Customer Acquisition Cost is the perfect example of how financial metrics should be the basis for business decision making.
Needless to say, investing in customer acquisition is key for most E-Commerce business. But your business may be set up for a destined failure, if you are spending without looking into a key metric: customer acquisition cost.
Imagine having selling a product with USD 10 gross margin, but it costs USD 15 to acquire each customer for this product. It does not take a genius to see that this is not a sustainable situation.
So if your Customer Acquisition Cost are too high, then your e-commerce site is flirting with financial disaster. On the other hand, if they are too low, you could be losing out on potential clients.
What Are Customer Acquisition Cost?
Customer acquisition cost are the costs associated with obtaining new clients. To calculate your customer acquisition cost, add up all of your sales and marketing costs over a period of time, including your SaaS subscriptions, ad spending, staff and agency costs. Don’t forget to include the amount you spend on storing, producing and shipping items. These costs are essential because you are running an e-commerce business.
Also note that marketing spend to retain existing clients should not be included here.
Next, calculate the cost of acquiring each client:
divide the total amount by the number of new customers in that same period of time.
CAC Per Channel
You may work with different acquisition channels – possibly having a content strategy, as well as Facebook campaigns and Google Ads. It is important to track to what you are spending on each channel to be able to track your acquisition costs per channel.
The same goes for your customer acquisition – track as accurate as possible through which channel you acquire these new customers. In reality, this is not always 100% clear – a customer may have read several pieces of your content before he clicked on an ad that converted him to a customer. So when analyzing the CAC per channel, keep in mind that this may not be 100% accurate.
Why Do They Matter?
Customer Acquisition Cost tells you how much it costs to acquire a customer, and therefore also how much margin you need to make on each product or customer to build a sustainable business.
There is no hard-and-fast rule for how much your acquisition cost should be because they are different for each industry and business. For example, if you are a new e-commerce site, it may initially be costly to acquire new customers. Over time, the reputation that you develop will help you to attract new clients at lower cost.
Finally, in general it is far cheaper and more effective to retain the clients you already have. Especially when your CAC is high, customer retention becomes more critical to increase the lifetime value of each customer. In that case it may be more beneficial to invest more in retention rather than acquisition.
CAC and Gross Margin
Another way to evaluate your CAC is by looking at your gross margin. Your gross margin must be higher than your customer acquisition cost — otherwise, your business will lose money on each sale.
However, if you are selling a product that has a high repeat purchase rate, it may be acceptable to loose money on the initial sale (CAC higher than the gross margin) as you will earn a profit in the following repeat purchases. However, most businesses will either need to make sure their CAC is substantially lower than their Gross Margin, either by increasing their gross margin or decreasing the cost of acquiring each client.
Consider the following example.
Timo owns an e-commerce store that sells windmills. Each windmill is sold for $50 and has a 40 percent gross margin, so Timo will have $20 left from the sale of each windmill after paying for everything else. Since people rarely buy more than one windmill, Timo’s average price is $50. Right now, his customer acquisition cost is $15. Consequently, he makes $5 in profit from each windmill.
If he sells a large volume of windmills, he can earn a high income. Since this might be a challenge, Timo could consider increasing his price to $60. If he succeeds in this, his gross margin would jump to $24 (assuming it is still 40%). After subtracting the $15 acquisition cost, he would be bringing in $9 per order instead of just $5.
CAC and Average Order Value
If you want your e-commerce business to be successful, focus on your average order value. When you have a higher average order value, you have a higher gross margin per order. Therefore, you can afford higher customer acquisition cost; they won’t hurt your business.
For example, if your average order value is $500 with a 30 percent gross margin, then your gross margin is $150. You could easily have a customer acquisition cost of $50. In the windmill example, Timo had an average order value of $50 with a 40 percent gross margin. Since this works out to a $20 gross margin, Timo could not afford to have an acquisition cost of $50.
CAC and Lifetime Value
If you are going to spend money attracting a client, you ideally want them to keep coming back. Even if you are selling a one-time purchase like a swimming pool, you can still bring those clients back to purchase pool cleaners and replacement parts.
As you determine the right
acquisition cost for your business, consider the lifetime value of your customers. The lifetime value of your clients is
the total gross margin you will get from your typical client over the course of
their relationship with you. You must know how much money you will make from
each client after all of your costs are paid, so your gross margin matters the
If your acquisition cost per customer are higher than their lifetime value, you are losing money with every single client.
Alternately, if you are underspending on acquisition cost, you may be missing out on potential clients who could increase your total profitability. If your lifetime value is 10 times higher than your acquisition cost, your profit per customer flourishes, but the number of clients is lower that it could be. In most cases, your ratio of lifetime value to acquisition cost should be somewhere around four times what you spend on acquisition cost.
Let’s return to the example of Timo and his windmills for a moment. We will keep the average order value at $50. We will now assume his customers buy two windmills at $50, instead of just one. The gross margin is 40 percent, so this means that the lifetime value is at $40. The acquisition cost per customer are still $15, which means that $25 is left after these costs are paid. His lifetime value to customer acquisition cost ratio is at 40:15. Since this works out to just 2.67, we can conclude that his acquisition cost are too high. To reach a LTV:CAC ratio of 4, he may want to drop his acquisition cost to between $10 and $13 or increase his customer lifetime value to $60.
How to Manage Your Customer Acquisition Cost
Now that you know how vital customer acquisition cost are for your e-commerce business, your next goal should be figuring out how to optimize them.
One of the easiest ways to do this is by increasing your prices. With a higher price, you obtain a higher margin. So, you can have higher customer acquisition cost while remaining profitable.
As any e-commerce company knows, raising prices may cause your potential clients to purchase cheaper products from your competitors. Rather than raising your prices, you could lower your cost. Make your ads more efficient by focusing on your core audience instead of marketing to a broad consumer base. You might have a higher cost per click, but the higher conversion rates will bring your overall acquisition cost down.
Reduce Cost of Goods Sold
You could reduce your costs by decreasing the cost of goods sold (COGS) because this will automatically increase your gross margin. You could achieve this by lowering your shipping cost by, for example, shipping by sea instead of air. Sometimes, e-commerce companies lower their cost by renegotiating volume discounts with their suppliers. Another option is to negotiate a discount based on faster payment terms. You could also consider decreasing your warehousing cost by finding a cheaper warehouse for the majority of your storage, and only use more expensive fulfillment warehouses for smaller inventory quantities.
Improve Niche Selection
Finally, you can focus on less competitive niches. If it costs too much to acquire customers in your current e-commerce niche, consider targeting a different one. This might not be an option for every business, but it is certainly something you could consider doing.
How We Can Help
When it comes to running an e-Commerce business, customer acquisition cost are critical. How carefully you measure and manage them will determine whether your company is profitable or not. Since there is no single right or wrong amount, you must consider it in the overall context of your business.
A Virtual CFO can help you to identify, measure and improve your customer acquisition cost. That’s where we come in. At ABEL Finance, our goal is to make it easier for business owners and e-commerce companies to succeed. Schedule a free call with us to find out how we can help you optimize your customer acquisition cost.