Every time I start work with a new client, I ask them if they know the cost of acquiring a new customer for their business. I’ve yet to encounter one that does.
If there’s an answer at all it’s usually a hurried “we pay Google 50p a click” or “we spend £1000 a month on online advertising”.
They’re not great answers but they’re a lot better than the other most common answer, which is “all our business comes from word of mouth so it doesn’t cost anything to get a new customer.”
But mostly there’s a lot of looking at feet and shuffling of papers because very few businesses know the true cost of acquiring a new customer, even though it’s one of the most important metrics for any business.
We’ll get to how you can work out the customer acquisition cost for your business in just a moment if you haven’t run the numbers before. Rest assured you don’t need to be a CFO to work this out, nor do you need a degree in maths or anything approaching that. A piece of paper and a pen, together with the calculator on your phone will be all you need.
But first, we need to answer an important question…
Why do we need to know the cost of acquiring a new customer?
If you’ve read anything else of mine, you’ll know I’m very strong on the importance of customer retention and providing a great customer service. Done well, it means you need to spend less time and effort acquiring new customers because you’ll have fewer customers leaving you in any given period to replace some other way.
But I’d also be the first to acknowledge that, no matter what you do to retain the customers you already have, the rate of customers leaving every business in the world is always a number greater than zero.
Individuals move out of the area, they get married or divorced, their kids leave home, their lifestyle changes after they retire and, sadly, ultimately they die. In any given week the chances of one of those events happening might be slim, depending on the number of customers you have, but over a month or a year or even longer there’s a non-zero chance that some or all of those things will happen to your customers and they’ll stop buying from you.
Similarly, if you’re a B2B business, your client’s purchasing manager might leave to be replaced by someone who prefers to deal with one of your competitors, they’ll merge with another business who directs their purchasing elsewhere, they’ll get taken over, or relocate their factory to some far-flung corner of the world and want to deal with a local supplier for what they’ve historically bought from you.
There’s hundreds of possible reasons for B2B clients moving on too. Again, in anything other than the very short-term, there’s a non-zero chance of your business experiencing some or all of those events.
So, however good a job you do on customer retention…and you really should do a good job here as it’s the “secret weapon” of any successful business, and a very inexpensive secret weapon at that…you will need to replace your old customers with new ones from time to time.
When that time comes, it’s essential you know how much it costs you to acquire a new customer.
Why, you ask?
Because you want to make sure that every new customer coming in will make the business money. Even if it’s not quite as much money as a highly-profitable long-term client which has been tempted elsewhere, if your new clients make a profit for the business then you should at least be moving in the right direction.
The reason that’s important is that I’ve seen (a lot more often than you might expect) businesses taking on new clients and thinking that because they’re replacing the missing sales from their recently departed client pound-for-pound everything will be fine.
Those businesses often take on fundamentally unprofitable clients, a large proportion of which are also especially demanding to deal with (it’s almost a certainty that where you find one, you’ll find the other), and it ends up causing severe financial difficulties for the business.
For some of those businesses, although it would also have presented a level of challenge that wouldn’t have been easy to deal with at the time either, in practice they’d have been much better off not taking on that new client in the first place, even if it meant sitting with a half-empty factory for a month or two until a more profitable prospect came along.
So don’t be seduced by however much sales income your new prospects bring in. If it costs you more to acquire them as a customer than the amount of profit they’re going to bring, the right answer is nearly always not to take that client on at all.
What is a customer worth?
Before you work our your acquisition cost, first you need a clear idea of what each new customer is worth…not how much do they bring in sales income, but how much profit do you make from them.
A customer who spends £1,000 a month with your business at a net margin of 15% brings in £150 per month, after expenses. If an average customer stays with you for two years, they’re worth £3,600 (24 x £150) over their time as one of your customers.
It probably goes without saying that if it were to cost you £4,000, based on the approach I’ll share in a moment, to sign a customer up in the first place then they don’t make you a penny in profit. They’ve actually cost you £400 just for the privilege of having them on your customer list.
