CAC is one of the most important metrics to measure the health of SaaS businesses.
It is particularly often discussed in relation to unit economics. Calculating CAC will allow you to derive unit economics, which is often considered as a benchmark in managing a startup.
In this article, we would like to explain CAC in detail, from its overview, differences from other metrics, target levels, and notes of caution so that you can make full use of CAC in your business.
CAC stands for “Customer Acquisition Cost” and refers to the amount of cost spent to acquire one customer/client.
Companies spend various types of costs to acquire customers, including advertising fees, sales staff costs, and so on. By combining these costs, you can refer to it as CAC.
To calculate CAC for a given period of time, such as one month, three months (quarter), or one year depending on your purposes, you need to divide “the total amount of money invested to acquire customers during a certain period” by “the number of customers acquired.” The formula is as follows.
CAC = Cost spent to acquire customers ÷ Number of new customers acquired
For example, if you spent 1 million yen on marketing and sales in a given month and acquired 100 new customers (100 clients) in that month, the CAC would be 10,000 yen.
There is a similar metric to CAC called CPA.
CPA stands for “Cost Per Acquisition,” which means the same as CAC; the cost spent to acquire one customer/client, however, there is a difference in the scope of cost.
While CPA mainly represents the cost of advertising per customer/client, CAC takes into account not only advertising costs, but all costs including staff costs and operational costs.
It includes all channels whether online or offline that are used to acquire new customers such as social media, search engines, content marketing, sales, and exhibitions.
As a result, CAC is often used in the scope of projects, while CPA is mainly measured for actions. CPA is particularly often used in online advertising to measure how much advertising costs are spent per conversion.
Difference between CAC and CPA
There are some notes to keep in mind about CAC.
The new customers acquired during a certain period are not only the direct result of promotional activities conducted around that time, but also include customers who come in organically through channels such as referrals from existing customers, word of mouth, and search.
When you try to properly measure the cost-effectiveness of an advertisement or campaign implemented during a given period, you need to exclude customers who came in organically from the total number of new customers acquired. For this reason, CAC categorizes costs depending on the paths taken by acquired customers.
This refers to the cost of acquiring customers through non-paid channels.
Customer entries from search, word of mouth, and referrals from existing customers are categorized as organic CAC.
The number of customers do not necessarily increase through advertisements or campaigns, but can increase naturally through unintended channels.
When calculating CAC you often overlook the cost of acquiring customers through organic channels, but it is important to note that CAC cannot be measured precisely unless organic CAC is taken into account.
This refers to the cost of acquiring customers through paid channels.
It includes the cost of all measures that are intended to acquire new customers such as TV/taxi commercials or online advertising as well as participating in events or holding corporate events.
While you might suppose customer acquisition through organic channels as you move your business forward, using paid CAC as a metric is recommended when cost-efficiency of customer acquisition in marketing or sales matters since it makes it easier to identify the impact of your measures.
Customer acquisition cost is the sum of organic CAC and paid CAC. In general, when someone refers to CAC, it is safe to assume that they refer to blended CAC.
You might face a situation like “The number of customers is increasing, but our company is still in the red. Should we continue to pursue customer growth or prioritize profitability?”
In such cases, it is effective to divide CAC into organic CAC and paid CAC rather than lumping them all together. By dividing CAC, you can tackle each situation flexibly such as keeping the organic CAC steady while reducing the paid CAC.
The 3 types of CAC
Unit economics always comes into play when explaining CAC. It is no exaggeration to say that CAC is derived to calculate unit economics.
Unit Economics, as the name suggests, is a concept that means “economics per unit (whether you are making money or losing it).”
The unit of measure depends on companies. Depending on the business, it might be a product or a sales tool, but more commonly it would be a customer or an account.
In other words, unit economics measures whether each customer or account is making or losing money for the company.
Unit economics is obtained by dividing the “revenue earned per unit (CLV)” by the “cost invested to acquire that unit (CAC).
Unit Economics = CLV ÷ CAC
CLV is a measure of the total profit a customer brings to a company from the start to the end of their business relationship. It is the abbreviation for “Customer Lifetime Value.”
