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December 15, 2020
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Customer Acquisition Cost (CAC) – often abbreviated as C A C or C.A.C – is the average total cost required to acquire a new user.
CAC is the total cost of sales and marketing efforts divided by the number of new users acquired.
Calculations will generally include costs for advertising, salary expenses, payment processing fees, fees to external agencies, and market research during user acquisition.
Calculations should take account of all possible expenses required to acquire a new customer. Due to this, calculations often take place on different time scales.
From daily, weekly, and monthly to quarterly and annual reviews. It is essential to consider all aspects of the process to obtain a true value.
CAC is essential because it allows a business to calculate the viability and profitability of its business model.
It is one of the three most important metrics for Software as a Service (SaaS) businesses alongside Customer Retention Rate or Customer Churn Rate (CCR) and Customer Lifetime Value (LTV).
SaaS (also known as subscibeware or rentwar) describes a company that rents-out software licensing right in return for a subscription fee. An example would be a website builder or a service such as Netflix.
If the customer acquisition cost is more expensive than the lifetime customer value, then a business model is unsustainable.
This refers to the number of customers lost during a given period, while the customer retention rate refers to the number of customers retained.
It is an important calculation in understanding if a subscription-based business model is sustainable.
This is the total revenue contribution from a customer over a given period.
It is essential to understand this metric as it shows the time it will take for a given customer to pay-off their acquisition cost.
If this period is longer than the expected “lifetime” of a user, then a business model is also unsustainable.
In order to change this, SaaS businesses can do one of three things:
At its core, these calculations allow businesses to investigate and optimize the allocation of resources necessary to acquire a new customer.
CAC is essential because it reflects the total Return On Investment (ROI). It can help improve a product suffering from a high churn rate.
It should help a business effectively manage its resources while interrogating the effectiveness of its marketing strategies.
The two key takeaways from this are:
Calculating CAC is useful because it is a numerical expression of whether or not a business will be profitable in its current form.
CAC is subjective.
The question of how to calculate CAC will vary from business to business, depending on where a company draws the line of sales and marketing costs.
In general, calculating the total cost of acquisition is a simple formula.
The customer acquisition cost formula is the total sales and marketing costs divided by the number of new customers acquired in a given period.
For example, let’s say a business spends $500,000 on marketing in salaries, advertising, market research.
The same company also spends $500,000 on sales (commissions, buying content rights) in one quarter.
The total sales and marketing costs for that quarter would be $1,000,000.
To keep the maths simple, let’s say that there were also 1000 new customers acquired during that quarter.
1,000,000 / 1,000 = 1,000. The cost for new customers during that quarter was $1000 per customer.
In this example, the total costs of marketing, sales and salaries are $80,000 + $360,000 = $440,000.
Over a year, Sarah acquires 1600 new customers through marketing, sales, and organic growth.
CAC is equal to $440,000 / 1600 (the total outlay divided by the number of new customers) = $275 per customer, per year.
This is the most basic way to calculate the metric. Now, let’s zoom in on a slightly more complex scenario.
Assuming that Sarah spends her budget equally each month and always spends the entire budget, the quarterly CAC is equal to $275 / 4 (the annual CAC divided by the number of quarters in a year) = $68.75 per customer, per quarter.
However, in practice, Sarah reserves half of her total marketing budget ($180,000) for a Black Friday marketing campaign and spends the rest equally.
Black Friday is in the 4th Quarter. So, our calculations look like this:
|Quarter||Sales and Marketing Budget||Salary Expenses||Total Sales and Marketing Expenses||New Customers Acquired||CAC|
This scenario shows how the value can change depending on resource allocation, even if the total resources and period remain the same.
In this scenario, Sarah can reduce her CAC in Q4 by taking advantage of an effective marketing strategy.
It is an example of how a company can successfully reduce costs by carefully managing resources.
It also shows why these calculations are essential in increasing profitability because it demonstrates that it is better to devote resources to Q4 rather than split them equally throughout the year.
CAC is closely related to Customer Lifetime Value (LTV). Both CAC and LTV are core metrics to consider for any SaaS business.
LTV is the total revenue that a customer will generate over a given period. Many businesses will calculate the LTV of their customers over 1, 3, and 5 year periods.
Calculating LTV relies on a few different variables:
Finally, multiply customer value by the average customer lifespan to calculate LTV.
This metric is a good estimate of the average amount of revenue that businesses can expect from new customers after acquisition.
Neither CAC or LTV alone tell the whole story. To truly understand the relationship between the value and cost of a business’ customers, it is necessary to calculate a ratio between the two.
The LTV/CAC ratio is a model that businesses use to determine how much it should cost to acquire new customers.
It is a useful metric because it shows a business if it is spending too much on its customer acquisition costs and can show when a company is missing opportunities and needs to spend more.
As a marketing metric, it is more powerful than either LTV or CAC alone because it is reactive. Calculating the ratio will indicate which path a business should follow.
The formula to calculate the ratio is LTV/CAC.
For example, a business with an LTV of $2000 and a CAC of $1000 would have a ratio of 2:1.
What does this mean?
A ratio of 1:1 would mean that a business is losing money each time it makes a sale.
Meanwhile, a very high ratio of 5:1 would mean that a company is underinvesting in marketing and can grow even faster with the right resources.
For many businesses, reducing costs is an essential part of achieving sustainable growth.
When it comes to sustainability, if the CAC is higher than the LTV, then a business is unviable.
With that in mind, let’s consider a few ways to reduce CAC and increase the ratio: