One out of ten businesses fail in their first year of operation! If you are familiar with the SME world, this is no news.
Inadequate funding, wrong pricing, and poor cash flow management are some of the factors responsible! Again this is no news to most of us.
Customer Acquisition Cost is one major metric that determines the success or failure of many businesses! Wait a minute, what on earth is Customer Acquisition Cost?
Not many of us have heard of Customer Acquisition Cost before now. Nevertheless, it remains a major determinant of business success or failure.
Customer Acquisition Cost (CAC) is an important metric which calculates how much it costs a business to convert prospects into paying customers over a specified period of time. It takes into cognisance, every cost related to acquiring a customer such as marketing and sales figures (which is quite obvious), and the time spent on nurturing prospects. You might argue that the time spent on nurturing prospects is not a cost; however if your business grows large, you will have to pay someone to do that.
CAC is calculated by simply dividing the total cost incurred in attracting new customers over a period by the total number of customers gotten during that same period.
For example, if your costs for a year totalled $50,000, and you got 500 new customers during that period, your CAC is $50,000÷500 = $100.
However, for effectiveness, the CAC is used alongside another related metric called Lifetime Value (LTV), which measures the lifetime value of a customer to the business. LTV is the gross margin expected from each customer over the course of your business relationship. This takes customer retention efforts into consideration as well.
Simply put, business success is when CAC is less than LTV. So if it cost you $100 to acquire a one time customer who earns you a $30 profit, you are experimenting with an unsustainable business model. If however the customer earns you $400, then you business is poised for growth.
If this is the case, then the action point for any business is to seek ways to reduce CAC and increase LTV. This however should not be done by slashing your marketing budget (as most business owners do) as this will not reduce the CAC. From the previous example, if the cost is cut in half to $25,000, it will most likely result in an equal reduction in new customers acquired (250) which leaves the CAC at $100 still.
What should be done instead is to identify the most effective marketing medium, and then redirect funds towards the identified efforts. This is just one of many ways of reducing CAC. You may also improve LTV by learning to retain your customers. LTV is measured on repeat business so we should seek ways to ensure that. Encouraging your customers to become your advocate is another major way of bringing your CAC down.
Understanding CAC is of great importance to any business as it helps to focus your marketing efforts. For startups, CAC is even more important for its role in defining the business model, and its role in cash flow analysis and revenue projections. Investors also look out for this metric because it helps determine the safety of their investment.
In conclusion, it is recommended that your LTV is 3 times your CAC. This maintains your business equilibrium, and creates the platform upon which the growth of your business is based.
So, whether yours is a startup operating from your garage, or you have 20 people employed in your stores, as long as you desire to be profitable, as long as you desire to scale your business, you MUST identify and (rightly) balance your CAC and LTV.
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