How much money should we spend on customer?
A brief introduction to customer life time value and customer acquisition cost
Are we spending too much money on our customers? How much should we spend on a customer? As a marketer while planning a marketing campaign or an ad campaign, these questions naturally come into our mind. In this article, we will explore the answers of these questions. We will also define and calculate Customer acquisition cost (CAC) and Customer Life time value (CLV).
So, are we spending too much money to acquire new customers? The answer of this question depends upon the following two factors.
- How much money do we spend in such as Ad campaign to acquire new customers?
- How much money do we get from these new customers?
The answer of the first question can be obtained by calculating the customer acquisition cost (CAC).
What is customer acquisition cost (CAC) ?
The customer acquisition cost is the average cost to acquire new customer. It is defined as,
The calculation of customer acquisition cost (CAC) can be explained by the following example
suppose a restaurant owner is planning to promote his newly opened restaurant by sending marketing flyers through mails to his potential customers. he is planning to send mails to 5000 potential customers. It is estimated that each newly acquired customer will spend on average $5. He planned to spend $1500 to the marketing campaign. Now, the question is whether he should spend $1500 on the proposed marketing campaign or not? The details of various cost heads for the marketing campaign is as
- Purchase of the list of potential customers: $40 per thousand
- Designing of Marketing flyer: $90
- Marketing copy writing: $150
- Printing of the flyer: $0.01/piece
- Distribution cost of the flyer: $0.2/piece
- Response rate of the customer: 4% (a rough estimate)
Total cost of the marketing campaign = $40 x 5 + $90 + $ 150 + $ 0.01 x 5000 + $0.2 x 5000 = $1490
Since, the response rate is 4 %; therefore, number of newly acquired customer = 4% of 5000 = 200
The customer acquisition cost (CAC) = $1490/200 = $7.45
Total number of spending that these customers will make = 200 x $5 = $1000
Therefore, Profit from the customer = Total spending that customers make minus total acquisition cost
= $1000 — $1490
And, therefore, based on the above calculations, restaurant owner should not spend $1490 on the marketing campaign because there will be a loss of $490. but what about the future purchases that these newly acquired customers make. Does the above framework to calculate customer value covers the future purchases of the newly acquired customers? Answers is no. we need a different framework that incorporates not only, the first purchases that newly acquired customers make, but also, the entire future purchases that customer make in his or her entire lifetime of business with the restaurant. This framework is called Customer Lifetime Value (CLV). The restaurant’s decision whether to go for the marketing campaign or not, not only, depends upon the CLV, but also, on the marketing attribution, that compares the results of marketing campaign with the case when there is no marketing campaign. The marketing attribution is out of the scope of this article. we will focus on CLV.
So, What is customer life-time value?
According to ‘Harvard business review’, the customer life time value is defined as “ It is the total present value of all the future streams of profits that an individual customer generates over the life of his or her business with the firm”.
The components of the customer life time value are as follows:
- The total period that customer do business with the firm.
- The retention rate, that is the percent of customers retain in the period.
- Average spending of the customers in the period.
- Gross margin on the purchases.
- Retention cost, which is nothing but the cost associated to retain the customers e.g., ad cost.
- Discount rate: to calculate the present value of the future purchases.
Therefore, the calculation of CLV should be like this:
CLV = Sum of CLV for each period — Acquisition cost
CLV for period 0: the period when customers make their first purchases.
= Number of newly acquired customer x Average customer spending in the period 0 x gross margin
CLV for period 1:
= number of customers x retention rate x average customer spending x gross margin
CLV for period n:
= number of customers in period n-1 x retention rate x average customer spending x gross margin
if the discount rate is r %, then the total CLV
= CLV for period 0 + CLV for period 1/ (1+r) + CLV for period 2/(1+r)² +…..+CLV for period n/(1+r)^n
Now, the question is how to determine the retention rate and total period n of a customer. The retention rate can be calculated by making a probabilistic model of customer propensity to purchase and a separate article is required to discuss this. The total period n depends upon the firm. some firm take n as 5 years; others take 10 years. Hence, based on the calculation of CLV, a firm can decide whether to go for a marketing campaign or not.