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How Much Can You Afford to Pay to Acquire a Customer? The 5-Step Customer Acquisition Cost Formula

How much is a customer worth to your business?

And how much can you afford to pay to acquire a new customer?

These are simple questions, but important ones.

In this post, I’m going to share a simple five-step process you can follow to figure out EXACTLY how much you can afford to spend to profitably acquire a new customer.

This is called your Customer Acquisition Cost, or CAC.

Knowing your CAC will also give you some crucial insights into many other areas of your business, and can help answer questions like, “What’s a good cost per click for my company?”

Before I dive into the five-step process, however, there’s something you need to know first.

Whoever Can Spend the Most, Wins

I’m going to repeat a phrase that’s been repeated by many of the most successful marketers of all time, including Dan Kennedy, Michael Masterson, and even our own Ryan Deiss:

“He or she who can afford to spend the most to acquire a new customer, wins.”

This is so true, because if you can afford to spend more than your competitors to acquire a new customer… then you’ll get all the customers!

That’s how you win at business.

(RELATED: Customer Value Optimization: How to Build an Unstoppable Business)

So, you want to spend as much as you can to acquire a new customer… but no more.

In other words, let’s pretend that you are able to spend up to $25 to acquire a customer. "That's how you win at business."

You certainly don’t want to spend more than $25 to acquire a new customer (because then you’ll be losing money).

But if you spend less than $25 – say you’re only spending $15 to acquire a new customer ­– then you’re limiting your scale. You won’t be able to grow as big or as quickly as you should be because you aren’t spending enough money on customer acquisition.

Running traffic campaigns with the right CAC is the key to scaling as quickly as you can… while still remaining profitable.

Of course, in order to do that, you have to know how much you can afford to pay to acquire a new customer.

So, without further ado, here is…

The 5-Step Customer Acquisition Cost Formula

This five-step process will work for ANY type of business or selling system. It works for digital companies like DigitalMarketer, phone-based selling companies, and even brick-and-mortar stores.

Don’t get intimidated by the calculations here. I’ve noticed that some people tend to get hung up on the details and obsess over getting these numbers exactly right.

If you’re just getting started, it’s OK if your numbers aren’t exactly right!

Do what you can. Start with a ballpark figure to help guide your marketing. Over time you can refine that number to get more and more accurate and specific to your business data.

(RELATED: Perpetual Traffic Episode 106: How Much Can You Afford to Pay to Acquire a Customer?)

Here is the five-step Customer Acquisition Cost Formula:

Customer Acquisition Cost Formula Step 1: Estimate How Much a Customer Is Worth

The first thing you’ll need to figure out is:

How much revenue do you generate from a typical customer over the life of their relationship with you?

Keep in mind this extends beyond the revenue you generate from your initial sale. Your initial sale might only bring you $25, but many of the customers who buy that $25 product will go on to make additional purchases.

So, if your products cost $25 each, and each customer buys five products on average, then a customer is worth $125 on average. If each customer buys six products on average, then a customer is worth $150 on average.

"It's an extremely valuable metric to know about your business."Make sense?

This is known as your CLTV (customer lifetime value), and it’s an extremely valuable metric to know about your business.

(RELATED: How To Calculate Your Average Customer Value (And Why It Matters))

There are three ways you can figure out this metric:

Customer Lifetime Value Method #1: Ask Your Data Analyst to Figure It Out

If you have a Data Analyst or other analytic whiz on your team, just ask them to figure it out for you. Easy peasy.

Customer Lifetime Value Method #2: Calculate It On Your Own

To calculate this on your own, there are two things you need to know:

  1. How many customers bought your products.
  2. How much total revenue you generated.

You’ll need to choose a date range for this data. I recommend going back 12 full months, if you can, to get lots of data. If you don’t have that much data then try to go back 90 days.

Then, you simply divide the total revenue by the total number of customers: Revenue / Customers = Customer Lifetime Value.

Revenue / Customers = Customer Lifetime Value

For example: Say you generated $156,250 in revenue over the past 12 months, and over that time 1,250 customers bought your products.

Just divide $156,250 / 1,250 = $125.

This number, $125, is your customer lifetime value.

Customer Lifetime Value Method #3: Estimate It to Get a Starting Point

Now if you don’t have the data available to follow Method #2, that’s OK. You can start out by estimating your CLTV.

A good benchmark to start with is anywhere from two to eight times the price of your initial conversion value.

So, to stick with our example here, if our company’s first conversion value is $25, then a good benchmark to start with would be anywhere from $50-$200.

