As business owners and managers, we need to look at a variety of numbers to gain a better understanding of our businesses. In this article, we are going to consider two very important metrics in business marketing – Cost Of Customer Acquisition and Advertising ROI (Return On Investment).
One of the most important numbers we need to always be mindful of is the “Cost of a New Customer” or “Cost of Customer Acquisition”.
Understanding Customer Acquisition Costs
If you are unfamiliar with this concept, let me give you a quick tutorial on this advertising metric.
Suppose you run an advertisement in your local newspaper for your furniture store. Suppose for the sake of this example that you paid $1000 for your display ad in the newspaper.
Now, suppose your advertising brought 4 new customers into your store, who bought from you. Suppose also that the average spend for each customer was $1500.
With the example I am drawing, your $1000 display advertisement in the newspaper brought in 4 customers who spent a total of $6000 in your store.
I am going to keep this example simple, so that more people can keep up with the numbers.
On the basic premise of our example, you generated 4 customers after an outlay of $1000 in advertising. So your basic Cost Of Customer Acquisition was $250 per customer.
If your business received fewer customers, from your outlay of $1000 in advertising, then your Cost Of Customer Acquisition is more expensive.
But, if your business earned more customers who spent money, then your Cost Of Customer Acquisition would be much smaller.
In its simplest form, the Cost Of Customer Acquisition is the money spent to get the customer to your store divided by the number of new customers acquired. We will look at this in more detail, later in this article.
The Best Way To Measure Sales And Marketing Performance
Entrepreneur Magazine in a 1999 article reflected on the Cost Of Customer Acquisition in the dot com world. The article suggested, “the cost of new customer acquisition is one of the best ways to measure sales and marketing performance.”
In 1999, the Cost Of Customer Acquisition for the following companies were:
- BarnesAndNoble.com – $42
- Amazon.com – $27.60
- Priceline – $32.30
- Beyond.com – $29.30
On the surface, these numbers may seem small. But, Amazon’s Average Sale is in the $17-range! This makes the challenge that Amazon and other major retailers face fairly transparent. If these retailers could only count on one purchase from the newly acquired customer, then these businesses would be losing money by the truckload.
Fortunately, Amazon continues to perform well in Repeat Business from a single customer. The following calculations reflect additional numbers that we business people should also factor into our Cost Of Acquisition metrics.
The Real Value Of A Customer
Amazon’s first-sale may only be $17, but in 1999, Amazon’s Average Sales Per Customer was $116, up $10 from the previous year. Unfortunately, Amazon isn’t very forthcoming with these numbers, so after two hours research, I was unable to come up with more up-to-date numbers for you to consider.
The point of mentioning this is that it is important for business owners and managers to recognize that the Value Of A Customer is not how much sales revenue is derived from the initial purchase, but more importantly, from the Lifetime Value Of A Customer.
If we looked at Amazon’s Cost Of Customer Acquisition only in terms of that first sale, then they will be losing money hand-over-fist. With a Cost Of Acquisition of $27.60 and the first sale of $17, Amazon could not stay in business long if they were continuously producing numbers at that level. However, once you factor in the Lifetime Value Of A Customer, then Amazon is spending $27.60 to acquire a customer that is worth $116 in sales for them. Therefore, by measuring the Lifetime Value of a Customer, Amazon is spending only 24% of their revenue in order to acquire one customer.
Few businesses invest 24% of their revenue in advertising, but Amazon hopes that the Lifetime Value of a Customer will eventually exceed the $116 value, known to have existed in FY2000.
As the Lifetime Value of a Customer increases, the overall Cost of Customer Acquisition will fall, as an overall percentage value of Cost Of Acquisition divided by the Lifetime Value of the customer.
The Compounding Lifetime Value Of A Customer
If you have a hair-cutting salon and your advertising budget for one month is $1000, and you get 30 new customers through the door, who will spend an average of $20 for a hair cut, then your basic Cost of Customer Acquisition is roughly $33.34 to gain $20 in new sales.
