Metric Stack - Customer Acquisition Cost: the startup killer
Fifth edition: how far will you go to gain customers?
Welcome back to Metric Stack. I’m Priyaanka Arora, your personal metric assistant and Content Researcher & Writer at Klipfolio. Can you believe it’s week 5 of Metric Stack?!
This week, we’ll discuss Customer Acquisition Cost, a crucial metric for startups, in depth. We’ll go through the definition, some examples, and determine when the cost of customer acquisition is too high or too low - and how that impacts you.
What is Customer Acquisition Cost?
Customer Acquisition Cost (CAC) is the cost incurred to acquire new customers. The calculation includes all sales and marketing costs, which are essential to bring new customers into the business.
Here's the formula:
Customer Acquisition Cost = (Marketing Cost + Sales Cost) / Number of New Customers
Customer Acquisition is 5 times more expensive than retention. However, you absolutely do need to generate new customers for your business to grow. Can you identify the problem here? You need to perfect a balancing act that would put a tightrope walker to shame!
How far should you go to acquire new customers?
As you can probably tell, dumping all of your money on acquiring customers is not the way forward. Why? Simply because it's highly unlikely that high acquisition costs will lead to even higher customer value. Even if you have enough capital to ignore increasing costs, there are no guarantees that you'll generate sufficient returns on that investment - see our discussion of Hype Factor in a previous edition of Metric Stack.
If you find yourself paying more to acquire customers than they bring in, you’re losing money, but more importantly: you probably don’t have the right product-market fit. I love applying this quote in my personal life, but I feel it’s relevant to this discussion:
“Love shouldn’t feel like hard work”
If you’re literally throwing money away to acquire new customers, that might be an indication that you need to look inwards at your product, conversions, and business operations to understand if you’re targeting the right customers with the appropriate product features and value.
CAC to Customer Lifetime Value Ratio helps measure the return on acquisition costs and is a metric you should look at along with CAC Payback Period, when seeking that fine balance between pouring money into acquisition and reaping the rewards.
How do you optimize customer acquisition costs?
Now that we’ve determined how and why high CAC can be detrimental to your business, you might wonder what the solution is to the problem I’ve highlighted. As a marketing or sales leader, you carefully budget each dollar against overwhelming acquisition targets. Before you go about increasing your spending on that advertising campaign, try these steps:
Generate value for the customer. Customers will come to you if they find value in your business. Remember how we considered if we’re the right fit for our target market? That’s super important. Market research, data analysis, and product positioning can lead you to generate value through every aspect of your product and its sales and marketing strategies.
Get your processes in line. An unorganized internal state of operations will eventually leak out and scare away your customers. Perfect the way you work to cut down project turnaround time that can be channeled towards better serving the customer.
Strengthen your organic acquisition. Although difficult to achieve, especially as a B2B, it’s free and you have (almost) nothing to lose. Viral and word-of-mouth marketing, community building, and social initiatives can tighten the gap between your overall audience and your best fit customers.
If you don’t focus on optimizing your acquisition strategy at the get-go, you’ll find the need to address it anyway eventually, when CAC exceeds LTV. Be self-aware and strategic in your approach to acquisition to gain maximum return on CAC.
Customer Acquisition Cost Example
Let's look at two simple scenarios to wrap up our understanding of this metric. In both scenarios A and B, monthly sales and marketing costs are $20,000. In that same month, both businesses gain about 100 new customers. The CAC for the month in both scenarios is $20,000 / 100, or $200 cost of acquiring one customer.
Imagine now that scenario A has a Customer Lifetime Value (LTV) of $700 and scenario B has an LTV of $350. Can you guess which scenario is better?
Both scenarios have the same CAC, but scenario A has a CAC to LTV ratio of 3.5 while B has a CAC to LTV ratio of 1.75. A is gaining $3.5 per customer acquired while B is barely breaking even on the acquisition cost.
Knowing which metrics to track makes all the difference between analytics for the sake of it and unlocking insights. A curated view, such as a dashboard, can help you stay on track with the metrics key to your business.
What’s new on MetricHQ
MetricHQ is the powerhouse of Metric Stack Newsletter. It’s always refreshed with the latest metrics, and this week we have three new finance metrics for you to check out: Return on Incremental Invested Capital (ROIIC), Enterprise Multiple, and Reactivation MRR.
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