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Customer Acquisition Cost

If you are a SaaS business, it is important for you to learn about Customer Acquisitions costs because:

  • Such costs help a SaaS business to attract potential customers
  • Optimizing such costs help in bringing efficiency
  • It is one of the most important metrics that e-Commerce businesses use to measure performance

As per the US Small Business Administration, businesses with revenues less than $5 million should allocate 7-8 percent of their revenues to marketing. This showcases that businesses must incur costs and invest time and effort to acquire customers and enhance customer satisfaction in order to retain them.

Today, hyper-connectivity has exposed consumers to digital content continually. As a result of such exposure, consumer expectations have risen with regards to having a wholesome experience while shopping online.

Consumers are not only seeking high-quality products but are also in search of brands that give them an enhanced online shopping experience. This has resulted in increased competition for customer attention in paid advertising. 

As a result, Customer Acquisition Cost (CAC) is rising every year for e-commerce businesses whether they are dependent on organic search traffic or pay-per-click (PPC) advertising. In fact, e-commerce businesses spend money on highlighting their value proposition, driving traffic, and enhancing the overall digital experience for their customers.

In this article, we are going to discuss what is Customer Acquisition Cost (CAC) and how to do CAC calculation. In addition to this, we will also discuss the factors affecting CAC.

What is Customer Acquisition Cost?

Customer Acquisition Cost (CAC) refers to money that a business spends to acquire a new customer.  This includes costs associated with marketing and sales that e-commerce businesses incur in order to attract potential customers to purchase their products.

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For instance, Netflix, Inc., which provides a subscription-based online video streaming service, had a marketing expense of about $2.2 billion and acquired around 29 million customers in the 12 months ended March 31, 2021. It had a CAC of about $77.

Note that this Customer Acquisition definition can overstate CAC. This is because not all sales and marketing expense is dedicated solely to acquiring new customers. It may include other forms of acquisition costs like freemium offerings, hardware subsidies, promotions, and installation costs.

Some even define Customer Acquisition Cost more broadly by including even the cost of the customer experience in CAC. This is done as it is considered that consumers choose a product because of how they are treated throughout their entire experience. 

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CAC is one of the most important metrics that e-Commerce businesses use to measure performance and understand the segments that are more profitable. In fact, the investors use this financial metric to understand business scalability and evaluate the company’s profitability.

Besides looking into standalone CAC, the investors consider CAC in the context of the Lifetime Value of a Customer (LTV). This is because it helps them understand the return on investment. 

Thus, the cost of the customer experience is core to the total CAC calculation. The manner in which an e-commerce business executes the digital customer experience increasingly determines whether they build or lose value.

How To Do CAC Calculation?

Typically, CAC is calculated by adding marketing, advertising, and sales personnel costs and dividing that amount by the number of customers acquired. That is, adding the costs associated with converting prospects into customers and dividing that amount by the number of customers acquired.

Accordingly, the CAC formula is:

Customer Acquisition Cost = (Marketing Costs + Sales Costs)/Number of New Customers Acquired

This CAC formula may seem correct. However,  it fails to consider a lot of details with regard to different variables in the equation. This means that e-commerce businesses using this formula to calculate CAC may have misleading results. 

For instance, the above formula does not consider the fact that not all customers are new customers. That is, some customers are returning customers. Secondly, it does not cover the cost to support customers when they are using the free tier of a freemium product.

Also, such a formula fails to consider that it takes more time, around 60 days, for a lead to get converted into a customer.

Thus, to calculate a near to accurate CAC figure, an e-commerce business must consider the following things.

1. Time Between Marketing Expense and Lead Conversion

The first factor that an e-commerce business must consider is the time between business spending on its marketing or sales touchpoints and lead becoming a customer.

Say, for instance, Google Docs is a freemium product. A user first signs for the freemium tier of the product and uses it for some time period until he hits the storage space limit. Once this happens, he might plan to upgrade the plan and go for the premium product.

Likewise, an e-commerce store may make a lead as a result of its marketing efforts in a particular month. However, it might take the lead more than 60 days to get converted into a customer.

