How Much Can You Afford to Pay to Acquire a Customer? The 5-Step Customer Acquisition Cost Formula
Smart advertising is all about precisely allocating your funds to receive the highest payback for the lowest input. Budgeting is an important plan, and will eventually lead to either the great success or the tragic downfall of your business. The same can be said about advertising. In creating your budget when it comes to advertising, you need to ask yourself: how much is a customer worth to me, and how much can I afford to pay to acquire a new one? This article is here to answer these very crucial questions.
We have devised a 5-step strategy to determine exactly how much your company can afford to pay for a new customer (aka – determining your Customer Acquisition Cost, or CAC for short). Knowing your precise CAC will also be beneficial in deciding your budget for other things, like how much you should pay per click. Still, like any good strategy, this one requires some very essential background knowledge.
Whoever can spend the most, wins.
Some of the most successful marketers of all time — Dan Kennedy, Michael Masterson, and even our own Ryan Deiss — have successfully worked by the below phrase:
He or she who can afford to spend the most to acquire a new customer, wins.
You don’t need a degree in economics to understand that cash rules. This is part of why you have your own business. And this is also how you win at business. You never want to spend more than you can afford on a new customer. Let’s visualize this with a hypothetical example:
Your budget for one new customer is $25. You certainly don’t want to spend more than $25 on this customer, this will lead to financial loss). But what about spending less than $25?
Our team of experts would advise that this is also a bad idea, and here’s why:
Trying to save money by spending less than you can afford on Customer Acquisition will limit your scale. You will create a restraint on your business growth if you choose not to spend enough money to acquire a new customer. The key to scaling as quickly as you can and remaining profitable is to run traffic campagnes with a precise CAC.
Now for the magic you’ve been waiting for…
The 5-step Customer Acquisition Cost Formula
This process will work for ANY type of business or sale system. It has proven effective for digital companies like OMNI Development, phone-based sale companies, and even brick-and-mortar stores.
To begin, you must realize that it’s not about the precision of your calculations. It will not benefit you to get hung up on coming up with one magic number. If you’re just getting started, it’s OK if your numbers aren’t exactly right! You must do what you can. Start with a ballpark figure to aid in guiding your marketing. Over time you can refine that number to become increasingly accurate and specific to your business data.
Step 1: Estimate a Customer’s Worth
The first question to ask yourself is:
How much revenue do you generate from a typical customer over the span of their relationship with you?
Keep in mind that this figure extends beyond the revenue you generate from your initial sale. Your initial sale may only bring you $25, but many of the customers who purchase that $25 product will go on to make additional purchases in the future. So, if your products cost $25 each, and each customer buys five products on average, then a customer is worth $125 on average. Just as if a customer buys six products on average, then a customer is worth $150 on average. This figure is known as your CLTV (customer lifetime value), and it’s an extremely valuable metric to understand about your business.
Customer Lifetime Value Method #1: Ask Your Data Analyst to Figure It Out
If you have a Data Analyst or other analytic whiz on your team, they will likely be able to figure it out for you. A pretty much effortless situation for you.
Customer Lifetime Value Method #2: Calculate It On Your Own
If your business is not yet at a place of hiring a Data Analyst, you may calculate this on your own. To do so, there are two things you need to know:
- How many customers bought your products.
- How much total revenue you generated.
You’ll need to choose a date range for this data. (I recommend going back 12 full months, if you can, to get lots of data…or if you don’t have that much data yet, try to go back 90 days.) Then, you simply divide the total revenue by the total number of customers:
Let’s look at another example:
Say you generated $156,250 in revenue over the past 12 months, and over that time 1,250 customers bought your products. Just divide $156,250 /=by 1,250 to get $125. This figure, $125, is your customer lifetime value.
Customer Lifetime Value Method #3: Estimate It to Get a Starting Point
Now if you don’t have the data available to follow Method #2, that’s OK. You can begin the process by estimating your CLTV. A good benchmark to start with is anywhere from two to eight times the price of your initial conversion value. So, to stick with our previous example here, if our company’s first conversion value is $25, then a good benchmark to start with would be anywhere from $50-$200. For this example, we’re going to use the median of 2-8, getting $25 x 5 = $125 customer lifetime value.
Step 2: Subtract Refunds and Calculations
The next step is to determine how many people return your product for a refund. Subtract that from your CLTV. This figure is something you can pull from your CRM, but if you don’t have access to that data, you can use 10% as a conservative benchmark. Now that you have your refund rate, subtract that from the CLTV that you calculated in Step 1. Let’s say that your refund rate is 10%. Our Step 1 CLTV was $125, and 10% of that is $12.50. So now our CAC lies at $112.50.
Step 3: Subtract Cost of Goods Sold
Next, you’ll need to deduct the cost of actually manufacturing and delivering your goods. This figure can vary wildly. For an online company like DigitalMarketer, your only costs are the servers to house the data. But for an actual physical product, the cost of goods could be much higher. (Don’t forget to include the cost of shipping!) Let’s make the fictitious product in our example is to be a digital product, where the cost of goods sold is 10% of the CLTV, or $12.50. Now your CAC lies at $100.
Step 4: Subtract Overhead Costs
Next, you’ll need to account for overhead costs, which differ from the cost of goods sold. Your overhead includes things like:
- Legal Expenses
Multiply your overhead by your CLTV. For our fictitious example, let’s place our overhead at 30% of the CLTV: $125 x 30% = $37.50. Now your CAC lies at $62.50.
