High customer acquisition costs crush startups, so let’s discuss how your pricing strategy can help mitigate these costs so you can increase the profitability of your business.
If you’ve ever spoken with the Price Intelligently team, you know that we always tell you, “your customers don’t care about your costs, so don’t price based on them.” This is 100% true, but that doesn’t mean you shouldn’t understand your costs, particularly your customer acquisition cost (CAC). Understanding CAC is absolutely critical to picking the right customer and completing the other side of the pricing equation to maximize revenue. After all, you wouldn’t want to sell to a customer who’s willing to pay a lot, but costs just as much to acquire. On the flipside you don’t want to acquire a new customer who’s cheap, but willing to pay nothing.
Sadly, most of the SaaS companies we speak with understand their CAC, but not at a level granular enough to optimize for profit. As such, let’s first begin by looking at what constitutes customer acquisition cost (CAC), the impact it has on profitability, and a few simple, efficient methods for keeping CAC in the context of your pricing strategy on the right track as your business grows.
What Is CAC?
Customer Acquisition Cost (CAC for short) is the cost for a business to acquire a new customer. The metric is used in many industries but it's very important in SaaS, as the entire business model revolves around the lifetime value of the customer. To acquire new customers, most emerging SaaS companies devote a substantial amount of time and money before they can see the complete return on their investment. Examining just how many months of revenue from a customer are needed to recover these costs becomes essential as your business grows, as it may take much longer than you think for your company to recover CAC and begin to profit.
Why Is CAC so Important?
Customer acquisition costs are a concern in any industry, but analyzing them is even more crucial to SaaS because the model depends on the lifetime value of the customer. To acquire new customers, most nascent SaaS companies devote a substantial amount of time and money before they see a full return on their investment. Examining just how many months of revenue from a customer are actually needed to recover these costs becomes essential as your business grows, as it may take much longer than you think for your company to recover CAC and actually begin to profit.
From a pricing perspective though, CAC is exceptionally important to keep in mind. When identifying high value customer personas and measuring their price sensitivity, you may find that customers with a high willingness to pay may be too costly to acquire and maintain, pushing you into a different part of the market. The flipside can be true too, where freemium acquired users may be putting a burden on your revenue model. Essentially, customer acquisition cost is the other side of the pricing equation, allowing you to completely understand what your margins, revenue, and profit will look like as you grow. Your success depends on knowing these numbers to circumvent the death of your business under the weight of its own inefficiency.
How Do I Calculate CAC?
To calculate your customer acquisition cost, you simply take the sum of all your sales and marketing expenses over a given duration (including human capital costs) and divide it by the number of customers acquired in the same time period.
Having to wait months or even years before enough cash is flowing in to recover CAC and generate profits is typical, but the key to success is developing a business model that ensures you can make more money from your customers than it costs to acquire them. Sounds obvious, right? Yet, unfortunately so many SaaS companies don’t focus on the simple formula below.
There is little point in using this metric if you’re still refining your product and determining who your ideal customers are, but many SaaS companies grow incredibly fast before they realize how much they spend in the process. As you fine-tune your product, market fit, and sales process, you’ll want to use an analysis of your CAC to ensure your business is prepared for further growth.
The time it takes to recover CAC via your monthly recurring revenue depends on the unique facets of your business, but as David Skok states in this insightful article on SaaS metrics, ideally you should be able to recover the cost of customer acquisition within 12 months. Even if your SaaS company is just starting out and this doesn’t seem like a viable recommendation yet, it’s a proven time limit to shoot for as your business matures. There may be rare instances where the slow play works well, but unless you have a boatload of capital coming in, you’ll want to recover these costs as quickly as possible.
How Do I Optimize My CAC?
Attempting to reduce customer acquisition cost is easier said than done. In addition to traditional costs such as marketing expenses and employee salaries, time based costs such as the level of touch required to close a deal can increase your CAC dramatically. However, let’s look at how we can mitigate CAC and turn prospects into loyal, paying customers that contribute regularly to your revenue stream.
1. Quantify your proper customer persona - this is huge
Hundreds of articles have been written to help you define your customer personas. Yet, most of them fall short of a few 60 minute brainstorming sessions that culminate in some really pretty powerpoint decks, but very little traction into knowing thy customer. As such, it’s crucial for you to quantify the range of customer personas you could serve as early as even the initial customer development process.
You should know roughly the length of your sales cycle required for an optimal conversion rate, how much that customer is willing to pay and their price sensitivity, and even the proportion of those potential customers coming through your site. Furthermore, you should know what moves those customers to buy, what features they find most valuable, etc. Do this on a quantitative level though, not just guessing.
2. Optimize your funnel
Optimizing your sales and marketing funnel seems like one of the easier exercises for you to do, because you essentially have complete control over the process. Keep in mind though that optimizing for the wrong customer won’t do you much good in the long run, so make sure you focus on point one first.
That being said, you need to quantify each step of the process, and also understand exactly how many visits lead to leads, how many leads lead to opportunities, and how many opportunities lead to customers. Focusing on those three main areas provides a fulcrum for you to focus on different stages and experiment from with different channels, sales practices, etc.
Experimentation is key, but also keep in mind that you want to automate as much as possible. Hundreds of products exist to help in this effort (HubSpot, Help Scout, Salesforce, etc.). Find what works for you and what you need for each stage of your funnel and improve your efficiency as much as possible.
Rinse & Repeat
Always remember that understanding a SaaS metric is absolutely critical to the lifeblood of your business. Your business won't survive if you don’t understand your CAC, your customers’ price sensitivity, etc. Stay tuned for the second part of this series where we’ll be discussing churn, customer retention, and the importance of analyzing customer lifetime value (ltv).
To learn more about pricing specifics, check out our Pricing Strategy handbook, or request a free pricing audit from our experts. We're here to help!