The profit formula: what is your customer acquisition cost?
Understanding Customer Acquisition Cost
Estimating what you can expect to earn from each customer is only one piece of the puzzle. Attracting those customers and providing the product likely won’t be easy, and it will cost money.
As we discussed earlier, you need to understand all three of these components of the profit formula to ensure the viability of your idea:
The price you charge to your customers
The cost of providing your product/service
The cost of acquiring your customers
The first item is something you should be able to justify based on a clear understanding of the value your product provides for your target customer. If you are still unclear on this, consider visiting Activity 6 "Price Your Product".
It can be difficult to come up with a good estimate of the variable costs of providing your solution to a single customer (item number two). Whether you are manufacturing a product or delivering a service, your initial costs will likely fall as you learn how to increase the efficiency and effectiveness of providing your solution to customers.
The most challenging estimate to come up with will be your Customer Acquisition Cost, or CAC (item number three). Note that this will include most of your Go-to-Market expenses incurred up until the point of purchase. There are many different channels for customer acquisition—paid search, social media advertising, freemium, mobile, telesales, inside sales, etc. The cost of acquisition depends on factors like the suitability of the medium to the product, the presence of your target segment on the medium, the cost associated with exposing the audience to your message, and the effectiveness of the message within the medium.
You want to spend as much as you can afford to acquire a new customer without exceeding that amount. If you spend too much, you are losing money. If you don’t spend enough, you lost out on potential customers and revenue. How do you know what the magic number is?
Determine your CAC
To calculate your Customer Acquisition Cost, consider your Go-to-Market System. What are the costs associated with bringing your product to market? You may not have enough information to answer this question, so check out the examples below and consider if one of the approaches is similar to yours.
Example 1: inside Sales
CAC = $1000+
It its early days (circa 2006, long before its multi-billion acquisition by SAP), Qualtrics employed a phone-based customer acquisition process. Inside sales reps, so called because they reached out to potential customers from their desks (rather than traveling around the country to meet them). Reps sold the Qualtrics Research Suite, a flexible platform for survey creation and analysis, to companies and research groups within companies. Qualtrics, based in Provo UT, hired inside reps to fit the following profile: smart (average GPA of 3.7 out of 4.0), able to manage multiple roles at once (most reps had worked while they were in school), college athletes, and had lived outside Utah for at least two years (these were often Mormons who had served as missionaries). These reps were paid a relatively low base salary (about $2,000 per month), but earned commissions on every sale. As a result, the most successful reps were able to earn upwards of $100,000 annually. The firm also incurred some overhead in training and supporting these reps. If a productive rep was able to close ten new customer deals per month, the CAC comes out to about $1,250 per customer.
Example 2 : Digital Advertising and paid Social Media
CAC = $25 - $100
Livionex is a small, privately-owned company in the San Francisco Bay Area. They sell a next generation dental gel called LivFresh that is more effective than conventional toothpaste in cleaning teeth. The Head of Marketing for the company is John Maull, an MBA from the Stanford GSB. The company sells LivFresh, with a list price of $20, on its own website and on Amazon.com. To create awareness for the product and to bring prospective customers to the company's website, the company engaged in a native advertising campaign (where paid ads match the look and feel of the media format in which they appear). Clicking on a native advertising link would bring the prospective customer to a specially designed landing page designed to promote conversion. The economics of native advertising look something like this. The cost of impressions is very low. One thousand impressions might cost less than one dollar (e.g., a campaign delivering 50 million impressions might cost only $25,000). Click-through rates are typically very low in native advertising (on the order of 0.1%. CAC depends on the rate at which the company can convert the prospects who click through to their landing page. If conversion rates are on the order of 0.5% to 1.0%, CAC in in the range from $50 to $100 per customer. Livionex also experimented with running testimonial and direct response videos on Facebook. Running these ads is much more expensive. The cost per thousand impressions might 100x as expensive as native advertising, which means that a $25,000 campaign might only generate 500,000 impressions. However, with click-through rates (2%) and conversion rates (5% to 10%) much higher, the CAC for Livionex might actually be lower than native advertising, in the range from $25 to $50 per customer.
Example 3: Freemium
CAC = $1 - $50
Spotify uses a freemium strategy for its customer acquisition. It offers an ad-supported free service to attract users. Over time, some of those users drop off, some continue using the free service, and some decide to upgrade to ad-free Spotify Premium service (at a cost of $9.99 per month). Ads do not cover the costs of the music licensing fees and royalties of the songs streamed to users of the free service. Spotify thinks of these costs as a marketing and acquisition expense. In 2017, Spotify reported revenues of roughly $5 billion and still reported a loss of almost half a billion dollars. If we assume that it cost the company $5.5 billion to stream music to roughly 150 million active users (both premium subscribers and freemium users), the cost is between $35 and $40 per year per user. CAC would be higher if we also took into account any marketing expenses incurred by Spotify to promote awareness and encourage trial. Not all freemium services are the same with respect to the economics of acquisition costs. Dropbox offers a freemium service in which users receive 2GB of storage for free. Users receive incentives of additional free storage (in increments of 250MB) for referring other prospective customers to Dropbox. Users can upgrade to Dropbox Plus (which increases storage to 1,000GB) for about $10 per month. Unlike Spotify, where roughly 40 percent of users subscribe to the premium version), only about 4 percent of Dropbox customers do so. However, also unlike Spotify, where the cost of servicing a free customer is $35 to $40, for Dropbox the cost of 2GB of space (and bandwidth associated with the use of that store space) is probably less than $1 per month.
Explore a profit formula example
Jim Lattin, Stanford Graduate School of Business faculty, shares an example of calculating CLV and CAC.
Consider Adjustments to Your Profit Formula
Let's reflect and consider how you might refine your acquisition cost.
Now that you've explored a few examples and done some groundwork could you make adjustments to improve your profitability and viability?
In the “Ideas” row of your Customer Acquisition Cost Template, capture your responses to the following:
How can you improve your CLV by getting your customers to keep coming back? If you're not sure, take time to revisit your customer personas. Consider this: what would provide added or continued value for your customers?
Are there strategies from the video that could improve the balance of your CLV and CAC? Make a plan for implementing those strategies. This is a good time to revisit your Go-to-Market system and make any necessary adjustments based on what you’ve learned in this module.