Thus, it is important for an e-commerce business to consider all these factors while calculating its CAC. Ignoring such factors may lead to the results getting overestimated or underestimated.

CAC Calculation Example

‘Zapin’ is an e-commerce store that sells consumer products. The following table showcases the selling and marketing expenses of ‘Zapin’ month-wise for the year 2021.

MonthsMarketing ExpensesSelling ExpensesTotalNew CustomersCAC
January 2021$200$350$55015$37
February 2021$210$360$57018$32
March 2021$250$380$63015$42
April 2021$320$410$73015$49
May 2021$250$450$70020$35
June 2021$280$390$67025$27
July 2021$360$360$72030$24
August 2021$250$410$66040$17
September 2021$350$460$81060$14
October 2021$340$350$69065$11
November 2021$320$320$64060$11
December 2021$350$430$78055$14

As we can see in the above table, ‘Zapin’ spent money on new sales channels in the month of April 2021. This led to an increase in the marketing and sales costs. As per the standard CAC formula, CAC for ‘Zapin’ April 2021 is $49.  Note that ‘Zapin’ would cease expenditure on these marketing channels as actual CAC for April 2021 is more than the target CAC set at $40.

Now assume that it takes ‘Zapin’ 60 days to convert a lead into a customer. The following is another table that takes this into consideration and calculates the CAC accordingly.

MonthsMarketing ExpensesSelling ExpensesTotalNew CustomersCAC
January 2021$200$350$55015
February 2021$210$360$57018
March 2021$250$380$63015$37
April 2021$320$410$73015$38
May 2021$250$450$70020$32
June 2021$280$390$67025$29
July 2021$360$360$72030$23
August 2021$250$410$66040$17
September 2021$350$460$81060$12
October 2021$340$350$69065$10
November 2021$320$320$64060$14
December 2021$350$430$78055$13

The above table showcases that in March we have a CAC of $37, and in April a CAC of $38. This means that ‘Zapin’ will not cease to spend on new marketing channels in the month of March and April 2021. In fact, it will probably make the decision to scale them.

Note that where the time period between an e-commerce business spending money on marketing and the lead converting into customers is short, it will not have a greater impact on CAC. Also, such a period does not impact CAC when the marketing or the sales expenses of an e-commerce business are consistent and that normalize over a period of time.

Thus, an e-commerce business must take into consideration the correlation between the timing of the expenses and the timing of a lead converting into a customer.

This can be done by simply taking the average of the time it takes to spend money at the first market touchpoint to acquire the customer. 

Accordingly, the CAC formula can be:

CAC = (Marketing Expenses (n-60) + 1/2 Sales (n-30) + ½ Sales (n)) / New Customers (n)

Where n = Present Month

Let’s consider the above example once again.

MonthsMarketing ExpensesSelling ExpensesTotalNew CustomersCAC
January 2021$200$350$55015
February 2021$210$360$57018
March 2021$250$380$63015$38
April 2021$320$410$73015$40
May 2021$250$450$70020$34
June 2021$280$390$67025$30
July 2021$360$360$72030$21
August 2021$250$410$66040$17
September 2021$350$460$81060$13
October 2021$340$350$69065$10
November 2021$320$320$64060$11
December 2021$350$430$78055$13

2. Expenses To Be Included In CAC

The second factor that an e-commerce business must consider is the expenses it needs to include in the total marketing and sales expenses. Accordingly, the first type of expenses that an e-commerce business must include in the dales and marketing expenses are the salaries of all professionals working on marketing and sales. 

Many e-commerce businesses do not include the salaries of marketing and sales professionals while calculating their CAC. In fact, the e-commerce businesses must include not only the salaries of marketing and sales individual professionals who are solely dedicated to selling the products or services. But, they should also include the payroll and other related expenses of the individuals who are working part-time in marketing or sales.

Thus, CAC that includes the salaries of both the part-time and full-time marketing and sales personnel is called “Fully Loaded CAC.” In certain cases, it becomes important for an e-commerce business to separate the Fully Loaded from Non-Loaded CAC.

In addition to the salaries of marketing and sales personnel, an e-commerce business must include overhead expenses like rent, equipment, etc. It must allocate such expenses to those employees working on marketing sales.