For this example, we’re going to go in the middle, with $25 x 5 = $125 customer lifetime value.

Customer Acquisition Cost Formula Step 2: Subtract Refunds & Cancellations

The next step is to figure out how many people ask for their money back and subtract that from your CLTV.

This is something you can figure out from your CRM. But if you don’t have access to that data, you can use 10% as a conservative benchmark.

So now that you have your refund rate, subtract that from the CLTV that you calculated in Step 1.

Let’s say that your refund rate is 10%. Our Step 1 CLTV was $125, and 10% of that is $12.50.

Customer Acquisition Cost Formula Step 3: Subtract Cost of Goods Sold

Next, you need to subtract how much it costs to actually manufacture and deliver your goods.

This figure can vary wildly. For an online company like DigitalMarketer, all you’re paying for is the servers to house the data. But for an actual physical product, the cost of goods could be much higher.

(And don’t forget to include the cost of shipping!)

For the fictitious product in our example, let’s pretend it’s a digital product where the cost of goods sold is 10% of the CLTV, or $12.50.

Customer Acquisition Cost Formula Step 4: Subtract Overhead Costs

Next, you need to account for overhead costs, which are different than the cost of goods sold.

Your overhead includes things like…

  • Payroll
  • Utilities
  • Software
  • Accounting
  • Legal Expenses

Multiply your overhead by your CLTV. For our fictitious example, say overhead is 30% of the CLTV: $125 x 30% = $37.50.

Customer Acquisition Cost Formula Step 5: Subtract Desired Profitability

Let’s pause for a second and think about where we’re at.

We started with your total revenue per customer (CLTV) and subtracted all the costs associated with producing that product, including:

  • Refunds
  • Cost of Goods
  • Overhead

Let’s calculate everything to get an idea of where we’re at:

CLTV – Refunds – Cost of Goods – Overhead

$125 – $12.50 – $12.50 – $37.50 = $62.50

In other words, out of the $125 that you generate per customer, half of it ($62.50) goes toward creating and delivering your products. And you have $62.50 left over.

"How do you choose which profit margin will work best?"Does that mean you can afford to spend $62.50 to acquire a new customer?

Technically, yes, but then you wouldn’t be making any profit. You’d be breaking even on every customer.

So, the last thing you need to do is decide what sort of profit margin you want to earn.

This number will depend on a lot of different things like…

  • your business model
  • the industry you’re in
  • what your cash flow situation is

…and more.

For a digital product, a good profit margin to shoot for is between 20% and 40%.

Here’s what that would look like for our fictitious example:

  • 20% x $125 = $25 profit per customer
  • 30% x $125 = $37.50 profit per customer
  • 40% x $125 = $50 profit per customer

So, how do you choose which profit margin will work best?

This is where you want to refer back to the number we calculated above. Out of our $125 CLTV, $62.50 was used to produce and deliver the product. That means we have only $62.50 remaining.

If we chose a profit margin of 40%, we would earn $50 in profit for every customer. However, that would leave us only $12.50 to acquire new customers ($62.50 – $50). That’s NOT a lot of money to acquire new customers. "This is how much you can afford to pay to acquire a customer."

If we chose a more conservative profit margin of 20%, on the other hand, we would earn only $25 in profit for every customer. But that would also leave us with a healthy $37.50 in customer acquisition costs ($62.50 – $25).

So, let’s say that we decide that our desire profitability will be 20%. In this case, we can spend up to $37.50 to acquire a new customer. That’s our tolerable customer acquisition cost.

This is how much money is left over from the customer’s lifetime value after accounting for refunds, cost of goods, overhead, and profitability.

This is how much you can afford to pay to acquire a new customer.

3 Important Things to Keep in Mind

Now that you have a basic idea of how to calculate your customer acquisition cost, there are a few things that you’ll want to keep in mind as you’re thinking about this stuff.

1. How to Use Your Customer Acquisition Cost to Figure Out Other Metrics

I often hear questions like this:

“What’s a good cost per click?” Or, “What’s a good cost per lead?”

That’s a hard question to answer without knowing your customer acquisition cost. But once you know your CAC, suddenly it becomes a lot easier to figure out what these other metrics should be.

For example, if you can spend up to $37.50 to acquire a new customer, and you know that your sales team converts 10% of leads into customers, then that means you can afford to spend up to $3.75 to acquire a lead ($37.50 x 10%).

And if your landing page converts 40% of visitors into leads, that means you can afford to spend up to $1.50 per click ($3.75 x 40%).

