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How Much Can You Afford to Pay to Acquire A Customer? The 5-Step Customer Acquisition Cost Formula
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How much is a customer worth to your business? And how much can you afford to pay to acquire a new customer? These are basic questions, but also very important questions to ask yourself.
Lucky for you, there is a simple five-step process you can follow to figure out exactly how much you can afford to spend to profitably acquire a new customer. The process is known as Customer Acquisition Cost, or CAC.
Knowing your CAC may also provide some crucial insights into other areas of your business. But before we dive into the process, there are a few things you need to know first.Whoever Can Spend the Most, Wins
There is a common phrase which many of the most successful marketers life by-“He or she who can afford to spend the most to acquire a new customer, wins.”
This is so very true, because if you can afford to spend more than your competitors to acquire a new customer… then you’ll win all the customers!
So, you want to spend as much as you can to acquire a new customer… but not more than you have to. In other words, let’s pretend that you are able to spend up to $25 to acquire a customer. You certainly don’t want to spend more than $25 to acquire a new customer (because then you’ll be losing money).
But if you spend less than $25 – say you’re only spending $15 to acquire a new customer – then you’re limiting your scale. You won’t be able to grow as big or as quickly as you should be because you aren’t spending enough money on customer acquisition.
Of course, in order to do this, you have to know how much you can afford to pay to acquire a new customer. And here is the formula:The 5-Step Customer Acquisition Cost Formula
This five-step process will work for ANY type of business or selling system. It works for digital companies, phone-based selling companies, and even brick-and-mortar stores.
Don’t get intimidated by the calculations and don’t worry about getting these numbers exactly right.
First, start with a ballpark figure to help guide your marketing. Over time you can refine that number to get more and more accurate and specific to your business data.
Here is the five-step Customer Acquisition Cost Formula:Customer Acquisition Cost Formula Step 1: Estimate How Much a Customer Is Worth
The first thing you’ll need to figure out is:
How much revenue do you generate from a typical customer over the life of their relationship with you?
Keep in mind, this number extends beyond the revenue you generate from your initial sale. Your initial sale might only bring you $25, but many of the customers who buy that $25 product will go on to make additional purchases.
So, if your products cost $25 each, and each customer buys five products on average, then a customer is worth $125 on average. If each customer buys six products on average, then a customer is worth $150 on average.
This is known as your CLTV (customer lifetime value), and it’s an extremely valuable metric to know about your business.
There are three ways you can figure out this metric:Customer Lifetime Value Method #1: Ask Your Data Analyst to Figure It Out
If you have a Data Analyst or other analytic whiz on your team, just ask them to figure it out for you.Customer Lifetime Value Method #2: Calculate It On Your Own
To calculate this on your own, there are two things you need to know:- How many customers purchased your products.
- How much total revenue did you generate.
You’ll need to choose a date range for this data. We recommend going back 12 full months, if you can, to get lots of data. If you don’t have that much data then try to go back 90 days.
Then, you simply divide the total revenue by the total number of customers: Revenue / Customers = Customer Lifetime Value.
For example: Say you generated $156,250 in revenue over the past 12 months, and over that time 1,250 customers bought your products.
Just divide $156,250 / 1,250 = $125.
This number, $125, is your customer lifetime value.Customer Lifetime Value Method #3: Estimate It to Get a Starting Point
Now if you don’t have the data available to follow Method #2, that’s OK. You can start out by estimating your CLTV.
A good benchmark to start with is anywhere from two to eight times the price of your initial conversion value.
So, to stick with our example here, if our company’s first conversion value is $25, then a good benchmark to start with would be anywhere from $50-$200.
For this example, we’re going to go in the middle, with $25 x 5 = $125 customer lifetime value.Customer Acquisition Cost Formula Step 2: Subtract Refunds & Cancellations
The next step is to figure out how many people ask for their money back and subtract that from your CLTV. This is something you can figure out from your CRM. But if you don’t have access to that data, you can use 10% as a conservative benchmark.
So now that you have your refund rate, subtract that from the CLTV that you calculated in Step 1.
Let’s say that your refund rate is 10%. Our Step 1 CLTV was $125, and 10% of that is $12.50.Customer Acquisition Cost Formula Step 3: Subtract Cost of Goods Sold
Next, you need to subtract how much it costs to actually manufacture and deliver your goods.
This figure can vary wildly. For an online company, all you’re paying for is the servers to house the data. But for an actual physical product, the cost of goods could be much higher.
(And don’t forget to include the cost of shipping!)
For the fictitious product in our example, let’s pretend it’s a digital product where the cost of goods sold is 10% of the CLTV, or $12.50.Customer Acquisition Cost Formula Step 4: Subtract Overhead Costs
Next, you need to account for overhead costs, which are different than the cost of goods sold.
Your overhead includes things like…- Payroll
- Utilities
- Software
- Accounting
- Legal Expenses
Multiply your overhead by your CLTV. For our fictitious example, say overhead is 30% of the CLTV: $125 x 30% = $37.50.Customer Acquisition Cost Formula Step 5: Subtract Desired Profitability
We started with your total revenue per customer (CLTV) and subtracted all the costs associated with producing that product, including:- Refunds
- Cost of Goods
- Overhead
Let’s calculate everything to get an idea of where we’re at:
CLTV – Refunds – Cost of Goods – Overhead
$125 – $12.50 – $12.50 – $37.50 = $62.50
In other words, out of the $125 that you generate per customer, half of it ($62.50) goes toward creating and delivering your products. And you have $62.50 left over.
Does that mean you can afford to spend $62.50 to acquire a new customer?
Technically, yes, but then you wouldn’t be making any profit. You’d be breaking even on every customer.
So, the last thing you need to do is decide what sort of profit margin you want to earn.
This number will depend on a lot of different things like…- your business model
- the industry you’re in
- what your cash flow situation is
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, $62.50 was used to produce and deliver the product. That means we have only $62.50 remaining.
If we chose a profit margin of 40%, we would earn $50 in profit for every customer. However, that would leave us only $12.50 to acquire new customers ($62.50 – $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 $37.50 in customer acquisition costs ($62.50 – $25).
So, let’s say that we decide that our desire profitability will be 20%. In this case, we can spend up to $37.50 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!
