03 August 2018

The customer equation, Do they spend more than you do?

Business try to make more money than they spend. More specifically, they try to get customers for less than they have to spend to acquire them. Sounds obvious, but for many businesses it’s hard to figure out how much they spend per customer. This spend is called the Customer Acquisition Cost and it’s closely linked to the LifeTime Value (LTV: click to read about that)

The LTV is the value that one customer brings (on average). If you know the LTV of your customers, you can estimate how much you will be able to spend to acquire new ones. This simplified equation describes that relation:

(Marginal)Profit = LTV - CAC

High-school math, just three terms, where we want the left side to be as high as possible. But the only thing we can control is the right side: the hard part.

How much do you allow your CAC to be?

As discussed in our other post, the LTV can differ a lot per company. Well, this time it ain’t gonna be different. Often CAC differs even more per company. It depends on many things, like how much profit you want to make. For early-stage startups, the profit margin can be very low (or even negative) in order to build a user base and gain market share. While for others profit is more important, if you have a lot of demanding shareholders, for instance.

Another thing to consider is the specific cost structure of your business. What I mean with that is, the size of your LTV and how much of it you can spend on acquiring customers. In other words, how much other stuff do you have to pay, besides getting those customers in and how much will those customers be worth. This LTV/CAC ratio varies a lot between different types of businesses. Let me give you some example of business that have different LTV/CAC ratios:

  • SaaS rule of thumb: ±30% of LTV for acquisition
  • Physical businesses: ±1/4th of LTV for acquisition
  • Growthcasts: ±80% CAC for LTV still work.

Measure your CAC with all things considered.

How do you measure your CAC properly? Keep in mind that you want to make a ‘fully loaded’ calculation, with all the costs included. If you buy paid ads, the costs are obvious. But what about that content writer, do you include that? If those blogs bring in customers: Yes! And what about sales: if you do it yourself, include your salary. If you hire a sales team, include costs like the sales manager, the training, and the bonuses!

You want all the costs that are included in acquiring 1 customer in your calculation.

Once we have the basics down, it’s also a good idea to split the performance per marketing channel. Aggregate data hides the real insights: perhaps the Facebook ads you run perform (much) better than your Google ads (or the other way around), but if you dump them together under “paid ads”, you’d never know. If you split it out, you’ll get a better grip on the real cost of acquiring one additional customer through each channel.

In many cases this calculating is hard or even impossible to make. For early stage startups this measurement is extremely important. If you are not able to make an honest estimate, this might be an indication that you design your sales funnel in another way to make it more straightforward and easier to measure. If you cannot measure your performance and profit reliably, you will be unable to make important marketing decisions in a stage when that is of utmost importance.

Let’s look at an example of a hard to measure marketing strategy to illustrate this. A young business that considers to build their brand to bring in customers, will need a lot of initial investment to get things started. From that point on, you are waiting for customers to start to discover and like your brand. It’s mere speculation to find out which campaign actually paid off, let alone calculating how much you actually spend per customer. If you don’t have the coolest brand of the year, chances are, you will have a small chance of success.

A better strategy would be to start with a direct-response channel and build an initial user base. And than try to create some hype or friction with a branding campaign, that starts with your core customer segment. You could clearly measure your CAC in every stage, hence significantly improve your chances for success.

The takeaways:

  • Find your the LTV of your customers
    • To measure the success of a marketing campaign, you need to know how much a customer is worth. Read more here.
  • Estimate the LTV/CAC ratio of your business
    • This is not easy, but for different types of businesses, there is usually a ‘standard’ ratio.
  • Make a ‘fully loaded’ calculation
    • Get every cost that is used for your acquisition in your calculation, otherwise you can’t make ‘honest’ decisions.
  • Split you CAC per channel
    • Different channels have different cost structures, aggregate calculations don’t mean anything is one performs very different than the other.

NEXT STEPS

Take out pen and paper and match your own LTV with your ‘fully loaded’ CAC and calculate the ideal LTV/CAC ratio. Be aware, match the right CAC with the right LTV: read more on that here.