The cost to acquire a single customer (Customer Acquisition Cost or CAC) is a popular metric used by companies to determine the economic value of a customer. The logic is simple: the lifetime value of a customer (LTV) should exceed the cost to acquire that customer. You need both formulas to understand the results.
This post will show you two simple formulas you can use now to determine CAC and LTV. We’ll share with you a minimum ratio between these two formulas that can lead to a sustainably profitable business. You can also download a worksheet that will calculate these formulas for you and provide some additional analysis.
Computing Customer Acquisition Cost (CAC)
CAC= Total Sales & Marketing Costs for a Period / # of New Customers Acquired During that Period
The cost to acquire a customer includes all the capture costs of a customer during a period of time, divided by the number of new customers acquired. Capture costs are sales and marketing expenses. Some companies factor in the time spent on marketing, for simplicity’s sake we’ll just use actual expenses. You should be able get these from your Profit & Loss statement. New customers can come from your CRM system or your financial system.
- Company has spent $50,000 in the last six months and signed up 250 customers
- CAC = $50,000 / 250, or $200 per customer
The amount of time to use is important – today’s sales & marketing spend doesn’t translate into new customers today. If you know how long it takes to convert a prospect from initial interest to close, then use that time period. Otherwise, look back at least six to twelve months.
Computing Lifetime Value of a Customer (LTV)
LTV=Total Gross Margin for a Period * Number of Periods a Customer is Retained
The lifetime value of a customer is the profit delivered by a customer while they remain a customer of your company. We need to define what that profit is and how long they remain a customer.
We use gross margin because that is cash left over from a sale that covers overhead and profit. It is important to make sure your gross profit number is correct. Gross profit is your total selling price less any sales discounts and costs of goods sold.
- The company sells a subscription to a user for $50 per month
- It pays a commission of 10% on every sale, so the gross margin is $40 per user per month
- On average, a customer uses the service for 36 months
- $40 Gross Margin per month * 36 months = $1,440 lifetime value of a customer
The Sustainable Ratio
The rule of thumb is that the lifetime value of a customer should exceed its acquisition cost by a ratio of at least 3-to-1.
Using the above example:
$1,440 LTV / $200 CAC = 7.2. It exceeds our threshold of 3.0.
What Should My Customer Acquisition Cost Be?
Customer acquisition costs vary by industry. Much of it has to do with the value of the goods or services purchased, whether the company has businesses or consumers as customers and its industry. Companies such as Priceline spend about $7 per customer while Sprint PCS spends about $315.
You can find out what your CAC should be by performing a Google search or by reading recent annual financial statements of publicly traded companies in your space.
Your company’s stage of development will matter as well. Early stage ventures will have much higher customer acquisition costs than those more established in their market.
What Happens To CAC Over Time?
Your cost per customer acquisition should get lower over time. As you measure and upgrade your marketing efforts you should expect to become more efficient over time. Your customers can become a great source of referrals, which greatly reduces CAC.