Part 2 in a series about The Customer

3 Women Made of Money
When we last left this drama (known as your business) our heroine was in peril: Was she worth a little or a lot to you to acquire? (And I use the female gender since statistically they make more buying decisions. I won’t, however, get into the nuances between B2C and B2B buyer statistics. We’ll save that for another post.)

Is she worth flowers bought at the Food Mart inside the gas station or the original arrangement you described to the florist? (I know, Valentine’s Day has passed. But I can’t help offering suggestions for the other 364 days of the year!)

The cost to acquire a new customer varies considerably from one industry to the next. How do you compare apples to apples when one business’ product is $2.99 and another’s is $2,299? You don’t. At these dramatically different price points (and products), the buying decisions involved are vastly different as well.

If you’re strictly examining cost of acquisition against the revenue of the first purchase, you’re likely to come out on the losing end of the stick (unless all your products are on the high end). If it costs $50 in marketing to acquire a customer making a $10 purchase, and that is the only consideration to make, your business plan will never work.

If, on the other hand, you know that your average customer sticks with you for two years (or more), making that $10 purchase once every week, now you have different information to consider for a reasonable cost of acquisition. Now you know this customer’s lifetime value to your business is $1,040.

Customer Lifetime Value (CLV) = Product Price (MSRP) X Frequency of Purchase X # Years-Lifetime
CLV = $10 x 52 (weeks) x 2 (years)
If you spent that $50 to acquire this customer, it’s only 5% of her CLV ($50/$1040) – a not-unreasonable percentage of gross profits.

Whoa!(I can hear you thinking.) What about expenses? Cost of production? Yes. You should be factoring in your expenses as well. Let’s assume this $10 product costs $3 to make. That makes your net profit $728 over the lifetime of this customer ($7 net profit X 52 weeks X 2 years). And you spend another $100 over the course of two years in continued marketing and communications to this customer.

Now that you’ve taken all your expenses over two years into consideration, here’s what this Customer Lifetime Value looks like:

Cost of Goods Amount
Product Cost Lifetime ($3 x 52 x 2) $312
Marketing Expense (on first purchase) $50
Continued Marketing & Communications $100
Return on Investment (ROI)
Gross Sales to Lifetime Customer $1040
Less Total Cost of Goods $462

As anyone who’s known me any length of time will tell you, math isn’t exactly my strong suit. For those of you with greater skills in this arena (that should be just about every reader), you may have noted this business is barely eeking out a 2.3:1 in my example. There are about a zillion variations on this example: The CLV for your business may be three years or five, resulting in a far better ROI. The cost of goods may be far lower. The product price point you offer may have many more zeros on the end.

The Acquisition Sweet Spot

In my example I showed a mere 5% cost per sale when taken as a percentage of the CLV. Across many industries the range can be as low as 5% for Allowable Cost Per Sale (ACPS), but it’s more often seen in the range of 8% to 12%. And given the not-exactly-booming economy we’re in, most marketers have campaigned and budgeted for 10% to 15% ACPS.

So what’s the sweet spot of acquisition? It’s going to vary dramatically from one industry to the next. Working with the numbers is just the starting point. The benefits of using CLV to help determine what are reasonable marketing costs for acquiring new customers is that it provides far more opportunities for you to examine different tactics at different price points.

In the past you may have quickly dismissed utilizing specific magazines or event the cost of ongoing search engine optimization (SEO), eliminating them at the get-go due to the up front costs. But when reviewed against potential long-term gains, they may become more attractive. Further, you may now find that your target market shops at one of the more expensive venues that you previously nixed due to your price considerations.

The sweet spot will begin to unveil itself as time passes and you can review costs over a long period of time. You may find a steady stream of Best Customers by allowing 14% cost per sale. And while you may also get good customers at 8% ACPS, they may not stay with you as long as those acquired when you spent more up front, reducing the CLV. Additionally, you may acquire far fewer clients using the tactics at 8% ACPS than the total number acquired at 14% ACPS.

The Unmeasurables

In the above example, you’ve acquired two types of customers: one that cost you only 8% to acquire and another type at 14%. We’ve left out one last factor to consider: What if the 14% group refers new clients to you twice as often as the customers acquired at 8%? What if the 14% group post comments, testimonials and recommendations on your Facebook fan page or website one third more often than the 8% group?

Now we really know who your best customers really are!

For more on this topic, David Skok has an excellent post on the cost of acquisition on his For Entrepreneurs blog. He even includes an online Excel schedule for you to plug ‘n’ play your own numbers. Also Panalysis has an excellent cost of acquisition calculator, which is geared primarily towards web-based businesses. And Entrepreneur magazine also has a wonderful article on the same subject with an array of dollar examples.