The Economics of Customer Acquisition

Acquisition cost, lead gen, cost per lead, customer life-time value, ROI... Making sense of customer acquisition metrics

We live in a world of supply and demand, this applies to customer acquisition. Gaining a customer isn’t free, nor is it cheap. It’s a necessary expense when running a business, but it is possible to overspend. It’s important to find a good balance when it comes to customer acquisition, but that’s no easy feat.

It’s difficult to keep costs down because of the competition that’s inherent in any industry. Marketing costs are necessary to beat out the competitors. With so many more demands for customer attention circulating in the modern world, your draw needs to stand out in order to succeed.

Looking at the overall economics of the situation can help with this.

Supply and Demand

The idea of customer acquisition isn’t much different from the way the stock market runs. It’s driven by supply and demand. Timothy Sykes, investment guru, gives an excellent description of supply and demand in the stock market: “When there are more buyers than sellers, the stock prices rise to attract more sellers. When there are more sellers than buyers, stock prices fall to attract more buyers. Price is always changing based on supply and demand.”

The same goes for customer acquisition, and it’s an important component in calculating the actual cost of a customer. Obviously, the more customers you have, the more profits you’re making. The fewer customers, the fewer profits. Therefore, if trying to get customers on board has cost implications related to services available versus services desired, you're functioning within these basic market forces.

Customer Acquisition Costs

The first step in truly understanding the economics of acquisition is calculating the lifetime value of the average customer. Tallying up the cash flows you’ll receive on average and putting this in a dollar amount will show you the value, which will act as your baseline as you begin to evaluate several other aspects of acquisition, including:

• Annual Spending: Define the difference between your one-time customers and loyal customers by looking at what they spend. In general, the loyal customer will spend more rapidly, particularly as you present more offers. From there, you can determine if you should be spending more to acquire new customers, or if you should hold back because you’re putting too much of a dent in your profit margins.

• Retention Rate: You can discover likely retention patterns simply by evaluating the longevity of your biggest spenders. Based on their interactions and the costs you’ve presented to win their loyalty, you can gauge the cost of retention.

• Price Point: Your one-time and infrequent customers will snap up any deal and discount they can get while your loyal customers are less likely to quibble over price. Compare the margins of what you make from your loyal customers with the margins you make from your less-loyal crew.

• Word of Mouth: Sometimes the cost of acquisition is measured less in dollars and more by the actions of your customers. If they’re spreading the word about your business and products, that reduces your costs and ups your profits. This is an important metric to measure, since 84 percent of customers say they trust recommendations from family, colleagues, and friends.

Every one of these metrics can have a profound impact on customer acquisition. Looking at the numbers developed through these calculations can lead you to discover where you’re overspending and where you should spend more.

Customer Value

Obviously, your loyal customers will be worth more to you than your non-valued customers, but that doesn’t mean you shouldn’t bring more customers to your company.

You must look at consumers like they have the potential to stay with your company for years to come. If you knew every first-time customer would make at least one purchase per month for the rest of their lives, you would do whatever it took to get those customers on board.

This is one of the reasons that startups tend to struggle more than established companies: startups are living with an out of balance business model in which the cost to acquire a customer – which includes all the costs such as marketing, salaries, and other company expenses – is far greater than the current lifetime value of that customer.

In order for startups to turn a profit, they need to rapidly reverse this equation, a challenge when you’re still dealing with all the overhead costs involved in opening a business. Another problem is that companies often don’t see the precise cost of conversions. Instead, they focus on lead generation. Leads are important – they’re where conversions start – but if your conversion rate is too low, you’ll quickly find your marketing campaigns too expensive.

As you can see in the following example, in order to understand the real cost of customer acquisition, you need to take an accounting of each step in the supply chain. First, understand the steps – you need to go from visitor, to lead, to acquisition, and at each step you’ll see a drop off in the number of customers and an increase in the cost of your marketing.

In this model, we’ll take a basic pay-per-click scheme as the customer acquisition method with a budget of $1000. The goal here is to demonstrate the problem of imbalance as well as our often inadequate calculations at the start of a campaign.

Step 1:

• Starting budget: $1000
• Clicks: 500
• Cost per click: $2

Two dollars for a click may not be great, but 500 clicks for a site that’s new or had low traffic before might be a great improvement. If the calculations stopped here and clicks equaled customers, this would be a great value on the lifetime monetization scale. Unfortunately, this is just the start.

Step 2:

• Cost per click: $2
  Conversion to leads: 5%
• Cost per lead: $40

Things start to get pricey here. Forty dollars is an rather lot for a lead (depending on the industry)– especially when we remember that a lead hasn’t bought anything yet. We haven’t converted these individuals. We have to take the lead one step further.

Step 3:

• Cost per lead: $40
• Acquisition rate: 10%
• Cost per customer: $400

Here’s where we see the real problem at hand – your campaign cost you $400 a customer, an amount that’s untenable for the vast majority of companies. Although one look at the most expensive keywords will show they're are some industries happy to pay it.

Sure, on a high enough profit margin over 20 or 40 years, this could ultimately reverse the balance between acquisitions and lifetime value, but it’s hard to get out of that initial slump unless you have a lot of startup money to burn.

What’s more, recognize that not all customers will jump on your bandwagon. Even those that you convert through this first thread will not all become lifetime customers. Your real calculation will require you to figure out the ratio of those long-lasting customers to one-time purchasers and determine what you can afford to spend to bring in new customers vs. how much you make.

You’ll also have to consider how long it will take to begin to see profits turn around and rebalance your business model. Lifetime value is about repeating these exchanges or other quality transactions. If you can’t stay afloat long enough to make lifetime value calculations work, then you’re already in the wrong business.

Boost Your Customer Acquisition

Ultimately, the best way to ensure positive customer acquisition is to boost your customer numbers, thereby dropping the acquisition cost per customer. To do that, there may be some aspects of acquisition you should work on developing.

• Use Videos: Right now, online video consumption is taking over the internet, particularly for those aged 18-35. According to a Nielson survey, video traffic will make up 80 percent of online internet traffic in 2019. It’s currently one of the best ways to reach the younger generation and increase your customer reach.

• Make Interactions More Personal: Marketing tools have evolved significantly in just five years, making it possible to tailor your marketing towards a targeted audience. Using personalization to your advantage can be a great way to see your acquisition rates jump. For example, personalized emails receive six times the transaction and revenue rates of traditional emails. 

• Engage Around the Clock: The internet doesn’t sleep, and if you want to make your customers feel truly valued, you can’t either. Well, your online engagement can’t. As unrealistic as it sounds, consumers expect 24/7 engagement with brands. That’s where freelancers and customer service companies come in handy. They can help you tend to your customers at all times. Even if they respond at 2 o’clock in the morning to say they’ll have a better answer at 8 a.m., it’s still better than no response at all.

Consumers are demanding more and more from their retailers, and only those who keep up with such demands survive. Putting forth the extra cash to develop a strong customer acquisition strategy is essential to developing a wide customer base, and those who wisely strike a balance between money spent and money earned have the best chance of succeeding.

Thanks to Larry Alton for sharing his advice and opinions in this post. Larry Alton is an independent business consultant specializing in social media trends, business, and entrepreneurship. Follow him on Twitter and LinkedIn.

Image credits:  Gabriel S. Delgado C.