Pay to Play: Customer Acquisition Costs
How do you acquire your customers? How much does that cost you? Figuring out consumer acquisition costs (CAC), will give you a good idea of how your business is doing, and what it can do better.
Customers are great!
Customers are what make businesses run. Regardless if you are a free game, an enterprise software company or a product on the shelves of Walmart your customers generate the revenue you use to run your business.
But customers aren’t free. Even Google, one of the most dominant companies of our time and a household brand name, spent $14.4B in 2015 on traffic acquisition costs. The reality is that you have to spend money to acquire customers, and the price you pay for each customer is your Customer Acquisition Cost (CAC).
Your CAC is not just what you spend on advertising! There are many hidden costs that go into customer acquisition, including:
- Discounts and promotions
- Publicity costs (including PR)
- Events and conferences
In fact, some of your marketing administrative costs need to be factored into your CAC, especially if you do content marketing. With all of this it can be surprisingly difficult to determine your CAC. Still, you need to know your CAC so that you understand if the customer lifetime value (LTV) is more than you pay to acquire the customer. If it’s not then you are losing money with every customer!
This week we’ll go through the details around CAC and how to calculate it.
- Part 2 — Attribution: How do you know where a customer came from?
- Part 3 — Blending: How do you calculate CAC in a multi-channel marketing world?
- Part 4 — Examples: How do you calculate CAC for different businesses?
- Part 5 — Payback: How long does a customer take to pay back their CAC?
This topic was requested by reader Barret T. (Hi, Barret!). If you have a topic you’d like me to cover just drop me a line.
Welcome to the Neighborhood
The first step in understanding your customer acquisition costs is knowing how you acquired them! Different acquisition methods will carry different cost structures, so the better you can pinpoint where a user was acquired the easier it will be to know how much they cost.
Unfortunately, in the real world customers are rarely acquired in a single transaction. A single customer might read an article about you, see some of your ads, receive a few of your emails, and finally click on a link shared by a friend on social media. Would the customer have clicked on that social link if they hadn’t read the article? If they hadn’t gotten the email? Or seen the ad? Here is the timeline, and as you can see it’s not clear:
So, who gets the credit?
Attribution is challenging and there is no easy answer. The good news is that there are a few common attribution models you can choose from depending on your marketing strategy.
Last Touch Attribution assigns 100% of the credit for a customer acquisition to the last channel the customer touched before converting. In our above example, the social sharing channel would get 100% of the credit and the others would get none.
Distributed Attribution (also known as Linear) divides up credit among all channels that touched a user. In our example, this means each of the 4 channels (ads, email, PR and social) would each get 25% of the credit for the customer.
Decaying Attribution also distributed credit across channels, but assigns more credit to the last channel the customer touched than the first one. This model reflects the traditional model of marketing where the customer is more likely to convert the more they are exposed to your company.
These are just a few simple attribution strategies, there are many more. If you’d like to read about more, Google provides a comprehensive list on their support website. Many web analytics tools support attribution tracking and there are even dedicated attribution tracking services you can use to automate whatever attribution strategy you choose.
Whatever you choose, you should not expect 100% accuracy. There will always be a few customers whose decisions are influenced by factors you will never know! Tomorrow we’ll talk about how to turn your attribution strategy into a CAC calculation.
(Note: Yes, I know the green areas of the above charts add up to more than 100% and are hence not accurate. It’s easier to read this way, so consider these artistic illustrations.)
And now for something more complex…
Calculating your customer acquisition cost would be much easier if all users came from the same channel! Unfortunately, as we saw yesterday, that rarely happens and you need to have an attribution strategy in place to decide which channels are responsible for a customer.
Few companies use the “Last Touch” model, which means you are likely to spread credit out across a few different channels. That is great, we love spreading credit around! But how do you calculate your CAC when you have assigned credit to multiple channels? It’s easier than you might think.
Step 1: Determine how much each channel costs you.
For Ads this is easy, it’s just your average cost per click or impression. For PR it’s the time you spend courting the media, as well as the cost of your PR firm (amortized). For sending emails it’s more complex as it includes the time you spend writing them as well as what it might have cost to get the customer’s email address in the first place. In all cases, you should be able to determine an average cost for that channel action.
