Acquisition Cost: How to calculate it and how to determine what your business can afford

Understanding what it costs to acquire a new customer and how long it takes to break-even on the investment is a critical step to growing your business profitably.

In an earlier post I spoke of the need to acquire new customers in order for your business to grow.  Understanding how much those new customers cost to acquire and how long it will take to recoup your investment is the key to growing your business profitably.  So how is it done?

Going back to the Buyer Matrix post, you will need to identify all new customers acquired during a given time frame (I typically use a year of activity) and attempt to link them back to the promotion that brought them in.  If you have a large portion of your first orders with accurate key code capture this is an easy task.  Most companies are not as fortunate and some analytics needs to be conducted to get customers associated with the promotion that converted them to customers.  One common technique is to do a match back.  This process requires a file from your merge purge house of all prospects who were promoted during the period you are measuring.  You then match all your new customers against this file, regardless of what channel they converted through.  (I wonder if JC Penny’s did this prior to deciding to eliminate all their catalog mailings.)  If your new customers have a valid source code use that as your source, if not, and the customer hits the match back file, use the list from the match back as the source, if the customer still does not meet either of those criteria label it as “miscellaneous” and leave it in the channel converted through.

You will also need some additional information including:

1.  Marketing costs by channels and specific effort – How much you spent on catalogs, Direct Mail Pieces, List Costs, Printing and postage, pieces or units sent, PPC, Banner ads, Email.
2. Gross margin – what was your cost of goods sold, try to get this down to the order if possible, if not, use the average
3. Fulfillment costs – what it costs to take an order and get the product to the customer, If your S&H is done at a profit, take this off the this cost, if it is done at a loss add it in.

You now have enough information to begin the calculation process.   You should have the new customers broken down into what promotion/channel the order was placed through (i.e. phone, web, email, SEO, PPC and other).  Get your total new customers counts down to specific effort and then any miscellaneous new customers in that channel get allocated across all that channel’s efforts.  You now have information telling you what channels and specific promotions delivered customers during the analysis period.  Now it is time to calculate Acquisition cost.  See the example below.

Acquisition cost Calculation example
100	Acquired Customers
Revenue	$12,500		Gross Revenue generated (does not include S&H)
AOV	$125		Average Order Value
GM%	50.0%		Gross Margin percent
COGS	$6,250		Cost of Goods Sold
Marketing	$10,000		Marketing Costs to acquiring these customers
Unit Cost	$0.80		Marketing expense divided by units sent
Response	0.80%		New Customers divided by Units sent
Fulfillment	$10		Cost to take and ship order
Fulfill Cost	$1,000		Total Fulfillment Cost
Profit(Loss)	($4,750)		Cost to acquire these customers
Acquisition	($47.50)		Cost to acquire one customer

The example shows an acquisition cost of $47.50 per customer for this promotion.  The more granular you can get this calculation, the more actionable your efforts.  By this I mean if you can get this down to specific lists or search terms the more you will be able to evaluate that specific effort.  If you can only do this at a channel, then you can’t evaluate specific efforts within that channel.

Now you need to determine if $47.50 is an acceptable acquisition cost.  To do this you need to utilize the Buyer Matrix to understand future behavior patterns of your new customers.  Typically I model customer behavior by channel the customer came in on and then compare those behaviors to see if there is any material behavior difference across the various channels.  The key to this kind of statistical comparison is to have sufficient customers in each channel to reduce “statistical noise”.  A few hundred customers is my rough standard for this comparison exercise.

The example below shows the behaviors for new customers across a few years of activity.  I only use two years since you should have a positive return on your acquisition invest in that time line.  If the acquisition investment takes longer than that, you are probably spending too much to acquire customers.

NTF Count		100
Same year Orders		30
AOV		175
Margin		0.5
Fullfilment		10
Demand		$5,250
Cogs		$2,625		Cost/Unit	Frequency
Marketing		360		$0.80	4.5
Fullfil		300
GM		$1,965
Per FTB		$19.65
Year 1
Pct. Return		0.35	35	Customers Returning
Orders Per		1.5
AOV		189
Demand		$9,923
Orders		53
COGS		$4,961		Cost/Unit	Frequency
Marketing		$720		$0.80	9
Fullfil		$525
GM		$3,716
Per FTB		$37.16
Year 2
Pct. Return		0.8	28	Customers Returning
Orders Per		1.7
AOV		189
Demand		$8,996
Orders		60
COGS		$4,498		Cost/Unit	Frequency
Marketing		$576		$0.80	9
Fullfil		$595
GM		$3,327
Per FTB		$33.27

From the above illustration in the same year acquired an average of $19.65 profit per customer is earned.  Over the next year a total of $37.16 is earned per buyer.  Both these figures are averages across the 100 customers being analyzed.  So with an acquisition cost of $47.50, the payback occurs at about the ninth month of the next year.  

This gives you the basis from which to begin evaluating various channels and promotions in terms of their respective effectiveness at delivering new customers at an acceptable cost.  Obviously if the investment cost cannot be recouped in two years, you are probably spending too much.  If on the other hand, if the costs are recouped in less than a year, you should probably be looking for ways to expand the volume and investments, without raising the costs too fast.

This type of balanced approach to your acquisition efforts will help grow your customer base and sales while generating sufficient profits to keep the growth engine running smoothly.