Customer acquisition cost (CAC) is a critical metric for ecommerce businesses. It measures the average marginal cost of acquiring one additional customer. It is used to determine whether or not your marketing budget is being used effectively and efficiently when it is referred to in conjunction with average order value (AOV) and lifetime value (LTV) in an analysis of your department’s profitability. Ultimately, it is a measure of the success or failure of your combined marketing efforts, and when the latter is in evidence, it signals the need for a complete revamp of your marketing strategy.inable.
CAC is A Numbers Game
Simply put, your customer acquisition cost is calculated by adding up all your marketing expenses and averaging that number on a per new customer basis:
Customer Acquisition Cost (CAC) = Total Marketing Cost (TMC) / Total New Purchasers (TNP)
To help better understand the concept, let’s draw a scenario where you solely own and operate an ecommerce business selling shoes online. In the month of January, you incurred the following marketing costs:
- Website hosting – $50
- Facebook advertising – $100
- Google advertising – $500
- Discounts and coupons – $5,500
- Whitepaper copy & Design – $1,500
TOTAL = $7,650
Based on data from your analytics tools, your ecommerce business acquired 500 new customers in January, and we know that on average customers spend $20 per order (AOV).
First we determine Customer Acquisition Cost where CAC = TMC/TNP
- CAC = $7,650/500
- CAC = $15.30
This gives us the following insights into marketing’s contribution to the business:
- It costs the business $15.30 marketing dollars to acquire one new customer
- The incremental marketing profitability we can reasonably expect is $4.70 (AOV-CAC), or a return on marketing dollars of 30%, or 1.3:1
There you have it!
Keep in mind this is a very basic example. In practice, ecommerce businesses will incur a variety of marketing related expenditures including but not limited to:
- Paid advertising campaign costs
- Marketing software including email, CRM and analytics tools and platforms
- Marketing salaries
- Third party expenses (e.g. agency fees)
- Coupons or discounts
- Affiliate fees
- Overhead costs attributed to marketing department
In this case, where CAC = TMC/TNP, then
CAC = (1 + 2 + 3 + 4 + 5 + 6 + 7)/ TNP
When adding all expenses over a longer period of time you will benefit from more accurate customer acquisition cost analysis, so keep track of all your expenses! The data based insights you glean are absolutely vital to long-term success, and of course you want to ensure you take them all into account come tax time.
The LTV: CAC Relationship
Once we understand how to calculate the cost of acquiring new customers or purchasers, we can take it one step further.
Customer lifetime value (LTV) is a metric used to calculate the total amount of dollars spent on our products by any given customer over the duration of their relationship with our business. If we compare that to the mean dollars spent acquiring a single new customer, we can determine the lifetime return on investment.
Let’s revisit our example from above, and add the fact that on average customers spend around $80 over their ‘lifetime’ with our store. We can now calculate the following:
- CAC = $15.30
- LTV = $80.00
- ROI = (LTV-CAC)/CAC
- ROI = $64.70/$15.30 = 423% or a return of 4:1
Although the ideal ratio depends entirely on your business, a ‘healthy’ level hovers at around 3:1. Should your ratio fall below this, it may indicate that your marketing efforts are not reaching the right customers, or that your cost of acquisition is too high. Either way it’s time to revisit all four P’s of your marketing strategy and likely reallocate your budget.
What if My Cost to Acquire New Customers is Too High?
If you’re spending too much to acquire each new customer, go back to the data and determine which channels were the most cost effective in with respect to driving volume and incremental profit. Let’s once again revisit our example:
If Facebook advertising drove 200 new purchasers for a spend of $100, and Google advertising drove 50 for a spend of 500, it would appear that our Facebook ads were far more effective.
Despite the simplicity of this explanation, the analysis shows that we can calculate the cost of customer acquisition and the ROI for each channel, allowing us to optimize the allocation of our marketing budgets based on business objectives.
The various analyses you undertake via your CRM and analytics tools will indicate not only which channels are most cost effective in your acquisition efforts, but also which channels attract the most profitable long-term customers. Understanding LTV, CAC and ROI facilitates effective budget management in conjunction with maximizing customer growth and profits.