In the realm of marketing strategy, understanding the worth of a customer to your business is paramount. At Mint, we believe that grasping the value of a customer and determining the affordability of acquiring new ones are foundational steps in any marketing endeavour.
Why does it matter, you may ask?
Fundamentally, marketing success hinges on the ability to outspend competitors in acquiring new customers, all whilst maintaining profitability. The concept is simple: whoever can afford to allocate the most resources to acquire a new customer stands the best chance of winning the market share. However, this expenditure must be sustainable to ensure optimal returns.
For example, if we can afford to spend $100 to profitably acquire a new customer, then attracting new customers for $101 is a bad result. But this goes both ways; if we can afford $100 per customer and we’re attracting them for $70, then we’re potentially leaving growth on the table.
But how do you determine this affordability? It boils down to calculating your maximum allowable customer acquisition cost (CAC), this can be done using a simple four-step process.
To get started, you’ll need two things in front of you:
1) Your profit and loss statement from the previous 12-months
2) A list of all of your customer/clients over that same period - depending on your business you may have this data stored in your CRM, or your accounting platform may be your best bet
Step One: Calculating customer lifetime value
Customer lifetime value (CLV) encapsulates the total revenue a customer generates over their entire relationship with your business. Beyond the initial transaction, it factors in repeat purchases and long-term engagement.
To compute CLV, divide your total revenue over a period by the number of unique customers within the same timeframe.
For example, let’s say your business generated $500,000 revenue over the past 12 months. If this was generated from 500 individual customers - your 12-month customer lifetime value would be $1,000.
Step Two: Deducting direct costs (COGS or COS)
Subtract your direct costs—expenses directly associated with delivering your product or service—from the CLV. For physical goods, direct costs include raw materials, labour, and packaging. While for service providers, they may comprise salaries, software expenses, and travel.
The easiest way to pull this into our calculation is to take your total direct costs as a percentage of total revenue, then apply that percentage to the customer lifetime value we calculated in step one.
To continue with our example, let’s say that our direct costs come to 25% of revenue - applying this to our customer lifetime value of $1,000 works out to be $250.
Step Three: Subtracting indirect costs (a.k.a overheads)
Deduct your overheads—fixed costs such as rent, payroll, and administrative expenses—from the remaining gross margin.
The reason we’ve split these costs out from the direct costs in the previous step is that overheads don’t necessarily scale in proportion to revenue, meaning that things get more efficient as time goes on.
So even though these overheads aren’t tied directly to fulfilling a transaction, we’re going to pretend that they are for the purpose of this calculation.
Back to our running example - let’s say that these indirect costs add up to 45% of our revenue over the past 12 months. Applying this to our customer lifetime value of $1,000 works out to be $450 of indirect costs.
Step Four: Subtracting desired profitability
Let’s quickly recap on where we’re at: we’ve taken our revenue over the past 12 months, subtracted our direct costs (COGS or COS) and subtracted our indirect costs (overheads).
Following our ongoing example, that equates to:
$1,000 - $250 - $450 = $300
Does this mean that we can afford to spend $300 to acquire a new customer? Not quite - we still need to factor in your business’s desired profitability. So the next question we need to answer is: what profit margin does your business need to generate?
This required profitability will depend pretty heavily on your:
- Industry
- Business model
- Cash flow situation
- Capacity and appetite for growth
Let’s say our example business has a target net margin of 20%, which equates to $200 of our $1,000 customer lifetime value.
Bringing it all together
By integrating these steps, you arrive at a clear understanding of your maximum allowable CAC—the threshold beyond which customer acquisition becomes unsustainable. Regular reassessment ensures alignment with evolving business dynamics and market conditions.
So bringing this all together, we have:
$1,000 of customer lifetime value
Less $250 of direct costs (COGS or COS)
Less $450 of indirect costs (overheads)
Less $200 in required net profit
Leaving us with a maximum allowable customer acquisition cost of $100. We now know (with a reasonable degree of certainty) that we can afford to spend $100 to acquire a new customer while still achieving our desired net profit for the business over a 12-month period.
This number is now a line in the sand you can use to determine whether or not your marketing efforts are succeeding or need some work.
Key Considerations and Takeaways
- Recalculate regularly: As your business evolves, so too should your maximum allowable CAC. Regular recalibration ensures alignment with changing operational and market landscapes.
- Focus on increasing CLV: Enhancing customer lifetime value through improved retention rates, repurchase frequencies, and average transaction values amplifies your capacity to invest in customer acquisition.
- 12-month snapshot: While CLV may span years, focusing on a 12-month window allows for actionable insights and immediate operational adjustments.
Determining the worth of a customer and calculating your CAC is not just an exercise in number crunching—it’s a strategic imperative. In the race to win customers, those who understand their value proposition best are more likely to succeed.
