Know Your Customer Acquisition Cost (CAC)

By Rachana Chotia / In Customer Acquisition / September 25, 2020 / 15 Min read

Customer Acquisition Cost (CAC) is the cost incurred by an organization to convince people to buy their product or service.   

A simple definition but a crucial metric for a company. CAC tells you how much you are spending on acquiring new customers. Customer acquisition can be achieved through various channels like Ads, Campaigns, Website Content (Blogs, case studies, whitepapers, etc.), Referrals, etc. 

For the growth of a company, it’s paramount to have a regular inflow of new customers. But growth at what cost? If a company is spending a lot of money on acquiring new customers and is not seeing the profit from them, is it even worth it?

To understand the importance of CAC, let’s go back in time and talk about the Greek Emperor, Pyrrhus (story time!). Pyrrhus of Epirus was one of the world’s greatest commanders (second only to Alexander the Great). But during the Pyrrhic War, his army suffered irreplaceable casualties in defeating the Romans in back to back battles. While he won the battles, he could no longer continue the war, and thus, ended his run. 

A victory which is not worth winning because you lose a lot is called a ‘Pyrrhic victory’. Spending a lot on acquiring new customers and not getting any profits/value from it is a Pyrrhic victory for your company. You are just burning a hole in your pocket. CAC is a metric that helps you see if you’ve just won a Pyrrhic victory or not.

How to calculate CAC?

Using a very simple formula, one can calculate Customer Acquisition Cost.  

         marketing costs + sales costs
 CAC =  -------------------------------
         number of new customers added

While the formula is straightforward, there is nothing easy about it. In fact, many marketers get the calculations wrong. It’s important to understand what costs are involved in marketing and sales that go into acquiring a new customer. Broadly, costs can be grouped under two categories:   

  1. Expenses involved in generating leads (marketing)
  2. Expenses involved in converting leads to customers (sales) 

The marketing and sales costs are not just limited to the amount you spend on Ads and tools. It also involves the salaries of your marketing and sales teams, the costs of software used for analysis and also the cost involved in supporting customers during the free trial period.

Some of the common costs are:

  • Ad spend – the amount you spend on advertisements and campaigns on different channels such as Google, Facebook, LinkedIn, etc.      
  • Team’s salary – the amount you spend on your employees who help in generating leads and talking to them to purchase your product. This includes the salary, bonus, and other overhead costs.   
  • Tools – this includes the costs involved in purchasing tools that help you in creating, distributing and analyzing content. 
  • Referrals – the amount you give as a gift to your existing customers to refer new customers. 
  • Freemium – this involves the amount you pay your support and engineering team to provide a seamless experience to a prospective customer on free trial. 

Let’s understand this with an example. For the purpose of simplicity, we’ll use whole numbers to calculate the CAC. Company A spends $5000 in a month. This involves $2000 on marketing and sales employee salary and overhead costs for a month; $1000 on all the tools required for ad campaign and content creation/distribution; $1500 on support/engineering team to help with the free trial product installation and customer service; and $500 on referrals). This investment helps Company A acquire 100 customers in that month.

Using the above formula, we get

       marketing costs + sales costs         5000
CAC = ----------------------------------  = ------ = 50
       number of new customers added         100

This means, Company A is spending $50 to acquire one new customer. Now, this should not be confused with cost per acquisition (CPA). In the table below, you can understand the difference between CAC and CPA.    

What does it mean for your company?  

As we had mentioned above, CAC is an important metric for a company. A high CAC for your company means that you are spending a lot of money to acquire new customers. While this is okay if you are just starting up, however, if it continues to remain high even after your company has reached maturity, it could be a problem. 

Marketers can optimize their customer acquisition strategies using CAC. They can find out which customer acquisition campaign is costing less and getting more customers. For example, let’s say you run three campaigns, one each on Google Ads, Facebook Ads and LinkedIn Ads and spend $10, $20 and $40 respectively. From Google Ads you get 10 customers, from Facebook Ads 5 customers and from LinkedIn Ads you get 10 customers. Let’s calculate CAC for each campaign and see how they fare.  

As you can see, on Google Ads you are spending $1 to acquire a customer. And while, initially, it looked like you are getting more customers from LinkedIn Ads than from Facebook Ads, after calculating CAC it’s clear that you are spending the same amount on Facebook and LinkedIn Ads to acquire one new customer.   

Unfortunately, there is a little flaw in the formula. In reality, what happens is that you don’t acquire customers in the same month as generating leads. So if you are investing money on marketing and sales in one month, you will see customers purchasing from you in the next month. It comes down to your sales cycle, which could be 30 days, 45 days or 60 days. So, if your sales cycle is 60 days, you need to change the formula a little. 

