How much are you willing to spend in order to acquire new customers? Are you willing to spend a lot? But should you? If you have similar questions, then you should the basics of customer acquisition and the customer acquisition cost formula.
Customer acquisition can become costly especially if for small businesses. It is said that the entrepreneur that can spend the most, will acquire the most number of customers.
This is the reality, especially in a competitive industry. There should be a balance, though. You should spend enough to acquire the highest number of customers as much as possible but you – and your business should be to sustain this level of spending. Also, you won’t want to spend so low that you miss vital acquisition opportunities.
The most common customer acquisition strategy is to run campaigns with the increase in traffic as the main goal. But before you implement this strategy, you need to use the multi-step customer acquisition cost formula in order know how much to spend for each campaign.
The Customer Acquisition Cost Formula :
There is a 5-step method for determining the customer acquisition cost formula. This formula is applicable for most business models, not only for online businesses but also for brick-and-mortar establishments.
This customer acquisition cost formula is also beginner-friendly. It can be easily implemented and scaled. As much as this formula can help you and your business, it is also advisable not to fuss on getting the exact numbers as much as possible. For one, the formula involves a certain level of estimation; second, several variables can’t be controlled; and lastly, not all sales models are made equal. Use the customer acquisition cost formula as a guide in your traffic campaign spending whether you are still in the early stages of your business or you are already scaling and want to acquire more customers.
Steps in the Customer Acquisition Cost Formula
Step 1: Calculate the customer’s lifetime value (CLTV)
This is the estimated profit that you can gain from a customer staring from acquisition to the customer’s last transaction with your business.
CLTV is considered as one of the most important metrics to learn and track in a business. There are several ways to determine the CLTV.
- One is to acquire pre-calculated data from a data analyst or analytics expert. This may cost you an additional amount and requires disclosure of your analytics data. It would be advantageous if you already have an employee or a team member that is already knowledgeable about analytics, especially with key metrics.
- You can also learn to calculate CLTV on your own. First, you need to determine the two variables in the formula:
- The number of customers that made a purchase.
- The total revenue for all the purchases.
It is advisable to gather data from a full year. If it’s not possible to do so, gather as much data from a date range that is no shorter than 90 days. Then calculate the average CLTV using this formula:
Revenue/Buying Customers = Customer Lifetime Value
Let’s say that you earned a revenue of $50,000 in the past 90 days, with 500 buying customers in that date range. You’ll have:
$50,000/500 = $100
This means that your CLTV is $100.
- You can also eyeball your CLTV if you don’t have data at hand. After this, make sure to start tracking key analytic metrics. In order to get your business’ CLTV, estimate your current conversion value in relation to your first conversion value. Multiply the first conversion value by two to eight times (a great place to start is four to five times) and you’ll get a close approximation of your CLTV.
For example: If your initial conversion was $20, multiply it by from two to eight times.
$20×5 = $100
The lowest estimate you can get is $40 and the highest being $160. As you can see, the estimate range is quite broad and the closest approximation is near the middle. Only use this method as a last resort.
CLTV plays a vital role in the customer acquisition cost formula so make sure that your data is accurate. After you have the value for your CLTV, you can start with the next step.
Step 2: Subtract the Refunds and Cancellations
The next several steps of the customer acquisition cost formula are not only important in ascertaining your customer acquisition cost, but these steps will also give you insights about the performance of your sales model and overall operation.
To start with the step, subtract any refunds and cancellations from your CLTV. These refunds and cancellations should be from the buying customers in your selected time range. You can only gather this data through a customer relationship management (CRM) system. If you don’t have access to one, you can estimate the percentage or use an industry benchmark.
A conservative benchmark is 10%. So you need to subtract 10% from your $100 CLTV. This makes your adjusted CLTV $90.
Step 3: Subtract the Cost of the Product
You also need to subtract the cost of the product that was sold in the selected time range. The cost may either be your capital for every product or the cost to make them from scratch. Also, include transport and handling in the total cost.
To calculate the average cost of production, you need to add the fixed cost of the product to the variable cost (other costs that affect the product cost) and multiply it by the number of products. But for this example, we will only need the cost of each product unit and subtract it from the CLTV. Let’s say that the fixed cost of a digital product is $15 and the variable cost is $1 per product so you subtract $16 from your CLTV, making your adjusted CLTV now $84.
Step 4: Subtract the Overhead Costs
Overhead costs are essentially the cost of your business’ operation. It is an indirect expense that may or may not affect the cost of the manufacturing of the product. This includes the rent for premises, administrative expenses, marketing expenses, utilities, and other non-labor expenses.
In online businesses, overhead costs may include internet data, subscription fees for platforms/tools/services, pay for team members/outsourced personnel, and marketing expenses.
The overhead cost is expressed in percentage. You can calculate the total overhead costs by adding all of the expenses and finding its percentage compared to the sales you have in a certain time period. Most often, a month is enough to be able to have enough data for overhead costs. For example, your sales for a certain month is $25,000, and your overhead cost that month is $5,000, divide the overhead cost by the total sales and multiply by one hundred to get the percentage of overhead costs.
