How to Correctly Calculate Customer Acquisition Cost

There are many important SaaS metrics, with two of the most common being Customer Acquisition Cost (CAC) and Lifetime Value (LTV).

In my experience as a consultant, advisor, operator, and as part of the diligence team at a venture fund, I have seen unique and creative calculations for both metrics. Which is not great.

This post walks through how to correctly calculate Customer Acquisition Cost and why it matters. Our previous post discussed How to Correctly Calculate LTV, if you want to take a look at that as well.

How to Correctly Calculate Customer Acquisition Cost

Customer Acquisition Cost (CAC) is a key growth and profitability metric. It's usually thought of as a marketing metric, but CAC influences more than marketing.

The results of CAC influence product design, engineering priorities, sales commissions, funding and budgeting, and more.

Understanding your user acquisition helps to answers questions like:

• Which sales and marketing channels are profitable for us?
• What level of customer support can we afford to provide?
• How long do we need to retain customers to be sustainable?
• How many different packages/plans do we need to offer?

If your sell a $15/month software product, you can’t spend forty or fifty times that amount trying to get new customers. That may seem obvious, but we see people miscalculating CAC and thinking they are in a better position than they really are.

Understanding Your Sales Funnel

The formula for CAC is...

Customer Acquisition Cost = Total Sales & Marketing Costs / Number of New Paying Customers Acquired

And here is a quick example of the CAC formula...

CAC = Total Sales & Marketing Costs / Number of New Paying Customers Acquired

CAC = $55,000 spent / 1,800 customers acquired

CAC = $55,000 / 1,800

CAC = $30.55

That means each paying customer, on average, costs $30.55 to acquire. Notice how we are measuring paying customers, so things like the effectiveness of your sign up forms and product onboarding influence CAC as well.

While this formula (and where we get the numbers from) may seem daunting, we are going to break it up into its individual components and walk through some examples.

Total Sales & Marketing Costs

At this point, we are going to stop and say that CAC is different from typical paid marketing metrics like CPC (cost per click) or CPI (cost per install) for a few reasons.

CAC is a measure of your overall effectiveness. It’s tempting to only include your best performing marketing campaign and say “We are able to get users for as low as $5!”. But that does not help anyone - not you, not your investors, and certainly not your team.

Instead, CAC takes a look at everything that you tried in a month, from marketing campaigns to sales salaries to that new martech software everyone has been raving about.

If your accounting system is configured properly, this data should be easy to pull. We suggest breaking operating expenses in Research & Development (R&D), General & Administrative (G&A), and Sales & Marketing (S&M).

Your total S&M on your Income Statement should be used for CAC.

Do You Include Salaries in CAC?

Yes! Customer Acquisition Cost should include every full-time sales and marketing person should be included in CAC without question.

To quote from Hubspot:

“The total sales and marketing cost includes all program and marketing spend, salaries, commissions, bonuses, and overhead associated with attracting new leads and converting them into customers.”

Imagine a startup hires their first full-time marketer and wants them to write a blog post every week. What cost should be attributed to their new blog post, which is written, edited, and published in-house?

The cost is not zero, as clearly you are spending money every month - on their salary, on taxes and fees, on software to facilitate their job, and more. There is time and money being invested in every step of the content creation pipeline.

Furthermore, as your business grows, you will have multiple strategies working together. Your SEO will benefit from your paid ads and vice versa.

Again, you have to think about your total investment into customer acquisition and not just a single campaign or a single strategy with costs that are easy to track (e.g., paid ads).

Another question that comes up frequently is how to handle someone who spends a portion of their time doing sales and marketing activities (e.g., a cofounder). In this case, we recommend attributing 25%, 50%, or 75% of their fully burdened cost to CAC.

In our experience, there is limited value going to more granular allocations of time.

What Makes CAC a Useful Metric?

Customer Acquisition Cost is a powerful tool that can help you understand a few things about your business. First, is your growth profitable. This is a key question that founders and executive teams need to ask themselves often.

If you spend $30,000 on ads and generate $50,000 in revenue, that may seem like a great formula - until you start to look at all of your other costs like salaries and overhead.

Moreover, CAC can be used to understand how long you have to retain a paying customer before you breakeven. This point is called “Payback Period” or “CAC Payback”.

If your CAC payback is too far in the future, you may be able to profitably grow (in theory) but your company will bleed cash and may require more dilutive rounds of funding.

For recurring revenue businesses: A CAC payback of 12 months is preferred, with 6 months being the target that companies should aim for.

Conclusion

In our discussion on Lifetime Value (LTV), we mentioned how you should remove items like Cost of Goods Sold (COGS) in order to understand the profitability of customers.

Similarly, CAC should be used to understand how the sum of all your sales and marketing activities - whether that’s paying someone to cold call prospects or running sophisticated CPC ad campaigns - translates into paying customers.

These two metrics combined show the efficiency of your business model.

In order to get the full value, we recommend looking at your LTV/CAC ratio. Your LTV compared to CAC shows whether you have enough margin to have a chance of showing a profit once you cover sales, marketing, and other overhead items.

Your LTV/CAC ratio should be 3x or higher, which means that every $1 you spend on sales or marketing activities will translate into $3 from customers.

Alluxo is a software platform that can help you automate your financial reporting, including automating your CAC calculations. Reach out to us today with your questions or if you would like to schedule a free consultation.