Question # 3: How much should I spend on getting a new customer?
The value of a customer should be three times more than the cost of acquiring them.
If we spend too much money chasing customers, it affects our bottom line. If we spend too little, we’re missing out on opportunities.
So how do you know if you’re spending the right amount?
You need some numbers.
First, you need to know how long the average customer sticks with you before they cancel. Because of course the longer a customer sticks with you, the more valuable they are. This is known as the LifeTime Value of a Customer.
Start by looking at your churn rate – the number of people who cancel their service in any given month.
If you have 1,000 customers and every month 20 of them cancel, that works out to two per cent monthly churn. By simply inverting this value ( 1 / Monthly Churn ), you can calculate how many months on average your customers will stick around. At a 2% monthly churn, that works out to 50 months.
You will also need to know your Gross Margin % (the percentage of profit that remains after you have paid your costs for the product or service), and then how much money the average customer brings in each month.
Lifetime Value (LTV) = Gross Margin % X ( 1 / Monthly Churn ) X Avg. Monthly Subscription Revenue per Customer
So, for example, if you had a gross margin of 75% and monthly customer churn of 2%, and each customer spent an average of $40 with you every month, the calculation would look like this: 75% X ( 1 / 2% ) X $40 = $1,500 LTV
The cost of acquiring a customer is the entire sales and marketing budget divided by the number of new customers acquired in a given period. This works really well if your sales cycle is short, where your sales and marketing costs can be tied to new customers in the same period. If it’s longer, you may want to stagger your costs and new customer wins to get a more accurate picture.
Cost to Acquire a Customer = Sales and Marketing Costs / New Customers Won
If you had total monthly sales and marketing expenses of $500K and you acquired 500 new customers in a given month, the calculation would look like this:
$500,000 / 500 = $1,000 Cost to Acquire a Customer (CAC)
The value of a customer should be three times more (at least!) than the cost of acquiring them. In the example above, if it cost me $1000 to get the customer, and their LTV is $1500 I am losing money. The LTV needs to go up or the CAC needs to come down.