I asked a group of business owners at a workshop recently what numbers they would like to learn about their business. An interesting one came up – how to measure the cost of getting a new customer.
What makes this interesting is that understanding how much it costs to gain a new customer is only relevant if you are also measuring the value of that customer to your business. It is the relationship between the two that gives you the context to decide whether the costs are justifiable or not.
Is $1,000 per customer a justifiable cost? It surely is if you stand to earn $50,000 from a client, but perhaps it’s not if you will only earn $1,500. There’s another consideration here, and that is that the cost of acquisition and value of each customer will typically differ for each sales channel.
A customer who is engaged via online advertising might be less profitable than one who was referred from a networking group – even though the costs to gain the customer might be higher face to face than online. Thus it’s important to segment against each channel to best understand which one is generating the most profitable customers for the lowest investment.
Calculating the costs to gain a new customer
To calculate the cost of gaining a new customer – also known as your Cost of Customer Acquisition (COCA) – combine all the expenses that go towards attracting a new client (typically your marketing costs), and divide them by the number of new clients you acquired in a given period.
For example – if you spend $100 on facebook advertising for a week, and from that had 300 clicks to the website that converted to 2 sales – then the cost of acquisition would be …
$100 / 2 = $50 per customer
It’s important to also include any labour costs associated with bringing on a new customer to complete the picture. For instance – if you do a lot of face to face networking, the real cost to acquire a customer might look like this –
The annual membership fee ($1200)
The cost of the networking breakfasts (52 breakfasts at $25 each for $1300)
2 hours of your time each week at your hourly rate ($75 an hour for $7,800)
For a total annual cost of $10,300
In that year, if you gain 100 new clients – then the Cost of Acquisition would be $103
Calculating the value of a customer
There are two methods for working out the value of a customer – the first consists of crunching your existing reporting, to work out customer profitability (CP). A mini profit and loss per sales channel that you can then divide by the number of customers for that channel. While this is accurate, it’s also historic and you may not have enough of a history to determine the value of a client. Less useful if you’re testing new marketing approaches.
My preferred method is to use Customer Lifetime Value (CLV), which is a model that predicts forward what the value of a customer is anticipated to be, and is much simpler to calculate.
The simplest way to calculate your CLV is to take the profit you earn from a customer, and subtract out the money spent acquiring and serving them.
CLV = (annual profit per customer x average years they remain a customer) – cost of customer acquisition
It’s important to highlight that the key is profit and not revenue. You want to find out what you earn from each customer after all costs have been accounted for.
For example –
If the customers from the facebook example had a lifetime of 2 years, and returned an annual profit of $1000
CLV = ($1,000 x 2) -$50 = $1,950
To work out the average years that a client remains a customer, you first need to know your customer retention rate. If 80% of your customers are still customers after a year, then your churn rate is 100-80 = 20%. Your average lifetime in years is 1 / your churn rate. 1/20% = 5 years.
For a more advanced model – you might start including aspects such as the annual profit contribution per customer for each year, the retention rate for a customer for each year, and adjust by a discount rate. This gives you an accurate model that takes into account how profitability typically increases for customers year on year, while retention degrades. It’s up to you how accurate you want your figures, but for simple decision making – the method I’ve shown gives you the quickest ballpark numbers.
3 quick tips to understanding the value of new customers
- Work out your Cost of Customer Acquisition and Customer Lifetime Value for each sales & marketing channel
- Use it to understand the true value of customers from each channel
- Quickly assess what works, and doesn’t work to make invest or kill decisions