Assessing risk with CAC Payback Period
Metric Stack 7: CAC Payback Period and more!
Did you know that CAC Payback Period helps you assess the risk of investing in customer acquisition? I’m Priyaanka Arora, your personal metric assistant and Content Researcher & Writer at Klipfolio. This week, we'll conclude our conversation about customer acquisition metrics with a deep-dive on CAC Payback Period.
What is CAC Payback Period?
CAC Payback Period is the time taken to earn back customer acquisition costs (CAC). The simplest form of this metric divides CAC by the annual revenue generated per customer:
CAC Payback Period = CAC per Customer / ARR per Customer
This metric is best used to estimate future financial state. While it's extremely useful to know how long you'll have to wait for your new customers to show returns on your investment, CAC Payback Period comes with several limitations you should be aware of.
First, CAC Payback Period can be calculated in many different ways. The formula we saw earlier, dividing CAC by ARR, is a straightforward way to look at CAC payback, but you could also multiply ARR by Gross Margin Percentage to get a more realistic number. You can also adjust the formula to a specific time period based on your specific needs for your analysis.
Another limitation of CAC Payback Period is that the calculation doesn’t include churn. So when you deduce that it will take you a year to recover CAC, you’re making the impractical assumption that you’ll have no churn and that your customers will always choose to renew.
This brings us to the final warning I’ll give you about this metric: there's a misconception that CAC Payback Period is used to calculate return on acquisition costs. You should use Customer Lifetime Value for that instead. The last two editions of Metric Stack cover CAC and LTV/CAC. We look at why CAC is called the startup killer and how to tackle high CAC, so definitely give those a read.
How to assess risk with CAC Payback Period
What I’m going to suggest here is an alternate way of looking at CAC Payback. Think back to the formula I shared with you. Basically, you put in CAC and take out revenue after sufficient time has passed. CAC Payback Period helps you look at that time between investing in acquisition and return on investment.
You should track CAC Payback Period to find the duration of risk associated with customer acquisition.
Here’s why CAC is a risk: you absolutely need to take on this cost for your business to grow. You’re looking at expense which is not optional, although there are ways to optimize CAC covered in Metric Stack fifth edition, while customer behavior is very difficult to predict. That’s why CAC Payback Period is a great metric for forecasting your future financial state.
Let’s look at a practical example of how to apply CAC Payback Period to your business. Say you spend $200 on average to acquire new customers who in turn pay an average of $100 per year. Your CAC Payback Period would be $200 / $100 which means that it takes two years to recover the cost of acquiring one customer. On top of that, customers will churn while your CAC keeps growing with returns that happen too late.
That’s the risk you’re taking by continuing in the current scenario, and that’s how you can use metrics like CAC Payback Period to mitigate problems you can control. As I mentioned previously on Metric Stack, strong product-market fit may be your best way to minimize risk in this sphere.
What is a good CAC Payback Period benchmark?
A good rule of thumb for CAC Payback Period is 12 months. Based on OpenView’s 2020 Expansion SaaS benchmark report, the median CAC Payback Period is just under 10 months for a company making between $1 and $2.5 million ARR, with the top quartile recovering acquisition cost in as little as 5 months. This median increases with an increase in ARR scale.
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