There’s no fun in tracking customer acquisition costs. Dealing with growth or customer acquisition tempo, or other dynamic metrics is much more thrilling — they float your business into the sunset of success. Nothing wrong with dynamic metrics, but let’s consider one tiny detail before you hit the gas.
Your speed and your growth don’t matter if the reward you gain from a paying customer is less than the amount burned to win that customer.
When you validate a SaaS idea, customers at any cost are okay — their existence itself proves that the idea resonates and you’re not wasting your time. When you start building your idea into a business, customers at any cost stop being okay. You need to balance the ratio of revenue and cost per customer to make a business model worth growing and scaling.
Eleken design agency specializes in designing SaaS products from scratch, but one of the most frequent requests we get is to redesign an app or a website, like it happened in cases of Gridle or Handprinter. Brilliant teams doing brilliant things but can’t reach CAC payback no matter how hard they are trying, so they ask for help.
UI/UX design can improve the situation with overblown customer acquisition costs. What else can improve the situation is understanding the fundamental driving forces of CAC and working on lowering this metric with every step you go.
That’s a bit abstract. So, let’s do some unpacking.
What is customer acquisition cost
The amount we burn on marketing and sales to win customers is called CAC (customer acquisition cost). This metric is a concern for any industry, but for SaaS, it’s crucial because the subscription model implies that reward is split into small pieces and extended in time.
You spent a ton of money to acquire new customers. FirstPageSage calculated the average customer acquisition cost by industry, and it’s impressive.
You need up to $341 to acquire one paying customer for B2B SaaS. Pretty dramatic.
All that money you spend long before you see a full return on your investment. Not to mention that a full return may never occur in case if a newcomer decides to churn after the first month.
Customer acquisition cost vs lifetime value
Let’s calm the intensity of emotions. Customer acquisition cost alone says nothing about your business, it’s a relative concept. Spending $341 for winning a customer can be too bad if that customer brings you only $300. Or, the same $341 can be a great investment if you earn $1,000 — that’s enough for a payback along with a sustainable profit.
For measuring the amount we earn from a customer, we have another metric called LTV, or customer lifetime value. In tandem with CAC, it makes a litmus test for a SaaS business model and has proved to be one of the key financial KPIs for SaaS companies.
David Skok SAAS metrics golden ratio
Venture capitalist David Skok in his blog defined that for SaaS companies, lifetime value must be at least 3x greater than customer acquisition cost. His rule of thumb became an industry standard, and now any guide on SaaS unit economics you can find will tell you that a golden ratio for SaaS is 3:1.
The chart below shows a perfect picture of your CAC payback model. All starts from spending your customer acquisition money that puts you deep into a red zone of loss. As your customer starts paying for a subscription, you slowly move towards a CAC payback point where you get your money back. That’s where you reach a 1:1 ratio. After, you build up your profit until your customer decides to churn (which is hopefully never).
If everything goes as in the picture, your business model is sustainable. You spend on acquisition less than you earn, and have enough resources to drive the startup’s growth. But things don’t always play out quite as you had intended.
When cost per customer acquisition gets out of control
A textbook case of broken LTV/CAC ratio presents Pets.com, a dotcom enterprise whose downfall was as magnificent as its rise.
Back in 1996, Pers.com was the first marketplace to push pet brands online. Realizing that their business model is operationally cheaper compared to their offline competitors, the company bloated its marketing budgets out of all proportion. Suffice to say, they spent $1.2 million on a SuperBowl ad.
Pets.com burned more cash than they were bringing in with every new customer acquired, and scaling the startup further was making it even worse. Pet.com shut down after they lost $300 Million of investor money. Not exactly what you’re hoping for when starting a business.
No need to go far for similar stories from the world of SaaS. Take Slack, which entered Silicon Valley's hall of fame as the fastest growing business app, and ended up staggering under $91 million of losses and selling itself.
Looks like Slack and Pets.com didn't do some math right.
