Aug 22, 2022 | Financial Acceleration

What is customer acquisition cost, and why is it important?

Q. Dear Zenagos, what is customer acquisition cost, and why is it important?
–Vinnie

Customer Acquisition Cost (“CAC”) is a key number (or “metric”) that estimates what it costs your business to win a new customer. It is important because it can tell you quickly whether your company is sustainable in the long run. Truly, it is the one number that will make or break your business.

How does one calculate Customer Acquisition Cost?
The formula for CAC is the cost of sales and marketing in a given time period, divided by the number of new customers acquired in that same time period.

CAC = Sales & Marketing Spend ÷ New Customers (in the same time period)

So, for example, if you spent $10,000 last year on sales and marketing, and you recorded 100 new customers in that same time period, then your CAC last year was:

CAC = $10,000 ÷ 100 = $100

That’s it! You can start calculating your CAC right now. Just get some accounting data from your ledger or spreadsheet or software.

Why is Customer Acquisition Cost important?
Your CAC is important because it tells you whether you make money or lose money on every customer. To see how this works, make a simple income statement for each customer:

Revenue per customer
minus Direct Costs per customer
minus CAC
= Contribution per Customer

Let’s say that you sell gift baskets, charging $150 for each gift basket. The materials to create each gift basket cost $25. You did the CAC calculation and came up with a CAC of $100. Then, your per-customer income statement would look like this:

$ 150  Revenue per customer
–    25  Direct Costs per customer
–  100  CAC
= $25  Contribution per Customer

This means that every gift basket sale you make contributes $25 to cover your fixed costs (“contribution”). That’s great! A positive contribution means that you are making money with every gift basket you sell. If you sell more, you will make more money, and eventually (once you cover your fixed costs) you will be profitable.

If your contribution turns out to be a negative number, then that’s a problem – you are losing money with every customer. Your business will not survive for long if you lose more money with every sale you make. CAC is important because it tells you if you are making or losing money in the long run.

Why is CAC the single most important number for a business?
It’s not true for absolutely every business, but it is true for most businesses that profitability hinges entirely on CAC. Marketing is one of the largest costs for most businesses, so if you can’t find a way to get your CAC down, then you won’t make a profit.

Another important issue is that your CAC can change, literally overnight. For example, if you have been advertising on social media and getting a certain number of customers reliably at a certain cost, the social media platform could raise its advertising price, making your CAC jump, or it could just change its algorithm overnight, making your customers disappear. Or, a sudden demand shock could change everything. For example, restaurants and salons had a certain CAC in early 2020; then, the coronavirus pandemic hit, and the next day their CAC was suddenly much higher, if they could acquire even customers at all. Most entrepreneurs live and die by their CAC.

What if I have a lot of questions?
Once you understand CAC, calculating it can become a deep rabbit hole. You will have lots of questions. Exactly which advertising dollars led to which customers? Which time periods should you use? If you do sophisticated digital marketing, you may be using Google Analytics or a similar tool to trace customers back to specific digital marketing campaigns. These tools can help you understand your CAC by specific marketing method (and they can cause you to tear your hair out, as customers defeat your tracking by evading tracking links and searching for your company directly). CAC is useful, but don’t spend so much time calculating it that you don’t spend time on your business! It is a backward-looking measure, so it can only tell you so much about the future. Calculate it quickly, do your best with the information, and move on to your next challenge.

If my CAC is negative, should I give up on my business?
A negative CAC is not great news. However, it may not be the end of your business. You should think carefully about every one of your marketing costs. Is there a better place that you could advertise that could be more efficient? Are there costs that you could cut to reduce your overall CAC? Do everything you can to trim your marketing costs.

Also, don’t forget the power of referrals. If your customers are really happy with your product or service, they will tell their friends. Referrals are free, and they can dramatically reduce your overall CAC. If half of your business comes from referrals, then that will cut your CAC in half. So, if you have enough savings that you can lose money for a while, as long as your CAC is going steadily down, there is hope that you can develop a profitable business.

Many people run their small businesses without ever knowing their Customer Acquisition Cost, which is like operating with their hands tied behind their backs. The more information you have, the better a decision-maker you will be. Put a little time into learning your CAC, and figure out what the levers are to make it as low as possible. You may not like the information at first, but it will make you a stronger business owner.

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