How to Calculate Customer Acquisition Cost
Customer acquisition cost, or CAC, is a crucial metric to determining the success of your marketing campaigns. In plain terms, CAC is a calculation of how much money it costs you to acquire one customer.
The word to focus on in that definition is “customer.” It's important when you're calculating your CAC to only focus on your new customers. For example, if you work at a SaaS company that operates on the freemium model, users of the free version are not customers and, therefore, shouldn't be included in your CAC calculation.
There's one big problem with calculating CAC: the most common formula can sometimes be too simplistic and give you wrong data about how successful your marketing campaigns are.
Basic Customer Acquisition Cost Formula
In theory, customer acquisition cost should be a simple calculation, but it can vary depending on your business model. The formula is total sales and marketing spend over a specific period, divided by the number of new customers over that same period.
For companies with a short sales cycle, this formula works great. If you work for a company with a long sales cycle, typically more than 30 days, this formula isn't always accurate.
For example, let's say your sales cycle is two months on average. One month, you decide to increase your advertising budget by $10,000. Therefore, your marketing spend increased by $10,000 for that month, but since you have a two-month sales cycle, you won't see a return on that spend for two months. If you calculate your CAC based on the current month's spend, it's going to look much worse than it actually is.
In the chart above, Month 3 contains the $10,000 advertising increase, and Months 4 and 5 contain the increase in new customers that resulted from the advertising increase. Calculating your CAC based on Month 3's expenses when your sales cycle is 2 months long results in a CAC of $115, which is higher than average. It's high enough that you might call your advertising campaign a failure.
To prevent this from happening, you need to factor in one additional data point: time.
Time-Based Customer Acquisition Cost
There's a very simple way to factor time into the equation. Let's stick with the two-month sales cycle to explain this.
To factor time into your CAC equation, you have to calculate your CAC based on the expenses from two months ago. This equation is: marketing and sales expenses from two months ago divided by the number of new paying customers from the current month.
When you use this formula, you might not notice a difference for most months, but when you have months with increased expenses, it will normalize your CAC so that you can get an accurate number to determine the performance of your marketing.
This Time-Based CAC equation has decreased our CAC for Month 3. In the Simple CAC equation, our Month 3 CAC was $115. In this Time-Based model, our Month 3 CAC is $106, which is about average based on the previous months.
The correct CAC number for the Month 3 advertising increase appears in Month 5 because of the two-month sales cycle. Month 5 has increased from the Simple CAC formula, but at $96, it's still well below average. You can, therefore, call this campaign a success.
As the name suggests, the Time-Based CAC formula takes time into consideration, which will give you a much more accurate CAC if you have a long sales cycle.
What Should You Include in Your CAC Calculation?
I mentioned that your CAC calculation should include your marketing and sales expenses, but which expenses?
You need to include ALL expenses in this calculation. At the very least, that's going to include salaries, tools/software, travel expenses, advertising spend, and freelancers you work with.
Basically, every penny that comes out of your marketing and sales budgets should be included in your CAC cost. If you send a few team members to a conference, include those costs in your budget for the month.
There's a good chance these costs will fluctuate from month to month. You might add new employees, new tools, or new freelancers. You might also have expenses one month that don't appear in other months — such as a subscription that you only pay once per year. That's why it's important to calculate these expenses each month. Your CAC will change based on these numbers.
2 Ways to Further Break-Down CAC
It's important to know your average Customer Acquisition Cost across all channels. You have to figure that out as a starting point. Once you've got that number figured out, it can be helpful to look at your CAC in different ways. This will help you figure out which channels, campaigns, and even locations are performing well and which are not.
A few examples:
1. CAC by Marketing Campaign
Breaking your customer acquisition cost down by marketing campaign can help you figure out if specific campaigns are successful, or if you're wasting your money.
Six months ago, Jerry's Berries, a B2C e-commerce company that sells berries, decided to hire an agency to run digital advertising for them. The agency's goal is to get new customers. The agency has a budget of $10,000/month to spend on digital ads. On top of that, they charge $3,500/month to manage the ad campaigns. Jerry's Berries' total monthly investment in this ad campaign is $13,500.