For example: ($5,000/$25,000)*100 = 20%
Your overhead costs are 20% of your monthly sales. Now, calculate what remains of your CLTV after you adjust it for overhead cost. Multiply the percentage of overhead costs by your CLTV.
Adjusted CLTV: $100 x 20% = $20
Your adjusted CLTV is now $80.
Step 5: Calculate Your Adjusted CLTV
So let’s recap on how the subtractions made on your CLTV:
- Refunds – 10%
- Cost of production – $16
- Overhead costs – 20%
So let’s calculate your total adjusted CLTV:
$100 – $10 – $16 – $20 = $54
Your adjusted CLTV is now $54. But what does this mean? This means that the customer cost acquisition formula shows that you can actually afford to acquire new customers but half of the $100 CLTV you get from each customer just goes to production costs. You would just break even so you need to adjust in order to have the right profit margin.
Step 6: Adjust According to Your Desired Profit Margin
The last step in the customer acquisition cost formula involves adjustments based on the cost-profit ratio. In order to do this, you need to consider several things like your business model, the profitability of the industry, and many more. There are industry benchmarks. For digital products, an excellent profit margin runs along 20 to 40%. Based on the $100 CLTV example, a 20% profit margin means that you can profit $20 from each customer and so on.
So if you want to have at least 20% profit margin, you need to subtract the desired profit to the adjusted CLTV: $54 – $20 = $34. This means that you only have $34 to spend on customer acquisition. This may not sound a lot, but you’ll have lesser if you decide to have a profit margin of 40%. You’ll only be left with $14 ($54-$40) to spend on customer acquisition.
If you select the 20% profit margin you earn much profit per customer but you will be able to acquire more customers compared to earning more per customer with a 40% profit margin but acquiring far lesser customers.
For a $100 CLTV with an adjusted value of $54, you need to spend approximately $34 dollars on user acquisition for the said acquisition to become profitable and the spending sustainable. But is this it? There are actually some things you need to take into consideration to make customer acquisition more cost-effective and profitable.
Beyond the Formula: The Impact of Customer Acquisition Cost to Other Metrics
Knowing the customer acquisition cost formula is important. The customer acquisition cost metric, in general, is important in ascertaining other key metrics of your business. Here are key metrics where the adjusted customer acquisition cost plays an important role:
- Cost per Click (CPC) – You just multiply the customer acquisition cost to the percentage of click to lead conversion and you’ll get the CPC. For example. If 20% of your landing page visitors are converted into leads, you can afford to spend $6.8 ($34 x 20%) for each click.
- Cost per Lead (CPL) – The formula is the same with the CPC. You just multiply the customer acquisition cost with the percentage of leads that are converted into customers. So if you convert 15% of your leads into customers, you can afford to spend $5.1 ($34 x 15%) for each lead.
This is important especially after the initial campaign. Once you were able to sell enough products and calculate the customer acquisition cost, you can adjust your CPC and CPL accordingly. This will make acquisition and conversion campaigns more efficient and profitable.
The Relationship between Knowing the Customer Acquisition Cost and the Success of a Traffic Campaign
There are two things to consider in a traffic campaign: 1) It would take some time before the campaign generates revenue, and 2) The success of the campaign depends on the sales funnel. So where does the customer acquisition cost comes in?
Firstly, the amount of time it takes for the campaign to generate revenue directly effects on the customer acquisition cost. For example, if invested a considerable amount of resources for a traffic campaign, then you would want to earn revenue in a certain amount of time so as not to upset your cash flow. If the desired revenue won’t be achieved at the expected time range, then you won’t be able to spend more to acquire new customers.
The success of the traffic campaign is important especially if the cash and resources on hand are limited. Limited cash and limits your capability to scale up and compete for customers. But you should also consider that traffic campaigns almost never become overnight successes. So it is also important that you don’t just know how much to spend but you also have more than enough to spend.
In order to make sure that your traffic campaigns perform as expected. One way to ensure this is to send traffic into an effective sales funnel. The steps in the funnel may defer according to the sales model but you should manage each step efficiently. The amount you need to spend on each funnel’s conversion rate.
For example, if a landing page has a 35% conversion rate and you spend about $1,500 for the traffic campaign, you’ll get 525 leads for $2.86 each. But when the conversion rate is only 25%, you’ll only get 375 leads but for $4. The lower the conversion rate, the higher the acquisition cost. And since the ultimate conversion goal is to turn these leads into customers, you should make sure that you begin with a high number of leads so the percentages of conversion down the funnel would be meaningful.
In the end, use a customer acquisition strategy that you are comfortable with but make sure that you first know how much to spend on each acquisition and how your spending can affect the profitability of your traffic campaigns. Let the customer acquisition cost formula guide your way.