The customer acquisition cost often abbreviated to CAC is simply the total costs incurred in trying to acquire new customers divided by the number of new customers acquired in the period.
Customer Acquisition Cost Formula
Since the majority of these costs fall under the heading of sales and marketing, the customer acquisition cost formula is usually written as follows.
The sales and marketing expense should exclude costs relating to current customers, such as those relating to customer support services. Likewise, if there are other significant costs of acquiring new customers not included under the heading of sales and marketing these should be added to the total cost before calculating CAC.
With this in mind a useful starting point to calculate sales and marketing expenses is our sales and marketing cost model template. This template is designed to calculate sales and marketing expenses for inclusion in the financial projections template.
Example Customer Acquisition Cost Calculation
As an illustration, suppose for an accounting period the sales and marketing costs relating to the acquisition of new customers is 12,000, and 150 new customers are acquired in the same period. Accordingly, assuming no other costs are relevant, the calculation of the cost of customer acquisition is as follows.
Customer acquisition cost = Sales and marketing expenses / New customers Customer acquisition cost = 12,000 / 150 = 80
As can be seen the average customer acquisition cost for the accounting period was 80 per customer.
It is important when calculating CAC that the accounting period used is sufficiently long to include all the activities and associated costs related to the acquisition of a new customer (prospecting, contacting, presenting, closing etc). The period is will vary from business to business and is usually referred to as the sales cycle.
Customer Acquisition Cost vs Lifetime Value
To make economic sense it stands to reason that the cost to acquire a customer (CAC) must be less than the amount earned from the customer over its lifetime with the business.
The lifetime value of the customer or LTV should be based on the gross margin earned from the customer and not the revenue. Our customer lifetime value calculator is available to help you calculate the value.
Of course in addition to sales and marketing expenses the business has other costs such as general and administrative costs, and research and development costs. In order for the business to be successful it is therefore necessary for the customer acquisition costs to represent only a part of the amount earned from the customer.
LTV CAC Ratio
Typically to have a chance of success the sales and marketing costs should be no more than one third of the amount earned from the customer leaving the balance to pay other costs and make a profit.
It should be noted that while this formulation is typical within the Saas industry, ultimately the level of CAC in relation to LTV will depend among other things on the cost structure of the business.
Furthermore we can rearrange the formula and restate as follows:
This ratio is referred to as the LTV CAC ratio and represents the number of times the customer acquisition cost is covered by the lifetime earnings from the customer.
Of course the LTV to CAC ratio should never be less than 1, at which point the cost of acquiring a customer is equal to the lifetime earnings. Typically a business will aim for a ratio higher than 3. In addition, although on the face of it the higher the ratio the better, a ratio which is too high might imply that the amount spent on acquiring customers is too low resulting in lost opportunities to acquire customers.
Customer Lifetime Value CAC Ratio Example
Suppose a newly acquired customer pays a subscription of 20 each month to use the service provided by the business. After allowing for the costs to service the customer the gross margin percentage is 70%.
Gross Margin
The calculation of the monthly gross margin contribution provided by the customer is as follows.
Monthly gross margin = Monthly subscription x Gross margin % Monthly gross margin = 20 x 70% = 14
The new customer contributes 14 each month to the gross margin of the business.
Lifetime Value
Assuming a churn rate of 5% each month and ignoring any complications relating to revenue growth or discounting, the lifetime value of the customer is calculated as follows.
LTV = Monthly gross margin / Churn rate LTV = 14 / 5% = 280
Over the course of its lifetime this customer will contribute 280 to the gross margin of the business.
Additionally our customer lifetime value calculator is available to help you calculate the LTV.
LTV CAC Ratio
We know know that the LTV of this customer is 280, and the CAC (calculated above) is 80. The calculation of the LTV CAC ratio is as follows.
LTV CAC Ratio = LTV / CAC LTV CAC Ratio = 280 / 80 = 3.5
The ratio is 3.5 meaning that the earnings from the customer are 3.5 times the cost of acquiring the customer. This is typically an acceptable ratio for a Saas based business.
CAC Payback Period
The CAC payback period is the time it takes to recover the customer acquisition costs from earnings from that customer.
In simple terms and ignoring the effect of churn, the formula can be stated as follows.
CAC Payback Period Example
In the example above the cost to acquire a new customer is 80 and the monthly gross margin earned from the customer is 14. The calculation of the CAC payback period is as follows.
CAC payback period = CAC / Customer gross margin CAC payback period = 80 / 14 = 5.71 months
In this example it takes 6 months of earnings from the customer to recover the 80 needed to acquire the customer.
It should be noted that if the effect of churn is taken into account the payback period extends to 7 months. The higher the churn rate the longer it will take to payback the costs of customer acquisition.
Clearly the longer the payback period the longer the business has to fund the amount spent on acquiring the customer. As the business expands rapidly this necessity to provide funding will grow resulting in a need for additional finance facilities or at best lost opportunities to use available finance elsewhere.
Typically it is considered appropriate and good practice to have a CAC payback period which is less than 12 months.
Using Customer Acquisition Cost CAC Ratios
By monitoring the LTV CAC ratio and the CAC payback period it is possible for a business to make adjustments to its business model to ensure the ratios stay within acceptable levels.
For example, the table below summarizes the ratio values calculated in the above example (original), and reveals the effect on the CAC ratios by changing the sales and marketing spend, the gross margin percentage, and the churn rate (revised).
| Original | Revised | |
|---|---|---|
| CAC calculation | ||
| Sales and Marketing | 12,000 | 20,000 |
| New users | 150 | 160 |
| CAC | 80 | 125 |
| Gross margin | ||
| Revenue | 20 | 15 |
| Gross margin % | 70% | 60% |
| Gross margin | 14 | 9 |
| LTV calculation | ||
| Churn % | 5.0% | 5.0% |
| LTV | 280 | 180 |
| CAC ratios | ||
| LTV / CAC | 3.50 | 1.44 |
| Simple payback | 5.71 | 13.89 |
| Payback with churn | 7.00 | 24.00 |
In this example, in an attempt to increase customers the business has increased its sales and marketing spend to 20,000 and dropped its prices to 15, with a consequent drop in gross margin percentage to 60%. Unfortunately the number of new customers only increases to 160 causing a significant effect on the CAC ratios.
The LTV CAC ratio has fallen to 1.44, way below the typical standard of 3. In addition the simple payback period has increased to 14 months meaning the business will need to fund the customer acquisition costs for an additional 8 month period.
Summary
The cost of acquiring a customer is an important concept to understand for any business. The CAC will depend on the amount spent on sales and marketing and the number of new customers the business manages to generate by incurring that expense.
CAC cannot be viewed in isolation but must be looked at relative to the lifetime value (LTV) of the customer acquired and the time it takes to recover the costs.
When dealing with the cost of acquiring new customers it is important not to lose sight of the fact that it is always more expensive to acquire new customers than to retain current customers. An equal amount of attention should always be given to reducing the churn rate and retaining and selling additional products and services to current customers.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.