The customer is always right, but how much does it cost to acquire them?

In the world of start-ups, the main focus can often be on creating an exceptional product, building a great team, and securing those first customers. What is frequently overlooked is how much each new customer is costing the company to acquire and how much it can potentially make from each customer. To understand your company’s cost of acquiring customers, you need to break it down into a few elements.

The cost of each lead

A good starting point is to list all your marketing and advertising costs for any given month. This might include flyers and ads (radio, magazine, newspaper, online), and even the cost of your sales and marketing team. You can exclude staff costs from this figure if their numbers are unlikely to increase as your customer base increases, or if your product or service does not require much in the way of human interaction to obtain leads.

Then you need look at the number of potential customers or leads you secured in that same period. If, for example, the total spend on marketing and advertising for the month was €5,000 and you secured 100 new leads in that month, the cost of acquiring each new lead, at a basic level, is €50.

Converting leads to paying customers

You’ve secured some leads, and you have an idea of how much each lead costs you. Once you’ve established that cost, you should then look at the number of leads you converted into paying customers. If you converted 20 of the 100 leads into paying customers (a 20 per cent conversion rate), the cost of acquiring each of those paying customers is €250 (basic cost by five).

Is calculating the cost of acquiring customers enough?

Knowing the cost of acquiring customers is an important metric for your business. But on its own, it may not be telling you all you need to know about your customers.

What happens, for example, if it is costing you €250 to acquire a paying customer, but you only ever make €100 from that customer?

In conjunction with customer acquisition costs, you also need to calculate the amount of revenue your business can generate from each new customer over the period in which you hope to retain them as a customer, also known as the lifetime value of a customer.

Taking the example above, we could estimate that we hope each customer would continue buying from us for the next three years, and that the gross profit that we expect to make from each customer is €500 each year. The lifetime value of that customer would be €1,500 (three years by €500). If it costs the company €250 to acquire that customer, the cost is recouped within 12 months. And that is a great position for your company to be in.

However, if the cost of acquiring a customer is greater than lifetime value of a customer, that could be an indication that something is fundamentally wrong with your business model.

A good rule of thumb is that the lifetime value of a customer should be at least three times the cost of acquiring that customer. The higher the ratio, the better it is for your company.

If you are an established business, you should have better numbers around the lifetime value of a customer. You may even be able to separate those customers that spend more with you and are more valuable. They may cost more to acquire, but could mean more revenue in the long term.

A better ratio

It’s not a one-number-fits-all scenario. What seems like a high cost of customer acquisition for one company, or industry, may be a perfectly good number for another. And there are ways to decrease the cost of acquiring customers. For example, you could aim to improve customer retention levels or focus more of your marketing efforts on a particular customer segment.

There are also many ways to increase the lifetime value of customers by, for example, upselling where you can and improving customer support.

For start-ups, knowing the cost of acquiring customers is vital to knowing how efficient and effective marketing spend is and to providing a better understanding of the costs associated with securing customers.

By knowing the lifetime value of a customer, your start-up can fully appreciate the relationship between revenues and costs. And remember it’s always easier, and costs less, to sell to existing customers rather than having to continually replace them with new customers.

Johnny Harte is a chartered accountant and works with start-ups and early-stage companies on all aspects of the fundraising process