Also, e-commerce businesses spend a lot on various marketing and sales tools. Such tools call for cost and must be included in the expenses of a firm’s CAC calculation.

Thus, the formula for Fully-Loaded CAC is:

Fully-Loaded CAC = Marketing Costs + Sales Costs = Salaries + Overhead + Cost of Tools

Factors Affecting Customer Acquisition Cost

The following are the factors affecting customer acquisition cost for an e-commerce business.

1. Fulfillment Fees

Fulfillment costs refer to the costs incurred in operating and staffing the fulfillment centers, physical stores, customer service centers, and payment processing costs of an e-commerce business. 

The customer service center costs include costs attributable to buying, receiving, inspecting, and warehousing inventories; picking, packaging, and preparing customer orders for shipment.

Fulfillment costs also include payment processing and related transaction costs.  Such costs include the costs associated with the guarantee of sale, responding to inquiries from customers; and supply chain management. In addition to the payment processing costs, the fulfillment costs of an e-commerce business include amounts paid to third parties. These are the networks that assist an e-commerce business in fulfillment and customer service operations.

Thus, an e-commerce business must adequately predict customer demand or optimize fulfillment costs from time to time. Inability to do so may result in excess or insufficient fulfillment or data center capacity, increased costs, and impairment charges. As a result, such costs could materially harm the operations of an e-commerce business. 

Note that the fulfillment costs of an e-commerce business increase as and when it adds fulfillment and data center capability or adds new businesses with different requirements. This happens because the fulfillment and data center networks of the e-commerce business become increasingly complex. As a result of such an increase in complexity, operating them becomes quite challenging. Hence, it calls for a lot of costs for the business.

Likewise, failure to optimize inventory in the fulfillment network of an e-commerce business increases its net shipping cost. 

Also, the inability of an e-commerce business to negotiate acceptable terms with third-party shipping companies can negatively impact its operating results.

2. Marketing Fees

The marketing costs of an e-commerce business primarily consist of advertising payroll and related expenses. The payroll and the related expenses related to the personnel who are engaged in marketing and selling activities. Such expenses may include sales commissions.

The advertising expense, on the other hand, may include the expenses incurred to direct customers to the e-commerce store. This is done primarily through a number of marketing channels like social and online advertising, television advertising, third-party customer referrals, and other initiatives. 

Note that the marketing costs of an e-commerce business are largely variable. That’s because such costs are based on sales growth and the rate changes. This means that the marketing costs of an e-commerce business may experience changes as a result of increased or decreased competition for the above-mentioned traffic sources. 

3. Referral Fees

An e-commerce store may also pay commissions to third parties when their customer referrals result in sales. Also, they may participate in cooperative advertising arrangements with certain vendors and other third parties. An increase in such costs may impact the CAC for an e-commerce business.

How Does Customer Lifetime Value Affect (LTV) Customer Acquisition Cost?

As per the Venture Capitalist, David Skok, one of the biggest reasons why startups fail is that their Customer Acquisition Cost exceeds their Customer Lifetime Value. This happens mainly because many businesses fail to focus on enhancing the experience of the customers post-sales. They just invest funds in enhancing the transactional value for a customer.

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As per the VC, an e-commerce business must make efforts to enhance the overall experience of the existing customers. This would help such a business reduce its CAC to a great extent and enhance the CLTV of a business.

In simple words, customer Lifetime Value means the amount a customer is expected to bring in during his stay with an e-commerce business. It explains how much a customer is worth to an e-commerce business. That is, LTV is the average monthly revenue per customer adjusted for Gross Margin and monthly churn rate. CAC on the other hand indicates the cost a business incurs in acquiring a new customer.

Accordingly, the LTV formula is:

Lifetime Customer Value (LTV) = [ Average Revenue Per Customer in a Month (ARPC) * Gross Margin] / MRR Churn Rate

An e-commerce business evaluates its customer acquisition cost and compares it with its customer lifetime value to understand ​​whether the amount it is spending in acquiring new customers is worth it.

That is, the CAC/LTV ratio pending too much per customer or if you’re missing opportunities from not spending enough.

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