The Everlasting Debate on How to Calculate CAC
CAC — that unassuming and elusive acronym that is nearly always miscalculated, misunderstood and misutilized. Let’s distill how to calculate CAC the right way.
CAC — that unassuming and elusive acronym that finds itself in everything from casual growth conversations to pivotal hinges that decide business valuations, from whether you are renewing the contract with your media agency to determining if you need some caffeine overdose before you walk into the quarterly review.
It is easy to understand why that three-letter word gets so much importance. CAC — or Customer Acquisition Cost — gives any business a central metric to work itself around. It’s the one metric to rule them all. Surely something this important would be unambiguous in definition and wanner of calculation. And yet, CAC is nearly always miscalculated, misunderstood and misuitlized.
CAC’s twin CPA — they are not the same
CAC is often confused with CPA, which stands for Cost Per Acquisition. The two are twins, but you do not want to mix the identities here. Much like you do not want to mix up the twin brother at the wedding. A whole lot of abrupt chaos would ensue.
To differentiate between CAC and CPA, a business must first define in no uncertain terms who a customer is. Now in certain verticals of the digital economy, the lines get blurred — more on that in just a bit.
Let’s define the word customer:
cus·tom·er /ˈkəstəmər/ (noun) — a person or organization that buys goods or services from a store or business.
“Buys” is the operative word here; making a purchase. So a customer is a service user who has paid a business some money for that service. This distinction is critical in today’s digital economy since customers, freemium users, trial users, free users and subscribers are all variations of the term user.
CAC, hence, is the to cost of acquiring a paid user. But, on the other hand, CPA is the cost of — here’s the fun part; you decide. CPA is non-exclusive, meaning there is a CPA for each type of user. So if your manager asks you what the current CPA is, you get to go all smug and reply, “CPA of what?”
You can tell by now that there is a different CPA for each kind of user your business is servicing — CPA for newsletter subscribers, CPA for a freemium user, and CPA for a trial user. CAC is exclusive and unforgiving.
Echoing life while calculating CAC
Business imitates life. Just like every significant milestone in our lives is dotted with triumphs and tribulations, and every prominent pitstop in life’s journey is made up of numerous little steps, in business, too, a customer’s journey from first coming in contact with your company to making a purchase is long and winding.
Let’s consider a freemium software-as-a-service product designed to work as a self-serve model (a myth, but that’s another day’s story). A simplified user acquisition journey would look something like the following:
Someone visits the company website ⟶ visitor signs up for a free plan ⟶ user stays “inactive” for a while ⟶ “reactivation” effort kicks in ⟶ user takes first usage action in the product ⟶ user tries different features in the product ⟶ user starts a trial of premium feature or usage volume ⟶ user purchases a subscription of a paid plan.
The right point to calculate CAC would be when the user first pays for the paid plan in this example. Until that moment, CPA does well to give the business a sense of acquiring the user. Various CPA metrics could be:
- Cost per sign up (you could say this is the cost per lead or, to be even more specific; cost per sales qualified lead)
- Cost per activated user (when the user does an activity that the business defines as an affirmative signal towards a future purchase).
- Cost per trial (when the user starts the trial of a paid plan).
What about microtransactions — Meet ROAS
If there are one-time purchase assets inside the product, like in the case of Canva, where you can buy premium icons or stock images or like in the case of Grammarly, where a user can purchase ala carte human writing help, we enter an interesting situation. The following concept applies to business models based not on not subscriptions but on individual transactions.
Meet ROAS or Return on Advertising Spends, a metric that measures the amount of revenue earned for every dollar spent on advertising. In the former examples of Canva and Grammarly, you’d see ROAS materializing before CAC becomes an actual figure. In the latter instance, where you can see revenue flow without being in a subscription, the correct way to calculate CAC could be to subtract generated revenue from marketing dollars spent before dividing by the number of customers acquired. We’ll get into the math formulas soon.
A hybrid version of ROAS factored in CAC can also be applied to consumer products where users are monetized for their content or through a marketplace, such as social networks with self-serve advertising. In this scenario, a business needs to differentiate between a consumer, an advertiser, and a user who is both a consumer and an advertiser.
The world of B2B sales and CAC
Enter the world of inside sales, multiple touchpoints, and account-based marketing, where the lifecycle journey of a customer is often complex and multithreaded. But we’ll keep to the topic at hand; when and how to calculate CAC.
We start seeing the emergency of yet another metric; CPL or Cost Per Lead. Or, if you do not mind going down the rabbit hole, two more siblings; marketing qualified leads and sales qualified leads. Without spending too much time here, marketing and sales qualified lead definition can be pretty simple or uber-nerdy based on whom you ask. I like it simple, so in my world, a marketing qualified lead is a person who fits the buyer persona of your business. A sales qualified lead is when the person with the perfect persona indicates a sales signal.
In a B2B inside sales driven organization, you have to consider the cost of sales (like sales commissions and the hourly rate of sales development representatives) and the cost of multitouch marketing campaigns (like the cost of marketing assets development and campaign tools costs) incurred while nurturing a lead towards an eventual sale.
The math behind CAC (done two ways)
Let’s get to the math — the formula to calculate CAC. If you made it this far, you likely have seen this formula many times before. It is likely that you live and die by it. The point of this essay isn’t as much about the formula as it is about better understanding what is CAC and when it is the right metric to use.
There is a simplified and more intensive way of calculating CAC. If your business has a relatively small sales cycle (how long it takes a user to convert into a customer), say within a month, the simplified CAC formula is mostly sufficient.
The formula divides the total cost of sales and marketing by the number of acquired customers. It is up to you how granular you want to get regarding what gets counted in these sales and marketing costs — for instance, some endorse the addition of salaries in the cost. I stay away from doing that on principle.
The second formula does the more careful calculation by considering sales cycle and being aware of average expenses during specific acquisition cohorts.
Let’s break it down:
[Mo] stands for mode — the mathematical value that occurs most frequently in a set of numbers. I prefer using mode instead of average because it weeds out outlying good and bad sales months. Anyone remotely aware of a B2B inside sales world knows how volatile and misleading average values can be. Therefore;
[Mo] Sales Cycle = Most common sales cycle unit over a period of time.
In the numerator, we multiply the mode sales cycle with the average marketing cost per month + the average sales cost per month.
Don’t ignore the cohorts: When you multiply the mode sales cycle with average monthly sales and marketing costs, pay close attention to the acquisition cohort as this varies significantly. At the same time, being aware of it can give your business unique seasonal success insights.
For example: The mode sales cycle during holiday seasons can be pretty high as your sales time will likely find it more challenging to get in touch with opportunities and close deals. On the other hand, your marketing team may consider cutting down on marketing spends during the same time as they detect lower buying intent.
Difference between CAC and cost of doing business.
Or a note on when to stop.
“Loaded CAC” is a corporate and media agency snake oil. I have often heard the term “loaded CAC” when someone goes on a neverending spiral of tacking on expenses under the costs umbrella. They include salaries of marketing and sales team members and even a percentage of wages of shared resources, cost of equipment, rent and other overheads. If one goes that far, it is only reasonable to start including corporate tax benefits from a business’s investment in R&D. This slope is neverending, and it’s for a good reason that the term “cost of doing business” exists.
It is imperative to separate the cost of doing business from sales and marketing and, consequently, from CAC calculation. When a company starts measuring every dollar spent towards the cost of acquiring a customer, what you have is not a business anymore but an evil corporation with no life.
