If you’re spending money on any sort of advertising, you’ve come to the right place.
Whether you’re a business owner, marketing professional, consultant or otherwise, you need to know how much you can pay for a new customer.
There are two key metrics that’ll get you there: the customer acquisition cost (CAC) and the lifetime value of a customer (CLV). These are the MOST IMPORTANT metrics for any business.
It’s as simple as this: your business will fail if you’re paying more to acquire a customer than they’re worth to you over their lifetime.
It’s also because you need to make money, which means you need to get a return on investment from your marketing and have a method to determine how effective it is for your business.
These metrics also help you calculate how much you can afford to acquire a new customer, which is why you clicked this in the first place.
Part 1: Customer Lifetime Value
Customer lifetime value is the value a customer contributes to your business over their entire lifetime with your company.
How is it calculated?
There are a few ways to do this, and the more detail you add to the equation, the more accurate your number will be.
For a ballpark figure if you don’t know the total sales / total customers, estimate between 2-8x the initial purchase price of your core value offer.
Say you run an online store and most of your products are around the $25 mark.
Anywhere between 2-8x that initial purchase price will be a good ballpark figure for your customer lifetime value.
- $25 x 5 = $125 CLV
If you have a customer relationship management (CRM) tool and can tell how many active customers have bought your products in the last year / 6 months / 3 months, you can divide your total sales in that time frame by the number of those customers to get a more accurate CLV.
This is still a pretty rough estimate, but it’ll be more accurate than the 2-8x your initial purchase price method.
Now, if you want to get more detailed - and more precise - there are a few equations that’ll calculate the historic CLV (pretty accurate) and predictive CLV (most accurate).
Historic customer lifetime value is simply the sum of the gross profit from all historic purchases for an individual customer.
Add up all the gross profit values up to transaction X where X is the last transaction the customer made with your store.
CLV (historic) = (transaction 1 + transaction 2 + transaction 3…+ transaction X) x AGM
AGM = Average Gross Margin
Calculating based on net profit gives you the actual profit a customer is contributing to your store but can be complicated to calculate on an individual basis.
The predictive CLV method, also referred to as the Gross Margin Contribution per Customer Lifespan (GML), forecasts the lifetime value of an individual.
As long as the GML equation is accurate, this value will become more and more accurate with every purchase and interaction. It’s also the most difficult and complicated to calculate:
- T - Average monthly transactions
- AOV - Average order value
- ALT - Average Customer Lifespan (in months)
- AGM - Average Gross Margin
From there, you can plug that number into another formula that takes into consideration your monthly retention rate and monthly discount rate for a more precise calculation:
- CLV=GML (R/(1+D-R))
- R - monthly retention rate
- D - monthly discount rate
Both models are never going to be exact, but they will be the most accurate forecasts for CLV.
Okay, so I’ve calculated my customer lifetime value. How does this help me?
There are 5 major reasons why using CLV as a central metric is vital if you want to increase profitability, retention, and overall success:
- Generate real ROI on customer acquisition by focusing on the channels that give you the most profitable customers.
- Enhance your retention marketing strategy by basing campaign value on the impact it had on the average CLV of the segment of customers you’re targeting.
- Create more effective messaging, targeting, and nurturing by segmenting customer base by CLV to improve the relevance of your marketing with more personalized messaging.
- Improve your behavioral triggers by discovering those that incentivized your best customers to make their first purchase, then replicate those behaviors with prospective customers.
- Improve output from customer support by giving special attention to your most valuable customers. Be aware of Pareto’s principle: 20% of your customers generate 80% of your revenue.
Part 2: Customer Acquisition Cost
What’s customer acquisition cost?
Customer acquisition cost refers to the price you pay to acquire a NEW customer.
[Not to be confused with Cost Per Action (CPA), as that’s typically the amount you pay to convert a customer, both new and existing. Google refers to CPA as the cost you’re willing to make a conversion, NOT acquire a new customer]
CAC can be used to determine how much you’re currently paying to acquire a new customer, as well as the tolerable customer acquisition cost you can afford to pay for a new customer.
How do we calculate what we’re currently paying for a new customer?
