When it comes to understanding the health of any business, the cost of customer acquisition (CAC) is an essential factor to consider. I previously discussed lifetime value (LTV) in a different article. A business's CAC provides insights into its strategies' success, future growth potential, and whether the investments being made are appropriate.
Knowing the ratio of LTV:CAC can provide invaluable information on whether a business has a strong balance sheet. In this newsletter, I will talk about CAC, the errors we make while calculating it, how to measure it correctly and how to reduce it.
🧐 CAC and its nuances
Customer Acquisition Cost (CAC) is the amount of money spent in sales and marketing to acquire a paying customer. Another metric, Cost Per Acquisition (CPA), is the cost to acquire any user, including a trial user, activated user, registered user, or lead. CAC refers to the amount spent to acquire customers, while CPA is the cost to acquire any type of user.
Let us take an example.
CPA for Dropbox = Cost per registration of free user or activated free user.
CAC for Dropbox = Cost per customer who has taken the Pro plan or Team plan
The formula for calculating CAC is (Total Cost of Sales & Marketing)/(# of customers acquired)
A few nuances in calculating CAC:
- Sales & Marketing not only include the money spent on running ads/campaigns. It also includes the salaries and tools used.
- The average time for a lead to convert into a customer must be considered. If you take 60 days on average to convert a lead to a customer, then it must factor into your CAC. For example, for a 2-month cycle - CAC in May = (Sales + Marketing Cost in March) / (# of customers in May).
- Only include the cost for acquiring new customers in CAC - an old customer buying a new product is cross-sell and comes under retention.
- Should you consider product or customer success costs for calculating CAC? If they are critical drivers in bringing new customers to the product, they can be incorporated into CAC.
- Adjust your CAC by taking into account product returns or cancellations.
🤔 CAC as a decision maker
CAC is a metric used to make a lot of business decisions. If CAC is high, then it may be a sign that the experiment should be killed, and if the CAC is low, then the experiment should be scaled or invested in further.
Simply looking at the average CAC is not enough to make a sound decision - to ensure you're getting an accurate picture, you should be segmenting your CAC. A few ways to segment your CAC are:
A. CAC by channel (Facebook Ads vs Google Ads vs other paid channels)
B. CAC by customer segment (B2C vs B2B, By customer location, By plan type, By income)
C. CAC by product or service line (Product-wise, High cost vs Low cost, Old vs New)
D. CAC by campaign (Year-end campaign, Festival campaign)
To do this effectively, attribution must be set up correctly. Ensure that you are tracking every action your user is taking - clicking an ad, downloading a resource, signing up for a webinar etc. Wrong attribution can mess up your CAC and lead you to take wrong decisions. For a sound business, the ideal LTV:CAC ratio must be around 3:1.
💡 How to reduce CAC?
Here are a few ways to reduce CAC for your business:
- Improve the engagement of the users who visit your website. If you can convert more users, CAC will improve. Optimize your cart abandonment process and ensure you nudge the users who have added items to the cart to complete the process.
- Focus on organic channels. Keep engaging with your potential audience on social channels with valuable content.
- Improve the touchpoints with the new users. Ensure you quickly touch the new users via email or SMS once they register interest.
- Try to increase the average revenue per user (ARPU) via bundling similar valuable products.
- Build a vibrant community of users who will become your fans and advocate for you. These evangelists will help refer a lot of users, which in turn improve your CAC.
At the end of the day, provide an excellent user experience, keep your ears open and adapt to their needs. That is the best way to induce referrals and improve your CAC.
Did you know?
When designing your referral program, it is essential to select the size of your referral incentives wisely. Offering large discounts or significant cash rewards to newly referred customers may seem like a great way to increase the number of referrals. Still, it can actually reduce the average lifetime value of these customers, potentially resulting in a loss for your business.
An analysis of a telecom provider’s data over 3 years found that referrals doubled when the reward was €15 (vs €5) but average profitability fell by 15%.
Source: Wolters, H. M., Schulze, C., & Gedenk, K. (October 2020). Referral reward size and new customer profitability. Marketing Science.