New Formula: 

         marketing costs + sales costs two months ago
CAC =  ------------------------------------------------
         number of new customers added in current month

Another failing of this formula is that it considers only the new customer. It doesn’t take into account that a customer can provide more value than just one time purchase. This is why we need to consider the lifetime value a customer brings to the company.      

Lifetime Value (LTV) vs Customer Acquisition Cost (CAC)

LTV is the money you get from a customer over their entire relationship with your company (before they churn). To calculate this, we use the formula:

LTV = customer value x average customer lifespan

Where, 
Customer value = average purchase value x average purchase frequency
Average customer lifespan = average number of years a customer continues to purchase from the company 
To calculate the customer value, you will first need to calculate
Average purchase value =  total revenue in a particular time / no. of purchases over the same period of time
Average purchase frequency = no. of purchases in a particular time / no. of unique customers who made purchases in the same period of time

Going into the details of LTV is a topic for another time. For now, it’s sufficient to understand that LTV is the prediction of the net profit attributed to the entire future relationship with a customer. Tying this back to our main topic, you can find out the health of your business by knowing the LTV and CAC of your company. 

Health of a Business = LTV:CAC

If the ratio is 4:1, it means for every 1 dollar spent, you get back 4 dollars in customer lifetime value. For SaaS, the industry standard ratio is 3:1. If your company is showing less than this, it means you are losing money in acquiring customers and not making enough revenue from them. If your ratio is more than this, then you are not spending enough on customer acquisition and there is scope for improvement. 

Who uses this data?

Earlier, we had discussed that CAC is an important metric for the company and how Marketers can use this information to improve their customer acquisition strategies. They can analyze this data to ensure that they are maximizing the return on the company’s investments. 

There is another party that finds this information valuable. The Investors. With this data, they can assess the business’ health as the LTV:CAC ratio is a direct reflection of the success of your company. Investors can gauge if they will see any profit on their investments or not. 

What’s a good CAC?

There is no such thing as a good or a bad CAC. A lot of factors help a company define what customer acquisition cost is good for them and what not. The costs involved in customer acquisition differ from company to company. Some factors to consider are: 

  • Industry/domain
  • Company maturity 
  • Length of sales cycle

If you look at the data below, the average CAC per industry varies drastically. 

Source: DemandJump

It would be really interesting to calculate the CAC for different channels, campaigns, keywords, geographical regions, etc. to get a better picture of what’s working for you. Based on this data, you can focus your customer acquisition strategies on highly efficient models. 

And this brings us to the next question. What to do when CAC is high? How to improve the LTV:CAC ratio.

Customer support and CAC

Companies try to keep a balance between LTV and CAC by adopting different tactics. Providing valuable content and optimizing the website for conversions are some standard methods. A great way to bring down CAC is by providing awesome customer support and service. As the saying goes ‘It costs 5x more to acquire a new customer than to retain one.’ 

If you can improve the LTV you get from a customer, then you have the flexibility to spend your money on customer acquisition as you wish. And one sure way of increasing LTV is by improving your customer success.  A better customer support system sees a positive retention rate and increases upsell. It also guarantees customer referrals and word-of-mouth advertising. 

Like Sid says, customer support is the new growth. Build it well and you create a moat. 

By automating your customer support, using tools like conversational chatbots, you can engage both your leads and customers to provide a seamless experience. Some of the advantages of customer support automation are:

  • Proactively engage with leads and customers. You can answer their questions accurately and consistently in real-time and at scale. This improves conversion rates and, most importantly, customer satisfaction. 
  • Leads who engage through chatbots are more likely to buy your product. And engaging through support tools like conversational chatbot also helps you reduce your marketing and sales costs. 
  • Chatbots provide 24×7 support ensuring good customer experience, increasing your opportunity to sell. 

Conclusion

Now that you know what customer acquisition cost means to your company, you can see why it’s an important metric to track. By regularly calculating the costs involved in customer acquisition and comparing it with other company metrics, the marketing team can change their strategies and improve customer experience. And by adopting customer support automation, you can improve your customer’s lifetime value and decrease your company’s CAC.

If you are interested in knowing how customer support automation can help you, you can consider reading 10 Best Chatbot Examples For Better Customer Service.

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Rachana Chotia

Content and Marketing, Verloop.io

Here to write about all things Customer Support Automation. If I’m not writing, I’m either reading or planning a trip.