Jerry's Berries had never done any sort of digital advertising, but they knew before hiring this agency that their average CAC across all channels was $10. They also don't have a sales team or a long sales cycle, so they're able to use a Simple CAC formula. Here's a look at the CAC of their digital ad campaign from the past six months:
Jerry's expenses for this campaign were the same across Months 1 through 6, but the number of customers coming in from this campaign has increased. That combination has caused the CAC to go from $15.88 down to $10.24. Jerry's agency is getting closer to giving them a great CAC. As a result of this trend, Jerry's should keep the advertising campaign running for a few months to see if they can continue to drive down their CAC on this channel.
2. CAC by acquisition source
Similar to breaking down your CAC by campaign, looking at CAC by acquisition source can help you figure out if you should spend more time and money on one channel over another. We'll use a fake company called Taco Analytics to explain how this can work.
Taco Analytics is a SaaS company that makes accounting analytics tools for restaurants. For the past twelve months, they've been spending a lot of time and money on content marketing with the goal of getting more customers through organic search.
To pull this off, they hired one full-time writer and have another employee working 20 hours a week on this. Both of those employees use a number of tools to help them do their work. The marketing expenses for this strategy are:
- Full-time writer's salary: $4,000/month
- 50% of Employee 2's full-time salary: $2,000/month
- Tools that both employees use: $250/month
On top of those expenses, Taco Analytics has a small sales team of four people. Those salespeople have gotten Taco's sales cycle down to 30 days, but this does require some traveling to customer locations. Total sales expenses:
- Salaries for all four salespeople: $20,000/month
- Travel expenses for salespeople: $6,000/month
- Tools that all salespeople use: $400/month
There's one thing that makes this calculation a little bit difficult. For CAC by source to work, you need to calculate the amount of time your sales team spends working leads from that source only. For Taco Analytics, their salespeople report that organic leads require much less work. As a result, Taco's salespeople only spend 33% of their time working organic leads.
From the chart, you can see that Taco's CAC has dropped drastically over the past 12 months. Month 1's CAC isn't available because of the one-month sales cycle, but starting with Month 2, Taco's organic CAC was $831. By Month 12, their organic CAC was all the way down to $288. That seems like a huge success, but there's still one more number to take into consideration to determine if this source is actually successful and worth the investment: Lifetime Value, or LTV.
CAC & LTV: Determining Success or Failure of a Campaign
Customer lifetime value is defined as, “the total amount of revenue your customer will generate for you throughout their lifetime.” If your average customer stays with you for two years and they spend $1,000 per year with you, your LTV is $2,000.
Now here's where it gets interesting. Your CAC needs to be less than your LTV, but how much less? If your LTV is $2,000, but your CAC is $1,500, is that good?
According to Geckoboard, using an LTV:CAC ratio is the best way for you to determine if that campaign is actually making money for your company. A good LTV:CAC ratio is 3:1, meaning for every dollar you spend on CAC, you need to be getting $3 back in revenue. The higher your LTV is compared to your CAC, the better. 4:1 or 5:1 are exceptionally good ratios.
Using our fake company, Taco Analytics, as an example, their Month 2 organic traffic CAC was $831. Taco knows that their LTV is $1,000. That means their organic LTV:CAC ratio for Month 1 was 1.2:1. That's really bad.
The good news for Taco Analytics is that by Month 12, their CAC was down to $288. Their LTV stayed the same at $1,000, which gives them a ratio of 3.4:1. That's pretty good, and signifies that they're headed in the right direction with their organic strategy.
One Last Tip--Pay Attention to Retention Costs, too.
If you are focused on your customer acquisition cost metrics, it makes sense to also manage your retention costs. It's generally accepted that retaining clients is less expensive than acquiring and onboarding new ones.
While lowering retention costs won't necessarily lower your customer acquisition costs there's another angle at play. If you have relatively high acquisition costs, you face a stronger need to drive retention rates to take that pressure off your bottom line.
This infographic was created by First Data, a provider of merchant services
Customer Acquisition Cost: An Important Metric for Marketers
Whether you're using a simple CAC formula or a time-based one, it can take time to pull together all of the expenses that you need. It'll be worth it in the end, though. Calculating your CAC and then comparing that to your LTV will go a long way to proving the value of the work that you do as a marketer.