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A Simple Formula For How Much to Pay for a Customer

I’m going to give you a formula to determine how much you should invest to acquire your typical customer.

I call it “Desired Customer Acquisition Cost.” I also saw it referred to as “Allowable Acquisition Cost” in Ready, Fire, Aim: Zero to $100 Million in No Time Flat, an excellent book I recommend by Michael Masterson (I borrowed a couple of his ideas for this article!).

Note: I’m going to write a separate article on customer acquisition strategies, customer acquisition programs, customer acquisition networks and the overall customer acquisition process — please come back for those!

How Much is Your Customer Worth?

How Much is Your Customer Worth?

Ok, on to your Desired Customer Acquisition Cost.

For starters, you’re going to need to do a few calulations of your own…don’t worry about having the perfect answers — just give it your best shot!

Calculate Your Customer Lifetime Value (aka Gross Sales Per Customer)

You need to estimate the lifetime value of your customer.

Let’s first define customer lifetime value. It is how much a customer will spend with you for their lifetime (i.e. the total number of products they buy from you over time multiplied by the price of each product).

If you’ve been in business already, you might know your Customer Lifetime Value. In fact you could simply divide the total amount of sales you’ve had since you began by the total number of customers you’ve had).

If you’re in a new business, I suggest you research competitors or other similar companies to yours to get a sense of their lifetime value.

For now, if you don’t know what your Lifetime Value is then you could use the range I use: where Lifetime Value is typically about 2X to 6X the price of the first product your customer typically buys from you.

For example, if you customer is likely to pay around $50 for the first product they buy from you, you could expect the lifetime value of your customer to be anywhere from $100 to $300.

Where’s the 2X to 6X range come from? That’s just my experience with businesses I’ve seen. Remember, your business and others can be very different.

Sidenote: If you are selling a subscription-based product (e.g. Netflix, DirecTV, Sports Illustrated) as your first/primary product, then your lifetime value is going to be very different. The lifetime value of a cable/satellite customer may be 10 to 40X the first month’s price since they are likely to stay with their service for a few years (i.e. 10 to 40 months).

We’re going to use a Lifetime Value of 3X for this exercise.

Obama’s Lifetime Value

Let’s pick a fictional company to make this easier…we’ll call our pretend company Obama Enterprises (they sell a set of information products on how to become the next President!).

Obama’s flagship product is a $50 DVD that he’ll ship you on the basics of what it takes to be Mr. President; he has more expensive products that he sells you on the back-end.

So, let’s use $150 (3X the price of his first product) as our Lifetime Value.

Calculate Your Refunds, Cancels, Bad Debt, etc

If your business is like most, your customers will cancel or request refunds, or simply not pay you.

This varies by industry and by business.

For Obama Enterprises, we’re going to assume that 10% of the sales will be refunded, canceled or otherwise just not collected as cash we keep.

So, Obama’s Refunds & Cancels is $15 per customer (10% of $150).

Calculate Your Cost of Goods Sold

First off, most people who know what Cost of Goods Sold is call it “COGS” (sounds cooler, right?).

Here’s the COGS definition:

  • The materials cost used in creating the goods plus
  • The direct labor costs used to produce the goods

Note: COGS excludes sales, marketing and distribution costs.

COGS varies by industry but are typically in the range of 20% to 50% of the price of your good.

For example, the retail industry is known to mark items up by 100% so in essence their COGS on a $20 shirt is 50% or $10.

In the Software or Internet industry, the COGS is very low (typically just 20% of the sale)…for example, if Microsoft is selling you a software product for $200, it likely only costs them $40 (20% of that) to create/produce.

Since the COGS for Obama’s video product are pretty inexpensive (Discs, box, etc.), we’re going to use 20% of $150 (or $10) as his COGS estimate.

Calculate Your Overhead Costs

Let’s define overhead cost: It’s simply all the costs that are NOT associated with any specific business activity we mention in this article.

Examples of Overhead costs include: Payroll (All Payroll except that included in COGS), Insurance, Rent, Utilities, Legal, Accounting, Travel and Entertainment.

Again, you’re going to have to research your business’s math (or that of your industry if you’re new), but a good rule of thumb is that Overhead will eat up about 33% of your Sales or Lifetime Value (most of this is due to your labor costs).

So, Obama’s Overhead costs are about $50 (33% of $150).

Now, the only other cost we haven’t covered so far is the Customer Acquisition (or Marketing) cost…we’re going to skip that for now as that’s what we’re trying to determine.

Calculate Your Desired Profitability %

Let’s skip to how much profit you want.

Profit is how much money you want to keep after all expenses (except taxes) are paid…you know it as the “bottom line” (Google and Microsoft tend to keep a profit of 20% to 30% while other businesses are more modest with a profit of 5% to 10%).

Obama’s people are not greedy, so we’re going to pick a profit goal of 10% for Obama Enterprises.

So, Obama’s Desired Profit is $15 per customer (10% of $150).

Ok, now for the good part. Here is how you calculate your Desired Customer Aquisition Cost:

Desirable Customer Acquisition Formula =

  • Lifetime Value minus
  • Refunds & Cancels minus
  • COGS minus
  • Overhead minus
  • Desired Profit

So the formula for Obama’s customer acquisition is:

  • $150 Lifetime Value minus
  • $15 Refunds & Cancels minus
  • $30 COGS minus
  • $50 Overhead minus
  • $15 Desired Profit

…And thus the amount Obama can spend to buy one customer, drumroll please, is…

= $40

And There You Have It (Your Desired Customer Acquisition Cost)

So, if our assumptions are ballpark-accurate, Obama can go out and spend an average of $40 to acquire each customer who buys his $50 DVD product, and still have all his expenses paid and a desired profit of 10% of all he sells.