Step 2: Weighted distribution.
With your channel costs in hand, you can use the credit distribution from your model to calculate a weighted cost! Let’s say a customer touches three channels (Ads, Email, Social) and we use a linear attribution model to assign credit evenly, our CAC would be calculated as follows:
There you go! You can calculate this for each customer (hard) or segment your customers into common cohorts (easier) depending on how accurate you need your CAC estimate to be. In businesses where margins are measured in pennies the CAC is usually measured at the individual customer level (e.g. mobile gaming) and in high margin businesses (e.g. enterprise software) by cohort.
As I mentioned yesterday, there are tools and services that will do all of this for you but it’s up to you if you want to use them. Even if you do, it’s important to understand the fundamentals of what they do!
Getting Real
After a few days of discussing the theory of customer acquisition costs (CAC), it’s time to talk about reality! The real world is a confusing place, so let’s talk about some example businesses and how their CAC might be complicated by reality. Now where did I put those examples…
Example 1. Physical Goods
When selling a physical product, like basketballs, you are almost certainly going to use channel distribution partners like wholesalers and retailers. In these cases you have a choice: you can treat the channel as the customer or treat the channel as a factor in your CAC. Most companies do the latter, especially since most wholesalers and retailers require their vendors to take on inventory risk (you need to repurchase any unsold inventory). Things get even more complex when you factor in the rate of returns, since you cannot assume a customer is “acquired” if they return the product soon after purchase!
Example 2. Enterprise Software
Enterprise software is typically sold using large teams of outbound sales people. In these companies, the majority of the customer acquisition cost is the cost of the sales person who makes the sale, and hence their commission on the sale (but not usually their salary), since it typically dwarfs marketing spend. You can choose to hide this cost by not making it part of your CAC, but that makes your CAC much less useful! For many enterprise software companies, the CAC is then a combination of marketing spend and sales commission.
Example 3. Mobile Apps
Mobile applications are distributed almost exclusively through advertising, which means the CAC is the easiest to calculate since it’s just the cost of the ads required to get a user to install the app. However, if you are using multiple different ad networks and services you will likely have different costs, so most mobile app companies measure their CAC by advertising partner and create a blended average for overall tracking.
And there you go! I’m sure you are wondering what you should do with your CAC now that you have calculated it? No worries, tomorrow we’ll discuss one of the most useful analyses you can do — customer payback!
What goes around…
Understanding your customer acquisition cost (CAC) unlocks a lot of valuable strategic tools and decisions for you. Along with your customer lifetime value (LTV) it allows you to understand the fundamental economics (and viability) of your business.
One important analysis you should undertake with your CAC is how long it takes a customer to pay back their cost of acquisition. If a customer costs you $10 to acquire, how long is it before you earn that $10 back again? This is a critical analysis because it will tell you how much capital you need in the business to hit your customer growth goals.
For some businesses, the payback is immediate because the customer makes a product purchase that is more than their CAC. However, for many subscription and recurring revenue businesses the payback period can be very long!
An example would be easier to follow
Good point. For example, let’s say that your CAC is $1,000 and you earn $100 per month from each customer. That means your payback period is 10 months, which is how long it takes you to earn $1,000 from that customer. Now, let’s assume you acquire 100 customers in January, so you spent $100,000 and made $10,000 from them so you have a $90,000 gap. You won’t get all of that $90,000 back entirely until October! If you continue to acquire 100 customers each month, you will quickly realize that you need to have a lot of capital on hand to be able to wait 10 months for your customer payback. In fact, your net cashflow will look like this:
Hence, in our example you will need a total of $450k in cash just to survive until October! However, after October the fact that you have paid back your January customers means that you will be generating enough cash to fund the acquisition of more customers, so your business will become cashflow positive (assuming no churn which is a bad assumption).
Remember, we use the Net Revenue for these calculations — not Gross Revenue!
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Have any data-driven dilemmas? Drop me a line: sean@outlier.ai