Doing some math: how to calculate customer acquisition cost
The cost of acquiring a customer is the sum of all marketing and sales expenses over a given period divided by the number of new customers added during that same period.
The customer acquisition cost formula looks like the simplest formula ever. Divide your $500 budget for search ads on your 10 new users, and that's it — $50 for an acquisition. However, there’s still plenty of room for misunderstanding. Like, what is included in customer acquisition costs? And do your freemium users belong to acquired customers?
Patrick Campbell indicates four most common mistakes in how is customer acquisition cost calculated:
- Counting paid advertising as your only acquisition expense;
- Forgetting to include indirect costs, such as subscription for tools, services and software;
- Missing the salaries of all acquisition-related personnel;
- Considering non-paying freemium users as acquired customers — you should count only paying customers.
Any of those mistakes may dramatically affect your LTV/CAC ratio, as shown in the chart below.
Now when we know how to calculate CAC, let’s learn how to define LTV so that we can compare the two metrics.
LTV means the average amount that you expect to earn per customer over their entire lifetime. To calculate it, you need to multiply the sum you’re charging per user in a given month by the average customer lifetime.
Let’s say one user brings $20 per month, and you know that they stay with you for, let’s say, 5 months on average. Using the formula below we can figure out that the lifetime value of one user is $100.
Now when we can measure customer lifetime value ($100) and customer acquisition ($50), we can compare them and figure out that our LTV is 2x greater than customer acquisition cost. Good, but can be better. Can we influence CAC to improve the ratio?
How to lower customer acquisition costs
Nice thing about lowering your acquisition expenses is that it lowers your payback target as well and gets you on the path to profits faster.
Here we’ve got some tips to help you reduce consumer acquisition cost:
- Make user experience frictionless
Only a fraction of your landing page visitors will get curious about your product, and you can easily ruin that small fraction with a landing that creates more confusion than clarity.
Attracted by the freemium offer, users may download your app. But unable to see the app’s value from the first minutes, they’ll abandon it without thinking twice.
Even being one step away from becoming paying customers people will leave if your pricing grid is not clear enough.
Customer friction pops up on every step of your SaaS customers’ journeys. It makes these journeys long and straggly (read expensive) and forces prospective customers to leave halfway to a purchase.
So it makes sense to identify moments of friction everywhere they happen and eliminate them to reduce wastage of customer acquisition budget.
- Optimize your marketing tactics
Calculate your CAC and your LTV within each marketing and advertising channel, so that you can understand their efficiency.
Chances are you rely too much on non-recurring acquisition channels like pay-per-click advertising. Inorganic traffic costs much more money and brings immediate results that reduce to zero as soon as you stop pouring money into Google Ads.
Organic traffic is less expensive in most cases, and its positive effect lasts longer. With content marketing, for instance, it takes time to gain traction in search, but as a reward, you’ll get a compounding effect where traffic from previously published articles adds to traffic from newer articles.
- Focus on audience segments that resonate better
With your early customer acquisition marketing, you may attract a broad variety of users. Many of those people won't be well-qualified; they won’t have a real need for your product and your offer might not be a great fit for them.
If you measure CAC and LTV for all SaaS buyer personas you have, you might figure out that some of the customers are willing to pay a lot, but cost just as much to acquire. On the flipside, you have a group of customers who’re cheap, but willing to pay nothing.
To lower your expenses, focus your acquisition efforts on personas with the best LTV/CAC ratio. Check out how Superhuman pawed their way to success focusing only on the biggest project supporters and abandoning all the other segments of their audience.
Other ways to improve your LTV/CAC ratio
Customers are costly, and you want to know how costly they are to make your acquisition process shorter and more efficient. If your team can lower CAC, you’ll bring yourself closer to your payback target and make your business more profitable. But what if lowering cost per customer acquisition is not the only way to shorten your CAC payback period?
SaaS pricing strategy optimization can skyrocket your LTV/CAC ratio just as good. But that is a whole other story (that we have already written).