Ensuring the success of your small business requires the balance of two very important factors: the Cost to Acquire a Customer (CAC) and the Lifetime Value of a Customer (LTV). If these factors are out of balance, you will spend more money than you can afford to bring in each new customer, which may eventually result in business failure.
Calculating CAC and LTV
To determine your cost to acquire a customer, divide the total cost of your marketing and sales over a given period by the number of customers acquired in that period.
To calculate the lifetime value of a customer, determine the gross margin you would expect to earn from a relationship with a single customer.
Comparing these two values is the first step to creating a successful business model. For best results, LTV should be significantly greater than CAC.
The Dangers of Optimism
Entrepreneurs must be optimistic about the value and appeal of their products. However, even though this characteristic is required for success, it can also upset the balance of CAC and LTV.
Because entrepreneurs are so sure that their products will draw in consumers, they tend to underestimate how much the company will spend to acquire each new customer. In fact, many entrepreneurs ignore such calculations completely when planning their marketing strategies.
To prevent business failure, entrepreneurs must analyze the relationship between CAC and LTV during the earliest stages of planning. These values are different for every business, and no exact formula for guaranteed success exists. However, by analyzing these values and making provisions to increase the difference between them, a business can maximize its chances of thriving in the market.
Tips for Small Businesses
Early in the small business marketing process, it may be difficult to determine an exact cost of customer acquisition. To get a rough idea of how much you will spend on each new customer, you must create an estimate using your company’s cost per lead and expected conversion rates. After you have an estimate, compare it to your expected LTV.
As a general rule, your LTV should be at least 3 times higher than your CAC. You must also be able to recover your CAC in less than a year. Otherwise, you might run out of capital.
If you calculate your CAC and find that it is too high when compared to your LTV, you should find ways to reduce the money you spend to acquire each new customer.
One of the most effective ways to reduce CAC is to increase your conversion rates during each stage of the sales process.Consider testing different marketing methods to see which gives you the best rate of conversion. For example, you can test the effectiveness of your landing page by creating several different models and funneling a portion of your web traffic to each one. After you have determined which page is most effective, eliminate the others.
You can also reduce CAC by finding ways to reduce the amount of one-on-one attention and coaxing required to bring in a customer.
For example, if your product is particularly complex, consider adding demo videos and frequently asked questions to your website to reduce the drain on customer service. Likewise, if customers are likely to compare your product to others before making a decision, you can prevent them from leaving the site by completing the comparison for them as a chart or diagram.
If you calculate your LTV and find that it is too low, you should find new ways to retain customers. One of the most effective ways to increase LTV is to cross-sell relevant products and services to existing customers.
Consider what existing customers might need and then be sure to directly ask them for confirmation. For example, you can routinely gather data and engage customers with polls and use email marketing to test the relevance and effectiveness of your offers. You wouldn’t want customers turning to a competitor for complimentary products and services, especially if they are among your core offerings.
You can also improve LTV by finding ways to enhance customer service. For example, a strong social media community can answer questions that otherwise would have been directed to your phone, website or email. If existing customers accurately answer the questions of new customers, the community itself may help retain customers.
Capturing the Opportunity
A viable business model results when customer acquisition costs are significantly lower than the amount each customer generates for the business. When that is achieved, sales and marketing can drive customer acquisition and capture the market opportunity.
Armed with a clear understanding of the value of each customer and what it costs to acquire them, a small business can forecast and prove marketing ROI.
What are you willing to pay for a new customer? Please provide any thoughts or ideas in the comments section below. If you liked this post, please subscribe to our e-mail newsletter!
I would like to thank David Skok for his ideas in Startup Killer: the Cost of Customer Acquisition.
Image credits: 401(K) 2013