Step 5: Subtract your Desired Profitability
As of right now, only half of your CLTV can be allocated to Customer Acquisition. Technically, this means that you can spend $62.50 on a new customer. That is, without generating profit. Breaking even, however, is never ideal. You’ll now decide your desired profit margin. This figure depends on many factors, some including your business model, your industry, and your cash flow situation. For a digital product, a good profit margin to shoot for is between 20% and 40%. Here’s what that would look like for our fictitious example:
- 20% x $125 = $25 profit per customer
- 30% x $125 = $37.50 profit per customer
- 40% x $125 = $50 profit per customer
So, how do you choose the best profit margin?
This is where you’ll want to refer back to the number calculated above. Out of our initial $125 CLTV, $62.50 was used to produce and deliver the product, leaving us with a remainder of $62.50. If we chose a profit margin of 40%, we would earn $50 in profit for every customer. However, that would leave us only $12.50 to use to acquire new customers. That’s definitely not an ideal budget for customer acquisition.
On the other hand, if we were to choose a more conservative profit margin of 20%, we would earn only $25 in profit for every customer. Although that would leave us with a whopping $37.50 for customer acquisition, our profits would be slightly dented.
Still, let’s say that we decide that our desired profitability is 20%. In this case, we can spend up to $37.50 to acquire a new customer — this is our tolerable customer acquisition cost. This is how much money is left over from the customer’s lifetime value after accounting for refunds, cost of goods, overhead, and profitability. And all in all, this is how much you can afford to pay to acquire a new customer.
3 Important things to keep in mind
Now that you understand how to calculate your CAC, you’ll want to keep a few things in mind before spending.
- How to use your CAC to calculate other metrics
I am often given questions like, “what’s a good cost per click?” or “what’s a good cost per lead?”. Without knowing your CAC, this may be a difficult question to answer. But with a clear idea of your Customer Acquisition Cost, these types of figures can be easily determined. To use our previous example, if you can spend up to $37.50 to acquire a new customer, and you know that your sales team converts 10% of leads into customers, that means you can afford to spend up to $3.75 to acquire a lead ($37.50 x 10%).
Similarly, if your landing page converts 40% of visitors into leads, that means you can afford to spend up to $1.50 per click ($3.75 x 40%). As previously mentioned, these numbers are highly dependent on your business model. Let’s say that the company in our example creates a new product that increases their customer lifetime value (CLTV). After releasing this product, they’re now able to spend $50 to acquire a new customer. Now they can afford to spend $5 per lead, and $2 per click. This is a wonderful portrayal of how different traffic and business metrics are all related.
- There’s a direct relationship between your campaigns and your funnel.
Note that the success of your traffic campaigns is directly dependent on the funnel or selling system that you send traffic to. To understand this, consider a landing page that converts at 40%.
If you spend $1,000 to send 1,000 people to that page, you’ll get 400 leads at a cost of $2.50 each. But if your landing page conversion rate was only 20%, then you would only get 200 leads out of that same traffic… resulting in a cost per lead of $5.00. This, all without making any changes to your traffic campaign.
It goes to show that your traffic campaigns and sales funnels are closely related. If you don’t have a high-converting sales funnel, your traffic campaign isn’t going to work. On the flip side, if you optimizing your funnel is going to make your traffic campaign more successful.
The benchmark metrics that we look for during the first three steps above are:
- Lead Magnet conversion rate of 40%
- Tripwire conversion rate of 10%
- Core Offer conversion rate of 10%
Knowing these numbers, along with your customer acquisition cost, allows you to really dive deep and understand some very cool things about your traffic campaigns.
Let’s say you send 1,000 clicks to your Lead Magnet landing page at $1/click. (So, you spend $1,000.) At a 40% conversion rate, that will generate 400 leads at a cost of $2.50/lead. If 10% of those leads convert on your Tripwire, that will bring you 40 new customers at a cost of $25 each. And, in turn, if 10% of those customers convert on your Core Offer, you’ll receive four new Core Offer customers at a cost of $250 each.
Now that you know how much a customer is worth to you and how much you can afford to pay to get a new customer, these numbers suddenly become a lot more useful.
In the example we were using earlier, we could afford to spend up to $37.50 to acquire a new customer. So, if our landing page and Tripwire are converting at 40% and 10%, generating new customers at $25 each, that would create a lot more room to play around with our traffic bids. We could continue to scale up that campaign until our CAC has increased from $25 to $37.50.
(Please note that what’s important here is NOT that you have the same funnel, or that your numbers are the same as ours. Remember that these are just examples.)
What matters is that you know your own numbers and are able to determine if they make sense for your business.
- Your cash flow situation could change things
Finally, and importantly, you must remember the following:
It takes time for any traffic campaign to start generating revenue. The vast majority of companies do NOT see an ROI on the same day they start a traffic campaign. So, that begs the question: Just how long can you afford to wait before seeing an ROI on your campaigns? The answer to this question will definitely help guide your customer acquisition strategy. If the backend of your business generates a profit on new customers after 60 days, but you need to generate that revenue within 30 days because of your cash flow situation, then you’re not going to be able to spend as much money to acquire a new customer.
Now Go Calculate Your Customer Acquisition Cost
By now you should have a pretty great idea of how to determine how much you can afford to acquire a new customer.
Remember, this figure doesn’t have to be exact. You can start with a ballpark figure now, and make it more accurate over time. Just having a general idea of your CAC is enough to help you make better decisions in all your traffic campaigns in the future.
So, get out there and figure out your customer acquisition cost!No Fields Found.