At this point, people usually harrumph and say “of course that’s obvious, we’d never do anything as stupid as that”. And they genuinely don’t think they do.
Yet it’s rare for me to go to a business and not find any customers the business wouldn’t have been better off never bringing on board in the first place. So a lot more businesses take on unprofitable customers than think they do, largely because they don’t understand their acquisition costs well enough.
Now, the example I’ve just given is admittedly a fairly simplistic one, but I’ve deliberately erred on the side of simplicity to make sure I can explain the concept with a minimum of confusion (hopefully…).
If you want to read more about this subject, and even try out the in-built customer lifetime value calculator on their website, HubSpot have prepared a really good primer on how to calculate customer lifetime values which will point you in the right direction for doing the same in your own business.
How to calculate your customer acquisition cost
Now you know how much profit each customer brings to your business, it’s time to understand what it costs to sign each one of them up. After all, we’re in business to make a profit, aren’t we?
There’s no point in taking on customers or clients which cost us more to service than we make in profits supplying them with our products and services.
The acquisition cost is a little more complicated to calculate than the customer lifetime value. That’s why you might find a piece of paper helpful, although this is not complicated maths. You just need somewhere to write down a bit of information to save keeping track of it in your head.
One very important point here is that we’re not calculating a “cost per click” or a cost per lead, although that might be part of your acquisition cost, depending on how you attract new customers.
Most businesses think that’s the same thing as their acquisition cost, which is why they drastically underestimate the cost of acquiring a new customer.
There’s a few steps to this, but just take it one step at a time and you’ll be fine. Scribble the answers down on that piece of paper as you go…
First you need to map out your sales processes…
On the left hand side of your piece of paper, draw out a quick flowchart of how you find a new customer. Or alternatively list out the steps in your sales process,
To keep this fairly simple, I’ll use just some basic numbers, but you’ll get the idea from this and will be able to tailor it to meet your specific needs.
Let’s assume your business runs newspaper ads to drive traffic into a call centre where an agent sets an appointment for a field sales person. Let’s also assume one-in-five calls to the call centre results in an appointment and the salesforce signs up one-in-three of the people they meet with.
(And don’t think I’ve forgotten about the cost of the newspaper ads, we’ll get to that in a moment.)
What this pretty simple process tells you is that to win one customer, on average, you’d need your direct response newspaper advertising to generate 15 calls. (Obviously if you need, say, 100 new clients a month, you’d need 1500 calls coming into the call centre, and so on.)
This basic model works whatever channels you use. The details might be different if you use social media to send visitors to a squeeze page on your website, a proportion of which buy your product or service, or if you employ people to stand in shopping malls to accost passers-by with some offer or other. But the principles are the same however you acquire a new customer.
So, map out what your process is. Then, either manually or using Excel, do this quick calculation…(if you know what you’re doing on Excel, you can set the formulas up to do the calculations for you)…
You’ll see that we start off with 15 calls coming into the call centre, the team there converts one-in-five to a sales visit and the field sales team signs up one-in-three of the prospects they see. So for every customer we want, we need 15 calls into the call centre, on average, to sign up one new customer.
The cost of acquisition isn’t, therefore, the £20 per call centre call plus the £80 per sales visit. You have to recognise the costs of all the potential customers who weren’t converted as well. And that’s usually a blind spot for businesses, even those who think they’ve got a decent handle on their acquisition costs.
Now you’ve got that information, you can just multiply the numbers up. If you need 1 new customer a week, that will cost you £540, if you need 10 that will cost £5,400 and so on.
To make it slightly more complicated, however, we haven’t get factored in the cost of running the newspaper ads to generate the calls in the first place.
Newspaper advertising executives will tell you all sorts of good things will happen when you advertise in a newspaper, that it helps brand image and makes sure people know what your business does in case they need your services in the future.