For example, he could offer to pay you $40 for each customer your Web site sends over to his…and if you sent him 1,000 customers, he would gladly pay you $40,000 (1,000 times $40) because he would eventually receive about $150 in Lifetime Value from each of those customers and eventually receive a profit of $4,000 (the 10% Desired Profit he calculated) on his partnership with you.

Caveat here (which you probably already figured out):

Since Lifetime Value is over time, Obama has to make sure that he has the proper cash flow to afford to pay all bills while he earns the lifetime value for customers.

That’s called “Cashflow” or “Working Capital” and it has to wait for another day!

Though, if you want to improve your creditworthiness (so you can get better/larger loans or credit card limits), you should read How to Boost Your FICO Score.

17 Comments

  • J

    Can’t wait for your other customer acquisition articles – Great stuff!

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  • http://www.responsemine.com/customer-acquisition.shtml Customer Acquisition Programs

    I really like this article–I've seen a lot of mostly small businesses who have seen customer acquisition as an investment that always pays off. I'm glad somebody is out there advocating some strategizing before spending.

  • http://www.responsemine.com/customer-acquisition.shtml Customer Acquisition Programs

    I really like this article–I’ve seen a lot of mostly small businesses who have seen customer acquisition as an investment that always pays off. I’m glad somebody is out there advocating some strategizing before spending.

  • http://www.responsemine.com/customer-acquisition.shtml Customer Acquisition Programs

    I really like this article–I’ve seen a lot of mostly small businesses who have seen customer acquisition as an investment that always pays off. I’m glad somebody is out there advocating some strategizing before spending.

  • http://www.responsemine.com/customer-acquisition.shtml Customer Acquisition Programs

    I really like this article–I've seen a lot of mostly small businesses who have seen customer acquisition as an investment that always pays off. I'm glad somebody is out there advocating some strategizing before spending.

  • http://www.localdumpsterrental.com Dumpster Rental

    Quantifying customer acquisition as an investment is the hard part, and this article gives some interesting insight.

  • http://www.localdumpsterrental.com Dumpster Rental

    Looking at customer acquisition cost as an investment that is almost always thought of as an investment. Quantifying it is the ahrd part and this article gives some interesting insight.

  • Miguel Aristizabal

    You said in the example the price of the product sold is a $50 DVD.

    Then you calculate $150 that is 3X the price of the first product sold) as the Lifetime Value.

    Then you said, that the COGS is  20% to 50% of the price of the good.

    And finally you said we’re going to use 20% of $150 as his COGS estimate.

    The question is why you take the 20% of $150 if 150 is the lifetime value — shouldn’t you take that from the $50 price of the product?

  • http://www.robdkelly.com Rob Kelly

    Great question, Miguel. 

    Perhaps I could have been more clear. In this model, I apply the % costs (e.g. COGS) to all the purchases of the product by one customer (the $150); not just the first $50 purchase. 

    For example, if Obama sold me three different videos for a total of $150, the cost of goods sold to me (assuming it’s 20%) would be $30 over the lifetime of me the customer. 

    Hope that’s more clear. 

  • ntoya

    Question, do you not for account brand building in the CPA? If going into a new market, with a new product, using the model above, would I only have $40K to launch the business?

  • http://www.robdkelly.com Rob Kelly

    Thanks for the question, ntoya.

    Brand building certainly is important.
    And a point of clarification: the $40K I mention is just about hypothetically paying for 1,000 customers.

    I probably didn’t answer your question, so feel free to give it another try and I’ll do my best to answer!

  • ntoya

    I’m trying to develop a marketing budget for a new company. Certainly $40K is not going to be sifficient. Is there a formulat to determine the amount of marketing budget required to launch the brand, and close 1,000 customers?

  • http://www.robdkelly.com Rob Kelly

    Thank you for clarifying. There is no “silver bullet” answer to that one.

    You can use my “How Much To Pay For A Customer Formula” in the article with some simple guesstimates on the assumptions.

    The main point here is that if you have a product or service that has a lifetime value of multiple times the price of the first purchase, then you can often spend the amount of the price of the first purchase on your marketing and still generate a profit (assuming you have the cash flow to do so).

    I hope that helps. Best of luck!

  • http://www.ongig.com/ Rob Kelly

    Chet Holmes (in his Dream 100 Sales video) gave a couple of good examples of customer lifetime value, such as:

    • Walmart ($12,240) versus Target ($6,300)
    • Hertz ($15,000)
    • A Restaurant ($10,400)
    • Dentist ($6,800)

    Here’s the video where he mentions it:

    http://youtu.be/kNGAF7Kx_q4?t=43m15s

  • Anonymous

    Great article…. gave me a lot of important points to think about…. Does anyone know where i can get statistics about customer acquisition cost per industry? I am sure there is something out there…. if not i will use the method in the article….. I need it for my website http://www.apartmentsrentrebate.com/

  • http://www.ongig.com/ Rob Kelly

    Thanks for the comment. There are a few customer acquisition cost by industry references in this piece: http://www.quora.com/Does-anyone-have-a-good-resource-for-B2C-customer-acquisition-costs-across-different-industries