The purpose of this article is to provide an economic framework in setting up a sales compensation plan. In my experience, I usually see a commission rate
Computing the cost to acquire a customer is not a one size fits all. It’s a straightforward calculation, however, there are several unique business nuances that impact the CAC result, which can provide an inaccurate number leading to incorrect operational decision making. For example, looking at the CAC formula, which is the sum of Sales and Marketing expense divided by the count of new customers, at what time period are you recording the cost and the count of customers into the equation? This time interval is referred to as the sales cycle time. How well do you know your sales cycle time? In the denominator of the CAC equation, should you include all customers? How about the Sales & Marketing expense, what expenses do you include? How can you optimize CAC? What’s a good CAC number?
The purpose of this article is to provide more visibility into the details that drive CAC by pointing out the data points that lead to misrepresenting the true business cost to acquire a customer as well as optimizing the cost, to drive more profit.
Sales Cycle Time
The CAC formula is a great tool in helping the business understand the expected amount of new customers driven from the efforts of the Sales and Marketing team. But how long will that process take, meaning how long will your investment be tied up before you start generating a return? Is it one month, 6 months, somewhere in between? A lot of the sales cycle timing depends on the sales model (no touch, low touch, high tough) and product complexity. Not knowing your true sales cycle time can misrepresent your CAC number, throwing off the unit profit economics. Below is an example of how multiple sales cycle intervals can provide multiple CAC results.
|Customer Acquisition Cost||Month 1||Month 2||Month 3||Month 4||Month 5||Month 6|
|CAC – 1 month Sales Cycle||4,000|
|CAC – 2 month Sales Cycle||2,500|
|CAC – 3 month Sales Cycle||5,000|
|CAC – 4 month Sales Cycle||6,667|
|CAC – 5 month Sales Cycle||20,000|
|CAC – 6 month Sales Cycle||10,000|
First touch point – It’s common to start the Sales and Marketing expense at the point when a Sales rep is involved to help convert the prospective customer through each funnel stage. However, there were likely multiple efforts made to get the prospective customer to the sales rep, such as advertising, SEO, lead generation, etc. Conversely, a Sales rep could be the first touch point in the sales funnel process for scenarios such events or referrals. The point here is that there are multiple sales channels, which can have different sales cycle times. A good way to misrepresent your CAC is lumping all sales and marketing channel investments into one cost bucket. My advise is to start the S&M expense at the first touch point as well as segmenting each S&M channel to get the true sales cycle time.
Paid vs Free
For sales models that have a free trial component, it seems intuitive to include the free trial customers in the CAC calculation, but including free trial customers is a big mistake. Customer Acquisition Cost is used to determine the unit economics in tandem with the Customer Lifetime Value. The Customer Lifetime Value is the expected monetary value the customer provides to the business. Free trial customers do not provide any monetary value, and thus should not be included into the new customer count. Make sure to exclude free trial customers in the CAC formula, so that you are not misrepresenting your CAC number, leading to make incorrect operational decisions.
While cautioning counting free trial customers in the CAC calculation, it’s also worth mentioning that sales cycle time ends at the paid conversion and not the free trial conversion. Depending on the company sales model strategy, free trials can be within a month or perpetual. For data usage companies like Dropbox or Google Drive, the paid version depends on how much data is being used. If your business has a free trial component, it’s imperative to know both the free to paid conversion rate and cycle time.
Breaking Down CAC Numerator
Customer Acquisition Cost is should be represented as fully loaded CAC, which is ALL Sales and Marketing expenses, which I will explain more below. However it’s important to segment CAC expenses in order to optimize expenses and provide visibility into which investment channels are driving the best ROI, and alternatively the worst ROI.
So what are all the expenses included in the numerator? Ideally, all deliberate efforts related to attributing to a new customer should be captured in the cost to acquire a customer, which can also include non Sales and Marketing efforts. For example, if employees in Customer Success or Product are involved with new customer acquisition, then their time spent on these efforts should be allocated to the cost to acquire a customer. I do believe these non Sales and Marketing costs should be a recurring effort to acquire new customers and not one-offs. This can get tricky in early stage startups where employees are wearing multiple hats, so be sure to include the employee costs directly involved in the sales effort that would scale beyond the startup stage.
Should employees only directly involved with driving new customers be counted in the cost to acquire a customer? This sounds like kind of a trick question, because intuitively this makes sense, but management should also be included in the cost even thought they are not on the front lines selling to customers. As a rule of thumb, all of Sales and Marketing employees go into the CAC numerator.
All software tools and computer hardware related to Sales and Marketing should be included in the CAC numerator as well. Examples of S&M software tools would be SalesForce, Marketo, Hubspot, etc. Any tools or software that attribute to the sales funnel should be included in CAC.
Chart Of Accounts
Garbage in, garbage out. This data term is a phrase of caution for properly recording expenses to the correct chart of accounts. Even if you have the sales cycle down to a science, the CAC number is not going to matter if you’re not properly recording expenses. For example, if certain Marketing reps are recorded to the R&D department or software tools such as SalesForce are recorded to the G&A department, then the CAC numerator will be understated, which will provide an inaccurate result. From all of the startups I have been apart of, incorrect expense mapping is the most consistent issue I have seen. While expense mapping is not the most glamorous part of the job, it’s an incredibly important in proper P&L configuration. Incorrect departmental expenses will provide inaccurate metrics, leading to operational decision making based on false data indicators.