"It all starts with figuring out how much you can afford to pay to acquire a customer." ~Molly PittmanMake sense?

These numbers are highly dependent on your business. Let’s say that the company in our example creates a new product that increases their customer lifetime value (CLTV).

After releasing this product, they’re able to spend $50 to acquire a new customer. Now they can afford to spend $5 per lead, and $2 per click.

Do you see how these different traffic and business metrics are all related to one another?

And it all starts with figuring out how much you can afford to pay to acquire a new customer. Once you know that number, then you can work backward and figure out what your CPC (cost per click) and CPL (cost per lead) should be.

2. There’s a Direct Relationship Between Your Campaigns and Your Funnel

Remember that the success of your traffic campaigns is dependent on the funnel or selling system that you are sending traffic to.

(RELATED: How To Architect The Perfect Conversion Funnel For Your Business)

For quick proof, consider a landing page that converts at 40%. "That's only going to make your traffic campaign more successful."

If you spend $1,000 to send 1,000 people to that page, you’ll get 400 leads at a cost of $2.50 each.

But if your landing page conversion rate was only 20%, then you would only get 200 leads out of that same traffic… resulting in a cost per lead of $5.00.

All without making any changes to your traffic campaign.

This just goes to show that your traffic campaigns and sales funnels are closely linked together.

If you don’t have a high-converting sales funnel, your traffic campaign isn’t going to work.

On the flip side, if you optimize your funnel… that’s only going to make your traffic campaign more successful.

Here at DigitalMarketer, we have traditionally taught a funnel that starts with sending your prospects to a Lead Magnet, then a Tripwire, then a Core Offer, and finally a Profit Maximizer.

And the benchmark metrics that we look for during the first three steps are:

  • Lead Magnet conversion rate of 40%
  • Tripwire conversion rate of 10%
  • Core Offer conversion rate of 10%

Knowing these numbers, along with your customer acquisition cost, allows you to really dig in and figure out some cool things regarding your traffic campaigns.

Let’s say you send 1,000 clicks to your Lead Magnet landing page at $1/click. (So, you spend $1,000.)

At a 40% conversion rate, that will generate 400 leads at a cost of $2.50/lead.

If 10% of those leads convert on your Tripwire, that will bring you 40 new customers at a cost of $25 each.

And if 10% of those customers convert on your Core Offer, that will bring you four new Core Offer customers at a cost of $250 each.

And now that you know how much a customer is worth to you and how much you can afford to pay to get a new customer, these numbers suddenly become a lot more useful.

In the example we were using earlier, we could afford to spend up to $37.50 to acquire a new customer. So, if our landing page and Tripwire are converting at 40% and 10%, generating new customers at $25 each, that would give us a lot of room to play around with our traffic bids. We could continue to scale up that campaign until our CAC increased from $25 to $37.50.

Finally, please note that what’s important here is NOT that you have the same funnel, or that your numbers are the same as ours. These are just examples.

What matters is that you know your own numbers and are able to figure out if they make sense for your business or not.

3. Your Cash Flow Situation Could Change Things

Finally, and this is really important…

Remember that it takes time for any traffic campaign to start generating revenue. The vast majority of companies do NOT see an ROI on the same day they start a traffic campaign.

So, that begs the question: Just how long can you afford to wait before seeing an ROI on your campaigns? "It takes time for any traffic campaign to start generating revenue."

The answer to that question will help guide your customer acquisition strategy. If the backend of your business generates a profit on new customers after 60 days, but you need to generate that revenue within 30 days because of your cash flow situation, then you’re not going to be able to spend as much money to acquire a new customer.

When I started running traffic for DigitalMarketer, we didn’t have a lot of cash on hand. Cash flow was tight, which meant that whenever we spent money to acquire a new customer, we had to break even on that customer pretty much within a day.

Today, however, our financial situation has changed. Now we can comfortably wait 30-60 days before generating profit on our customers.

This allows me to scale more than we could in the past. It also allows me to pay more than our competitors to acquire new customers.

(Because remember, “he or she who can spend the most to acquire a new customer, wins.”)

Now Go Calculate Your Customer Acquisition Cost

By now you should know exactly how to figure out how much you can afford to acquire a new customer.

Remember, it doesn’t have to be exact. You can start with a ballpark figure now, and make it more accurate over time. Just having a general idea of your CAC is enough to help you make better decisions in all your traffic campaigns in the future.

So, get out there and figure out your customer acquisition cost!

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