How Customer Acquisition Costs Affect Your Business
All businesses face customer churn or turnover as customers do not remain customers of the same businesses forever. In understanding your true margin, you must look not only at customer acquisition costs (CAC) of additional customers but at the maintenance sales and marketing expense of replacing those customers who have left. The maintenance sales and marketing expense is the amount of sales and marketing (also described as CAC) you must dedicate to replace customers lost to churn. CACs are the costs it takes to gain new customers. To maintain a software business, one will spend a significant amount of money just to keep the total number of customers constant.
The leaky bucket analogy is a simple way of thinking about this. If one fills up a bucket with water from a hose, and that bucket has a few holes in it, some of that water will leak out. Water flowing into the bucket represents the new customers for a business, whereas water leaking out of the holes represents the customers who are leaving. The business has to decide whether it will patch up the holes in the bucket to keep the existing water (customer retention), add more water (customer acquisition) or both.
Focusing on customer acquisition instead of customer retention is not the best option for a growing company. Imagine a business has 100 customers and loses 20 of those customers in a year. This equates to customer churn to 20 percent. If the CAC of gaining a single customer is $1,000, then replacing the 20 percent churn rate will be a maintenance sales and marketing cost of $20,000. This amount is part of the cost of sales you need to reflect in your margin.
Think of it in terms of dieting. If someone loses 30 pounds and then stops dieting or working out, he or she will most likely gain that weight back. Instead, he or she should keep on dieting and working out to keep the weight off and do extra if they want to lose even more weight. Similarly, businesses have to spend money to gain back customers to maintain an amount of customers. They must spend money to gain additional customers just to maintain a consistent number of customers. A company can’t fool itself and calculate a margin without counting all of the cost of sales. If someone eats a salad for lunch, but then has three martinis later on in the day and does not count those calories, they are only cheating themselves. Likewise, a company who says its margin is 100 percent, but isn’t counting the maintenance sales and marketing expense isn’t being honest about how much money it actually has.
Read what the team at Growth Street Partners said on this subject.
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As executive director of entrepreneurial initiatives of the Greater Des Moines Partnership, Mike Colwell leads works with startups to build their business model, financial model, marketing strategies and capitalization plan. He is also co-manager of Plains Angels, a group of Iowa-based Midwest angel investors. Mike spends his days coaching, mentoring, consulting and asking tough questions to help entrepreneurs reach their full potential. Mike assists with business strategy, business planning, business plan execution, business model development and capital acquisition strategies.