When planning a search engine marketing (SEM) strategy, it is essential to understand how much you can spend to acquire a new customer before you exceed that customer's lifetime value (CLV) to your business.
While the concept is a simple one, failing to determine these figures can put your business in the express lane to failure. So, let's look at how to determine these numbers so that you can stay profitable while growing.
So how do you calculate customer lifetime value? Ask yourself these four questions:
Let's look a little more closely at those numbers. We'll use a simple example with simple numbers.
Say you are a marketing company, and your average customer spends $100 a month on your services, and they stay with you for one year. Their lifetime value is $1,200. If your profit once you have paid wages and supplies is 50 percent, then your profit is $600 per customer before taxes. If the tax rate on profits is 33 percent, net profit is $402.
This means if you spend any more than that per customer for acquisition (which is very possible), you lose money.
Figuring out this cost also seems like a simple formula. The overall amount spent on sales and advertising is divided by the number of new customers, and the result is the cost of acquisition per customer (CAC).
So, if a brand spends $1,000 on ads per year, and gets 100 new customers, their CAC is $100. In the case above, where the lifetime value of a customer is $402, the brand would still be making a profit.
Profits, however, are often eaten up by customer acquisition costs that are not properly figured, and marketing budgets that are spent in the wrong place, resulting in too few new customers. Early on, many startups acquire customers through low cost methods like word of mouth. As they start to scale though, it becomes more difficult to find new and perhaps different customers, resulting in higher costs. This is where the element of scalability comes into play.
Many companies run in a continual growth phase but spend very little time on process optimization. This type of mindset leads to companies that may gross $50 million per year but profit less than others that may gross $2 million per year. To keep your profit margins up as you seek to scale, there are a few common mistakes you should steer clear of.
There are two common mistakes that lead to profit eating CAC numbers. The first is that that cost per acquisition is underestimated. The second is that the lifetime value of new customers is overestimated.
Usually this happens when a business fails to project the future cost of marketing correctly. What a pay per click (PPC) campaign costs now, for example, may change based not only on competition in the keyword space but also a higher number of clicks. If a lower percentage of those clicks results in conversion, the cost per customer acquisition goes up.
To avoid cost creep, you should continually review and work to optimize paid advertising campaigns and outbound sales and marketing strategies as well.
When planning these figures, you also need to consider the amount you will spend before you are likely to generate customers. SEO, for instance, may take six months of investment before it starts to generate leads. In this case, that could mean it would take 12 months before your CAC came back down to a level of profitability because you had to cover the initial setup costs.
Knowing this in advance and making sure you have the capital to operate at a loss (or small profit) for 6 or 12 months while your SEO strategy has time to take full effect can enable you to significantly lower acquisition costs in months 13-plus.
On the flipside, if you need customers in a hurry to sustain your business, you may opt for PPC which over the lifetime of the campaign can have a higher CAC than that of a similar SEO campaign.
The point being, your current situation could dictate your CAC for the next several years, so don't focus on fast growth if you are able to grow at a slightly slower pace with a much lower CAC.
The second error, is the overestimation of lifetime value. This is especially challenging when you are a new business and are basing your numbers upon industry averages instead of actual data. It is not uncommon in the beginning for customer lifetime value to be lower as you work to find and implement retention strategies.
When you are in a very competitive market, the competition may drive up your customer acquisition costs beyond their current lifetime value to your business. Unless they are just looking to throw money away, you better believe they have retention (or upsell) strategies in place to boost the lifetime value of their customers.
If you find yourself in a situation where your costs seem to far exceed the value, you need to start looking for ways to get customers to spend more, come back more often, or even to send new business your way.
This is where strategies like re-marketing, email marketing and referral incentive programs come into play.
Clearly to be profitable, you have to cap the amount you spend to acquire new customers. However, this does not mean you should cap your marketing budget.
For instance, if you are running an SEM campaign with PPC ads that cost you $20 per click, and one in three clicks results in a new customer, then your CAC is $60. If you limit your spend to $300, you will only gain five new customers. However, if your goal is to gain 50 more customers, you will have to increase ad spend to $3,000. Likewise, if you want to rank for high value keywords, you must realize that so do your competitors and that means you should be prepared to invest accordingly.
Many companies focus on the total amount spent on marketing instead of the numbers that really matter, CAC and customer lifetime value. If you want to grow your business, don't be one of them. A good marketing campaign should be scaled up until you are getting your desired number of clients or you hit the point of diminishing returns.
So how do we make this practical for setting digital marketing budgets? Simple. Using the numbers, we set informed, achievable goals.
On the SEO front, if you want to rank top three for a keyword likely to generate 50 customers per month, you should be prepared to invest accordingly, while including estimates for the time spent improving rankings before new customers start to flow in.
If you have an outbound sales team and it takes 160 hours for your rep to sign up 10 new customers, you would need to hire four new salespeople or increase the close rates of the current one.
As your business grows, you digital marketing needs will change, and you will need to target new keywords, new audiences and set new customer goals.
Customer acquisition costs can either quickly eat up profits, or they can be a useful tool for setting goals and marketing budgets. You are going to have to spend more to get more, but so long as you are doing so profitably, it shouldn't be a problem.
Determining these costs and caps is a simple formula, but one you must follow to keep your business profitable while growing.