Sunday, February 19, 2012

What is the Cost of Customer Acquistion?

"It's a very, very tough market. So unless you do a really good job, you buy the right products from the manufacturers, you service the customer, they keep coming back, they bring their friends in, it's all about numbers, numbers, numbers." ~John Ilhan

What is a customer worth to your business? Too often I see entrepreneurs grossly understate the value of each customer. If you do not know the true value of a customer then it is so hard to estimate on how much to spend to acquire new customers or how much effort to put into keeping each existing customer.

Okay, then what is the real value of a customer? It is really a pretty simple computation involving 4 steps. First, you estimate the gross purchases the customer will make in a year. Step 2 is to take to figure out what the gross profit is from these purchases and Step 3 is to figure out how long would you expect to retain this customer. Finally, Step 4 is to bring these future cash payments back to the present value or today's dollars.

Suppose a business estimates that the average customer spends $500 a year at their store and their gross margin is 40%, which equates to $200 a year in gross profit. If we assume that the customer will stay with us for 6 years then the value of the average customer to us is $1,200 over the six-year period. However, the present value in today's dollars at 6% is for those 6 $200 gross profits are $1015.

Once you know the customer acquisition cost (CAC), then you have an idea of the real value on each customer and can make good decisions. In this example, it would be economical for the firm to spend up to, but hopefully a lot less, that $1015 to acquire new customers.

Where this customer acquisition costs becomes so critical is for new businesses or new product lines. Clearly, during the period, many, many companies were paying much more for a customer than they would ever generate in revenue which is why so many of these companies did not survive.

Frequently you can use this CAC to ascertain if it is wise to purchase customers or customer lists from firms that are going out of business or wish to get out of one element of their business.

By knowing the real cost of customer retention or acquisition, you can quickly see the very high value of each customer coming into your business. If you let one customer go, you are loosing not only that transaction but, probably, over six years of profits that you will be foregoing.

Now go out and make sure you know the cost of customer acquisition for your business set up by product line. You really do need to do this by product line as the gross margin is frequently so different between the lines.

You can do this!

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