But if only half of your 30 new customers become regular clients, then you can anticipate 15 of those customers coming to your hair salon at least once a month for the remainder of the year. Therefore, the first 15 customers will be worth $20 each, and the next 15 customers will be worth $240 each over the course of one year ($20 x 12 months). All told, your first 15 customers will put $300 in your cash register, and the next 15 customers will put another $3600 in your cash register.
Thus, in the hair salon example, your $1000 in advertising could generate new customers that will generate $3900 in new sales. Once you start to consider the Lifetime Value of a Customer, within the Cost of Customer Acquisition, then you will realize that the Cost of Customer Acquisition – although it might be higher than the initial sale – holds out the possibility and promise reducing itself as the Lifetime Value of a Customer increases over time.
As the end of the year winds down, you will be able to see that a $1000 expenditure was turned into $3900 in new revenue. In essence, for every dollar you spent on advertising that month, your return value was $3.90 over the course of one year.
In the second year, if only half of the original 15 regular customers or roughly 8 people stay with you for the full course of the second year, then the $1920 in revenue (8 people X $20 each X 12 months) you can expect from those customers could almost be considered free money. Of course, you will still have service fulfillment costs, but that second year will give you nearly $2000 in revenue that you will not have to chase.
Even if half of the customers drop off during the following calendar years, then a 50% customer attrition rate will allow you to have customers that could stay with you up to five years. Calculated against a 50% decrease in customers over each calendar year, your $1000 investment in advertising may translate into $7500 in revenues over five years ($3900 + $1920 + $960 + $480 + $240 = $7500), from the initial investment of $1000 in advertising.
The interesting thing about this scenario is that it is based on an advertising budget of $1000 ONE TIME. But, most businesses will continue the advertising process every month in every year. Therefore, the above example could compound month-after-month. Every month should bring the same or similar results to your business for the month and year.
Advertising Is A Process, Not An Event
Many small business owners have a dire misunderstanding of the nature of advertising and the value to be received from the advertising.
When business owners or managers fail to track and measure the new business generated from the advertising, then the business owners and managers will fail to see that advertising is an expense that can return huge dividends to the business.
When businesses fail to track and measure advertising successes, people tend to only see the money leaving the business without every seeing the reward coming back into the business. As a result, many business managers will employ advertising for a short time, then cancel the advertising, under the false belief that the advertising was not returning value to the business.
When businesses fail to understand the Lifetime Value Of A Customer, it is hard to appreciate any advertising method that fails to pay for itself in its first cycle. If Amazon was to only look at the initial sale generated by a new customer, they would quickly cancel all of their advertising efforts. Fortunately for Amazon, its management understands that the initial $17 sale is not the measure to use to determine the value of Amazon’s advertising efforts. Amazon’s management understands that the true Cost of Customer Acquisition should not be measured by the initial sale, but by the Lifetime Value of a Customer. In doing so, Amazon has ensured that it will continue to be one of the largest and most successful retail outlets on the planet.
When business managers fail to understand the Lifetime Value of a Customer, it is hard for them to appreciate and understand the compounding nature of the revenue stream for a business. It is hard for them to understand that money invested into advertising today, can deliver huge rewards over the next several years.
A Wake Up Call For Small Business Owners
According to Scott Shane, author of “Illusions of Entrepreneurship: The Costly Myths that Entrepreneurs, Investors, and Policy Makers Live By“, only 29-in-100 businesses will remain in business after ten years. That means that a full 71% of businesses started in any calendar year will be out of business in only ten years.
It is sad to say, but the reason most businesses fail is that business owners and managers fail to understand the nature of advertising, the importance of tracking and measuring advertising results, the Lifetime Value of a Customer, and the compounding nature of the revenue stream.
I don’t want to see your business on the trash heap of yesteryear. So, it is my hope that you will take this article as a wake-up call, as to the importance of advertising and its potential to lift your business into profits.
