The Cost of Doing Business: Customer Acquisition, Part 2
By: Diane Danielson
Tags: Financial, Entrepreneurship, Leadership, Startup

In Part 1, I did an overview of the basic numbers you need to understand and monitor to (1) get your business to maturity; and (2) manage your business on a day to day basis. In Part 2, we look specifically at numbers that are important for the sales and marketing of any products and services.

If there is one space where I find companies really don’t pay attention to their numbers it has to do with customer acquisition, retention, and growth. Yet this is where decisions get made on a daily basis despite many leaders, sales and marketing directors flying blind.

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Perhaps the best example of why you need to know your customer acquisition numbers is the Blue Apron story. Blue Apron was once valued at $2B, has since lost 97% of that valuation, and is now on a slow crawl upward thanks to the pandemic. What was the flaw in their plan? Customer acquisition costs exceeded the average lifetime value of their customers. In other words, they were spending more on marketing, advertising and discounting per customer than the total amount of revenue generated over the average lifespan of a client.

Blue Apron had a couple of standard startup challenges including market competition. However, the main issue they faced was that people on average dropped the service after 4 months, and they were not able to replace customers at an effective rate to make up for the attrition. During the pandemic, they were able to cut administrative costs by 5% by closing a facility plus they increased the average customer spend 20%. Some of the increase was through sales of cooking products and partnerships. However, the question remains is whether this will continue post pandemic, when restaurants come back and cooking fatigue sets in.

Other companies like Uber, rely on venture capital to subsidize user costs. For their company to operate at maturity (i.e. without outside funding), they will have to raise prices, reduce subsidies to riders and perhaps cut driver pay.

So, how can you avoid being the next Blue Apron? Drill down and understand your customer acquisition, retention and growth costs.

The basics:

Customer Acquisition Costs (CAC) are easily calculated by dividing all the costs spent on acquiring customers (sales and marketing expenses) by the number of customers acquired in the period the money was spent. For example, if a company spent $1000 on marketing and sales in a year and acquired 100 customers in the same year, their CAC is $10. Note that the true cost of sales includes more than marketing spend, it also includes salaries and commissions of marketing and sales people and any related overhead like benefits, administrative costs and so forth.

CAC = Total Sales and Marketing Costs/Total Customers Acquired

Customer Retention Costs (CRC) divides out the dollar amounts spent specifically to keep from losing customers. This might be the expense of providing thank you gifts/discounts, or even client entertainment of your most profitable customers. For a subscription model, it could be a pause option. For example, Audible allows customers to pause their subscriptions for 1 to 3 months every 12 months.

Customer retention will be a bigger focus for those companies that have fewer but higher revenue clients. If customer retention costs are minor, i.e. the majority of your customers are one time customers and not recurring, then it can be accounted for as part of the CAC.

Customer Growth Costs (CGC) is only relevant if you have an upsell program. For example, if your goal is to move customers from a basic to a premium program. This, like retention costs, can be pulled out as it is useful to track to determine effectiveness of specific campaigns, products, services or programs. Or if the number is small, you can count the upsells as new sales and have it remain in your CAC calculations.

Lifetime Customer Value (LCV) is a very important metric as illustrated by the Blue Apron story above. If you can calculate based on past history how much different customers are worth to your business over the course of your relationship, you can make better projections. Subscription models are the easiest business model to track, along with single sale business models. No matter what your model, you will want to ensure that any CAC is lower than the LCV.

Most Valuable Customers. This is not a metric, but it’s a useful list to maintain. With LCV models, there will always be those customers whose value might not be reflected on a spreadsheet. Keeping an MVC lists os useful for a couple reasons: first, your team will know to prioritize them; second, you can create marketing personas based on their characteristics and try to attract more like them; and finally, it can be a reminder to not make unprofitable deals for anyone who couldn’t potentially fit into an MVC category.

In other words, it’s okay to give in on pricing or have lowered revenue expectations if a client or customer might prove valuable in other ways. Typical MVCs are as follows:

Largest customers — They make up the largest percentage of your revenue. Even if they may have a smaller profit margin than others, they make up for it in volume. These are often older clients that are grandfathered in at lower margins. Largest actual gross margin customers — These are also your Most Profitable Customers. Marquee name clients — These are high-profile clients with whom your affiliation may cause others to purchase. Connector / source of referrals client — These are satisfied clients who recommend other clients and are willing to provide testimonials and word of mouth referrals. Low maintenance clients — This is often the most overlooked MVC, but customer support is an investment in time and resources, and high maintenance clients are often detrimental to morale, so MVCs should include any set it and forget it clients, too.

Customer Churn is an important number because it allows you to track and prepare for attrition. Going back to Blue Apron, their customer churn was on average every 4 months, this means they have to fully replace customers every four months.

Length of Sales Cycle — This number works in concert with Customer Churn. Do you know the average amount of time from initial interaction with a potential customer to the closing of the sale? In Blue Apron’s case, it needs to be less than 4 months to offset attrition. Larger, more complex sales can take months or years, and your projections will need to account for that time when looking at customer churn and attrition.

Additional Numbers that may be relevant from time to time.

Net Promoter Score (NPS) is a much talked about metric. While it’s good to survey your clients and customers, the NPS is limited in what it can tell you for projections. The NPS is calculated from client responses to a single loyalty question, “How likely are you to recommend us to your friends/colleagues?” It provides a snapshot poll of what current customers think about your company or product.

NPS is calculated based on grouping customers into three categories: promoters (those giving scores of 9 or 10), passives (7 or 8), and detractors (0 to 6). For most of us, even if we love a product, if someone asks us if we would recommend it, we would probably respond in most cases with “it depends on who is asking.” Or we might like a product, but wouldn’t necessarily recommend it. Or, we might recommend something but only with qualifiers. The information gained is useful if it’s negative because clearly it’s an indicator that something is off, but then you would need to dig further to understand why. In essence this is not a metric to be concerned with unless a potential investor specifically asks for it.

Total Addressable Market (TAM) is the overall potential demand for your product. This is a number that is important at the launch of a company, and should be updated from time to time, but is more aspirational than directly needed to run a company. TAM can be calculated in three ways:

Top-down — Use industry reports and other for generalized data.

Bottom-up — Use your own historical data (average sales per customer/year) x (the number of potential customers you’ve identified).

Value-theory — This is based on how much increased value potential customers perceive in your product versus competing products and the increased costs they are willing to pay.

Of these three calculations, the bottom-up one is generally the most accurate if you have the data.

Serviceable Available Market / Serviceable Obtainable Market (SAM / SOM) are important numbers because they give more definition to the TAM. SAM is that market that is within your geography and that will have demand for your product. The SOM is that part of the SAM that you can realistically expect to serve. For example, a COVID-19 vaccine has a TAM of everyone in the world (with some medical exceptions). However, the SAM is currently a much smaller number due to the limited ability to produce enough vaccines and considering those who will refuse to be vaccinated; and the SOM is the portion of the SAM that one vaccine company can actually capture v. the competition.

Conclusion

These are some of the numbers that a leader, and the head of marketing and sales need to use for everything from pricing to monitoring return on investments for marketing and sales campaigns. In Part 3 we will look at how all of the numbers in Parts 1 and 2 could be used to make data-based decisions re: pricing of products and services.

Click here to read Part 1.