All that’s true to a point, but at the end of the day your advertising should be built around bringing in new business. I cheated a little in the process above by making the newspaper a direct response ad, so its sole purpose was to drive traffic to the call centre.
You might pick up some random calls from more generic advertising, but I wouldn’t factor those into any acquisition cost models, mostly because response rates will be incredibly low and can be disregarded for most practical purposes.
But your direct response ads are there to generate a response (the clue is in the title) so you can take the full cost of those ads into your customer acquisition cost calculation.
The key here is that, while other metrics have some relevance along the way, especially in a small or medium-sized business your focus needs to be on how many customers each piece of advertising brings you.
For our example, let’s keep things simple and assume when the business runs a £200 direct response ad, 15 people ring up the call centre every time.
Now we can do the final calculation of the customer acquisition cost as follows:
Now we know it costs the business a total of £740 to sign up each new customer.
If we compare that to the £3,600 in lifetime value that each new customer brings to our fictitious business, that’s probably not a bad deal.
I fully acknowledge this is a very simple example and the reality is most businesses will have more than one way of bringing new customers on board. But it’s easy enough to follow exactly the same steps for every sales channel you use and work out the true cost of each.
The stat which most often surprises businesses is the cost of acquiring a customer through digital channels.
It’s been drummed into us that “social media is free”, but when you go through an exercise like the one above, businesses realise there are a lot of costs they’re not factoring in.
Perhaps they’re employing two people to write the content which is pushed out through “free” channels, which in turn makes readers click onto the company website. That sort of digital marketing isn’t free at all – it’s probably costing £50,000 a year in salaries.
Even digital advertising like Google Ads or Facebook Ads don’t just run themselves. Yes, there’s a cost-per-click usually, but there’s also the several thousand pounds a month you’re paying to a skilled Google Ads manager to run all those campaigns that “only cost 50p per click”.
But however you bring new customers on board, if you map out the process and cost it up like the examples above, you can pretty quickly work out what it costs you to find a new customer and how that compares to the profit you expect to make out of them.
Armed with this information, you have a much better handle on whether you should be taking a customer on at all, or whether you’re better to either wait for a more profitable customer instead or to see if there are ways you can get your acquisition cost down so you can handle your new client profitably.
A quick word about customer retention
Although this article is about customer acquisition, it would be wrong of me not to mention customer retention briefly.
The reason I’m so passionate about that subject is easy to demonstrate using the example above.
With an expected two-year customer lifespan, acquisition costs are about 20% of the profits you’ll make from that customer. (£740 as a proportion of the £3,600 lifetime value.)
However, if you can extend the customer lifespan to three years, that same customer would bring in £5,400 of profit instead of £3,600.
Your acquisition cost wouldn’t change by a penny, but it now only represents 13.7% of the customer’s expected lifetime value, not 20%. Your profits have increased by 50% for the same up-front investment to find the customer in the first place.
And even if you have to put a little of that extra money back into improving customer service to make sure they hang around for an additional 12 months, it’s easy to see how you could afford to do that out the extra profits the business will make and still be ahead of the game.
That’s why customer retention is the secret weapon of every great business. It costs you little, or nothing, extra and it’s the closest thing to “free money” you’ll find in any business.
Where do you go from here?
Knowing the customer acquisition cost is one of the more important numbers for your business. An astonishing proportion of businesses I speak with don’t know this number at all, and those who do generally underestimate what their customer acquisition costs are….while, at the same time, wondering why they don’t make as much money.as they thought they should.
Knowing your customer acquisition cost is one of the most helpful insights there is for any business.
And it’s not even that hard to calculate. A few numbers on a bit of paper and a quick bit of work with the calculator on your phone is enough for most businesses. Larger firms might want to set up a spreadsheet with different tabs for each different sales channel they have, but even then, each individual calculation is a reasonably simple one to make.
Why not grab your phone, a piece of paper and a pen right now and see what your own business’s customer acquisition cost really is? You’ll be glad you did…