At its simplest, current CAC can be worked out by dividing the total costs associated with an acquisition by total new customers, within a specific time period.
However, a more detailed approach will give you a more accurate idea of how much you’re currently paying for a new customer.
- Simple (less accurate, not necessarily correct, a general idea of CAC):
- CAC=MCC(Marketing campaign costs related to acquisition) / CA (Total Customers Acquired)
- MCC refers to direct costs associated with running a campaign
- Complex (correct) method:
- CAC = (MCC+W+S+PS+O) / CA, where:
- CAC - Cost of customer acquisition
- MCC - Marketing campaign costs related to acquisition
- W - Wages associated with marketing and sales
- S - Cost of all marketing and sales software
- PS - Any additional professional services used in marketing (design, consultants, etc)
- O - Overheads related to marketing and sales
- CA - Total customers acquired
- CAC = (MCC+W+S+PS+O) / CA, where:
How do I calculate how much I should be paying for a new customer?
To figure out how much you can afford to acquire a new customer, you’re going to need the customer lifetime value you calculated in part 1, as well as an approximate idea of your refund rate, cost of goods sold, overhead, and desired profitability.
Calculating Refund Rate
To calculate your refund rate, you’ll need to access your CRM to determine the percentage of people who buy that ask for a refund.
If you don’t have access to this information, you can estimate that 10-20% of people who buy ask for a refund, which errs on the side of conservative.
Using our same sample CLV of $125 from part 1, a 10% refund rate would be $12.50 of the total lifetime value.
Calculating Cost of Goods Sold
If you have a physical product, this is straightforward to calculate. Add up how much it costs to manufacture and put your product on the market, factoring in shipping and other expenses.
If you have a digital product, your cost of goods sold will be cheaper since you produce it once then just pay for hosting on servers.
And if you don’t have access to any of this information, you can assume an average cost of goods sold is 10% of your customer lifetime value.
Using our same sample CLV of $125 from part 1, a 10% cost of goods sold would be $12.50 of the total lifetime value.
Overhead takes into account payroll, utilities, accounting services, legal, software, travel and entertainment, and really any cost associated with people in your business.
If you don’t have access to this information you can assume a 30% overhead cost, which would be $37.50 of the total customer lifetime value using our sample from part 1.
Calculating Desired Profitability
The desired profitability is subjective and depends on the preference of your specific business.
Typically between 20 - 30% of your customer lifetime value is a reasonable profit margin for a product in the digital space.
Again using our sample CLV of $125 from part 1, a 20% profit margin would be $25.
Putting It All Together To Calculate Tolerable Customer Acquisition Cost
Now that you have your refund rate, cost of goods sold, overhead, and desired profitability, all you need to do is add them all up and subtract the total from your total customer lifetime value you calculated in part 1.
- CLV ($125) - (Refund Rate ($12.50) + Cost of Goods Sold ($12.50) + Overhead ($37.50) + Desired Profitability ($25))
- Tolerable Customer Acquisition Cost = $125 - $87.50 = $37.50
- This means you can afford to pay $37.50 for every customer that comes in
With that being calculated, you can figure out other important metrics that will let you know how much you can afford to pay for specific actions based on click and conversion rates.
For example, if you convert 10% of leads into paying customers, you have a tolerable cost per lead of $3.75.
Part 3: The CLV:CAC Ratio
The most important ratio to focus on is one that tells you exactly how much you’re making from your customers in relation to how much it costs to acquire them - CLV:CAC
Why’s this ratio so important?
Well for starters, your business will fail if your CAC is higher than your LTV.
- Less than 1:1 - you’re on the road to oblivion
- 1:1 - you’re losing money from every acquisition
- 3:1 - the sweet spot. You have a thriving business and a solid business model
- 4:1 - nice work, but you’re under investing and could be growing faster. Start more aggressive campaigns and bring your ratio closer to 3:1
The ratio also helps you analyze the overall health of your business, and helps you figure out how your marketing campaigns are performing.
It also lets you find out which channels and campaigns have the best CLV:CAC ratio so you can dedicate more time to the best channels.
- Remember that customer acquisition costs for different campaigns are always in flux. You have to be keeping track of performance, and when you stop getting an ROI, stop the campaign