In both cases, they offered huge discounts on products their local competitors had been offering for years, sometimes even selling at a loss, knowing that if they lost a dollar on this microwave oven, they’d make up for it in the profit on that ironing board – as well as the assurance of repeat business from every customer they attracted with the perception of greater savings. As your customers are literally the lifeblood of your business, it behooves you to invest anything you can in acquiring more of them! And marketing is just that – an investment.
So you want to spend as much as you can to attract a new customer, but no more than that. Let’s say you can afford to spend $20 per new customer. If you spend $25, you’re losing money. If you spend $15, you’re limiting your ability to scale and grow your business. Running marketing campaigns with the right CAC in mind is the key to growing your business and staying positive on the balance sheet at the same time.
So let’s look at how you figure out what your CAC should be, no matter what business you’re in.
Step 1: Estimate the Value of Your Average Customer
The first thing to look at should be obvious: how much money do you make from the average customer over the lifetime of their relationship with your business?
This extends well beyond the revenue gained from their first purchase. That transaction might make you $100, but many of your customers will go on to make additional purchases later. So if your average transaction value is $100, and each customer makes five transactions on average, then a customer is worth $500 on average, right? This is known as your Customer Lifetime Value (CLTV) and it’s a super useful metric to know for your business!
There’s a fairly easy way to estimate your CLTV right now if you don’t already have a figure. Look at how many customers have purchased your products over the last 12 months (if you have enough data, if not, try going back at least 90 days – and start tracking your data better!). Then look at how much money you made in that time period. Then divide the total revenue by the number of customers. If you had 3,000 customers over the last year, and you made $374,928 in that time, then you’re CLTV is around $125.
Step 2: Account for Refunds and Cancellations
If you’re using a Customer Relationship Management (CRM) software to keep track of your customers, it’s quite easy to figure out how many people ask for their money back and subtract that from your CLTV. For our purposes, let’s say that 8% of your customers return their merchandise for refund (or cancel their subscription, etc.). 8% of $125 is $10.
Step 3: Account for the Cost of Goods Sold
Next, you have to be mindful of the cost of the goods and/or services you’re providing to your customer. Depending on your industry, this figure can vary wildly. Let’s say, for our example, that the cost of goods sold is 20% of the CLTV, or $25.
Step 4: Account for Overhead Costs
Now consider your overhead costs, which are separate from the cost of goods sold. We’re talking about your
- Legal Expenses
Multiply your overhead by your CLTV. For this exercise, we’ll assume an overhead of 25% of the CLTV: $125 x 25% = $31.25.
Step 5: Determine your desired profit margin
Let’s review for a moment.
We started with the total revenue per customer (CLTV) and subtracted all the costs associated with producing your product:
- Cost of Goods
Let’s figure this all out and see where we are now:
CLTV – Refunds – Cost of Goods – Overhead
$125 – $10 – $25 – $31.25 = $58.75
In other words, out of the $125 that you generate per customer, over half of it ($66.25) is spent on creating and delivering your products, leaving you with $58.75.
Does that mean you can afford to spend $58.75 to acquire a new customer?
Technically, yes, but then you would be breaking even – you’d have no profit left to speak of! What’s the point in that?
So, the last thing you need to do is decide what sort of profit margin you want to earn.
This will depend on a lot of different things like…
- your business model
- your industry/niche
- your cash flow
For a digital product, a good profit margin to shoot for is between 20% and 40%.
Here’s what that would look like for our fictitious example:
- 20% x $125 = $25 profit per customer
- 30% x $125 = $37.50 profit per customer
- 40% x $125 = $50 profit per customer
So, how do you choose which profit margin will work best?
This is where you want to refer back to the number we calculated above. Out of our $125 CLTV, $66.25 was used to produce and deliver the product. That means we have only $58.75 remaining.
If we chose a profit margin of 40%, we would earn $50 in profit for every customer. However, that would leave us only $8.75 to acquire new customers ($58.75 – $50). That’s NOT a lot of money to acquire new customers.
If we chose a more conservative profit margin of 20%, on the other hand, we would earn only $25 in profit for every customer. But that would also leave us with a healthy $33.75 in customer acquisition costs ($58.75 – $25).
So, let’s say that we decide that our desire profitability will be 20%. In this case, we can spend up to $33.75 to acquire a new customer. That’s our tolerable customer acquisition cost.
This is how much money is left over from the customer’s lifetime value after accounting for refunds, cost of goods, overhead, and profitability.
This is how much you can afford to pay to acquire a new customer.
So now what?
It’s great to have your CAC pinned down, but without a context in which to utilize that information, it’s about as useful as the price of tea in China. Unless you’re into trading commodities in China… let’s move on.
Using Your CAC to Help Figure Out Other Costs
Once you know your CAC, it becomes much easier to figure out what an acceptable Cost Per Click or Cost Per Lead are for your business.
For example, if you can spend up to $33.75 to acquire a new customer, and you know that your sales team converts 10% of leads into customers, then that means you can afford to spend up to $3.38 to acquire a lead ($33.75 x 10%). And if your landing page converts 40% of visitors into leads, that means you can afford to spend up to $1.35 per click ($3.38 x 40%).
Of course, these figures depend on your business and will be different for every owner in every industry, every niche. Let’s say you create a new product that increases your CLTV. Now you’re able to spend more money to acquire a new customer, so you can afford to spend more per lead, more per click. You should always keep an up-to-date idea of these figures in mind to make sure that your business is always not only functioning, but also growing, efficiently and profitably. And it all starts with your CAC!
If you’d like some help going over your data, or setting up better data collection as part of your next marketing effort, click the Contact Us button to drop us a line!