Ecommerce stores often face challenges when acquiring new customers. More competitors are sprouting up by the day and customers are getting confused by the tons of different products available on the market. Whichever the case for you, you’re probably seeing your Customer Acquisition Cost (CAC) increase.
For merchants operating with the typical sale revenue model, your average customer won’t be as high as subscription merchants.
That’s not to say you can’t raise your average order value (AOV) and customer lifetime value (LTV) though. By comparing CAC to LTV, you can not only manage your costs better but also understand what levers to pull in marketing/ sales to move in the direction for success for your business. And this is what we’ll be covering in this post.
- CAC helps measure the value of bringing on new customers.
- Calculating your LTV:CAC ratio is the leading indicator of your spend to acquisition and if you’re investing enough in your marketing efforts.
- A successful ecommerce company will have a healthy balance of acquiring new customers to retaining existing customers.
What is Customer acquisition cost (CAC) in ecommerce
Customer acquisition cost (CAC) is how much it costs you to acquire a new paying customer.
And it’s more in-depth than you might think… you’ve got the costs like website maintenance and managing your referral network, ad campaigns, third party platform fees, agency fees etc. And if you really want to get into the weeds, you could even count the overheads – you’ve got an a sales team, a marketing team, your office, the list goes on. Everything has a cost. Add that all up and divide it by the number of customers you have.
How to calculate customer acquisition cost
The formula for customer acquisition cost is as follows:
CAC = Total amount spent on sales and marketing / number of customers acquired
To optimise CAC more effectively, many brands break it down per campaign per channel.
Doing so will allow you to compare success across the various activities happening at the same time. Your customer acquisition costs will inadvertently vary because some customers convert earlier, some convert later. Be sure to set up an attribution dashboard to get a more accurate representation.
The link between lifetime value and acquisition cost
LTV:CAC Ratio is a primary indicator of your brand’s profitability, growth potential, and the overall health of your business. In other words, the LTV:CAC ratio is a must-track eCommerce metric.
It’s essential to continue your acquisition efforts (getting new customers) in order to expand your customer base, as well as make efforts to keep that customer base on as long as possible (retention).
Lifetime value (LTV) is the metric used to determine how much revenue one customer will generate throughout their entire relationship with you.
LTV is calculated as:
Lifetime value = Average Order Value x Number of Transactions x Retention Period
Recap: CAC is the cost of initial acquisition. LTV is the total revenue a customer brings.
In order to have a better understanding of the effectiveness of your acquisition and retention efforts, it makes sense to pit these two metrics together.
It begs these questions…
How do you know where to allocate your resources?
How do you know what customer acquisition costs are acceptable?
What marketing and sales decisions will lead to greater profitability?
Because unless you’re a brand like Apple or Nike, clients don’t just happen upon your business and beg to work with you.
What different LTV:CAC ratios mean for brands (& What is a good LTV:CAC ratio?)
LTV and CAC are even (1:1)
If a brand’s LTV and CAC are the same, it means you’re spending the same amount as you earn from each customer.
While it may appear that you’re breaking even per acquisition, you’re likely losing money. Because LTV:CAC only takes into account marketing and advertising expenses. You haven’t factored in shipping costs and taxes.
LTV is lower than CAC (eg. 1:1.5)
If the ratio looks like this, the brand is spending more to acquire a customer than it will ever make from them. And this is only taking into account marketing costs. Considering other costs involved, the loss will be more significant.
LTV is higher than CAC (eg. 2:1 – 4:1)
When LTV:CAC is at 2:1 or more, you can expect that you’re making a multiple of whatever you’re spending. You’re in a good place.
A 3:1 ratio is a “healthy” benchmark. This is a common number that many investors would like to see because it shows the company has the capability to achieve steady growth.
LTV is much higher than CAC (eg. > 5:1)
While it might seem like a great thing to be earning a huge multiple, the brand may be leaving a lot of growth on the table. This is an indication that there’s lots of opportunity to be more aggressive in acquisition or expansion into new markets.
How high, unmanaged CAC harms long-term growth
When mattresses entered the ecommerce market, there was one clear leader; Casper. Since 2014, they changed the retail game and fought aggressively to gain market share from their competitors. But as they grew, they also suffered, mainly due to disproportionately high CAC relative to their LTV.
Because they had no overheads in brick and mortar stores, they could afford to offer their mattresses at a fraction of what it costs their competitors. With this revolutionary (at that time) business model, their valuation skyrocketed to $750 million within its first 4 years.
But they faced one big problem: Recurring revenue.
The average lifespan of a mattress is 10 years. Their CAC payback is extended to decades, which strains cash flow. A decade-long replenishment cycle also means that customers don’t come back frequently to make repurchases if they do at all.
Reducing CAC and managing the LTV:CAC ratio
All business owners should be heavily tracking this KPI. Investors want this, so you should too. Here’s how to optimise it.
Ways to lower CAC
Rely less on paid ads
In your early stages, paid ads are ideal for quick results and generating initial brand awareness. But rising ad costs drive your acquisition costs up; they’re not sustainable in the long run.
Start building your brand
If you were buying a new phone, would you buy an iPhone or an unknown brand? Apple would be an easier sell. Is it necessarily better? Maybe not. But a strong brand helps make the conversion process a lot easier. Word of mouth spreads and you build a loyal following without having to spend so much on paid.
Research your target audience
When you target better and position yourself for your ideal customer profile, you’ll start attracting better-fit customers. They’re less expensive than spray and pray marketing, while likely being the same customers who promote you.
Shift more to DTC
There’s nothing wrong with marketplaces and big box stores. But you’re paying significantly more in commissions. At the same time, you don’t collect useful customer data that you can remarket with. With Direct-to-consumer, you can easily build a relationship with your customers.
Launch an affiliate programme
Affiliate programs are especially popular among eCommerce businesses today, with good reason. Your acquisition costs for customers acquired through affiliates are the affiliate commissions, giving you more control over CAC. This way you’re leveraging their reach at a fraction of the cost
Ways to increase LTV
Invest in search engine optimisation (SEO)
Unlike paid ads, SEO is a long game. It can take many months before you reach Google’s highly coveted first page. However, while SEO requires patience and and considerable effort, the results are highly sustainable.
After you start ranking takes effect, your brand stands to gain free search engine traffic, and targeting keywords helps prospects discover you, increasing conversion rates.
Focus on retention
While social media channels are great for generating brand awareness and acquiring new customers, it’s important to remember that these platforms are borrowed territory. This is why building an email subscriber list is so important: they are your owned channels.
Through email, you can deliver content and offers to customers for virtually free. With a solid automated post-purchase sequence, you can keep customers engaged and always close to you.
Offer a subscription service to your customers
Subscriptions are a great way to get recurring revenue from customers by having them constantly use your products. The more they consume, the more value they receive from you and the more you become a habit in their lives. This makes you “sticky”, thus retaining them for longer.
You might be interested in: How to transition your business to a subscription model
Make customer lifetime value a metric owned by all teams
At the end of the day, customer acquisition cost is a useful metric to help you determine the health of your company as it relates to acquiring customers.
Thinking about the relationship from business to customer can help your online store make decisions that will boost ecommerce transactions and drive profitability. Considering LTV in relation to CAC is crucial — when the total cost to acquire a customer is balanced by how much they spend with your store, your company will find success.
Want a complimentary assessment of your business’ vitals? Let’s chat.