In subscription models such as SaaS businesses, you cannot price a product high enough to recover all costs on the first sale. As a result, you need to build a long term relationship with a customer. The relationship must be maintained over a long period of time, and the customer must continually pay for the service. Therefore, you need to adopt a time-based approach to measure revenues from customers.
Unit economics allows us to measure the health of the ongoing business.
If unit economics is positive, the business is expected to be profitable and can be considered stable even if you continue to operate the same way. On the other hand, if it is negative, the company is losing money for every customer acquired. Although this might be an unhealthy business situation, you sometimes need to aim for customer acquisition regardless of the profitability depending on the phase of your business.
In any case, by checking unit economics, it becomes clearer whether the business is profitable or not, and if it is in the red, when and how long you can accept the loss and continue acquiring customers.
Specifically, what value of unit economics would indicate a healthy business?
As mentioned earlier, unit economics can be calculated as CLV/CAC, and you can say that a figure of 3 or more is a level which indicates a sound business operation. This level is used as one of the criteria for investment in series A-B, and should be the first goal of any SaaS business. In fact, successful SaaS businesses are said to have achieved a level of 3 or more.
Incidentally, you may be wondering what the rationale is for having a CLV/CAC of 3 or higher, but it is not very clear. However, in order to maintain an operating margin of 30% or more, you could argue that the cost of customer acquisition must be kept below 30% of sales if you take the cost of development and existing customer management into account.
Having a high CLV/CAC ratio is good, but too high is not ideal. If CLV exceeds CAC too much, some might perceive that the investment in customer acquisition is weak and opportunities for growth are missed.
To grow a business, you need to invest more than a certain amount in customer acquisition.
Calculating unit economics on a regular basis will help you to understand the health of your business operations and develop a flexible business strategy.
There are many metrics used in the SaaS business, including CLV and CAC. Among these metrics, there are three that are generally considered important to determine the health of a business.
The first is the aforementioned CLV/CAC > 3. CLV must exceed CAC to be viable as a business, and its level must be 3 or higher.
The CAC payback period is the period of time it takes to recover the cost of customer acquisition, in other words, the time it takes to recover CAC by profit. It can also be taken as the period of time until the company is able to earn profits from customers. In general, the ideal CAC payback period for SaaS businesses is 12 months or less.
This is an important metric, especially for startups, since it affects cash flow. If the funding is going well, 18 months or less may be acceptable, but it is always important to keep a close eye on this metric regardless.
The churn rate means the percentage of customers who canceled a subscription. In SaaS businesses, the key to business growth is “how to keep customers using your service”. This is because the cost it took for the subscription is not recovered at the time the service is introduced to a customer, and profits are generated only when they continue to use the service.
As a result, for SaaS companies, a high churn rate means “no matter how many customers you acquire, there will be no profits.” Generally speaking, if the churn rate can be kept around 3% per month, the business is going well.
The above three indicators are organically connected. For example, understanding “② CAC payback period should be within 12 months” and “③ Monthly churn rate should be less than 3%” will help you understand the basis for “① CLV/CAC > 3” more precisely.
Chasm refers to the large gap that exists between the initial market and the mainstream market in delivering a new product or service into the marketplace.
To understand chasm, you need to understand first the innovator theory proposed by Everett M. Rogers, a sociologist at Stanford University.
Innovator theory is a theory that considers market penetration of new products or services by dividing the customers in the marketplace into five categories.
In order of the fastest response to a new product or service, they are as follows
Innovators
Early Adopters
Early Majority
Late Majority
Laggards
In the chasm theory, innovators and early adopters are defined as the initial market, and the early majority to laggards are defined as the mainstream market. And there is a chasm or obstacle between the two that must be crossed when you deliver a product or service in the market.
In general, early adopters are risk-tolerant and will become customers based solely on the quality of the product or service regardless of the company brand. On the other hand, early majorities have a characteristic of low risk tolerance and are willing to adopt what is already widespread so as not to miss out.
Thus, there is a big difference in the needs for products and services between early adopters and the early majority. You could argue that just because a product is supported by early adopters does not mean it will be supported by the early majority
Innovator Theory and the Chasm
CAC tends to gradually worsen as a product spreads in the market, particularly around the chasm.
There is little competition in the initial market, and the customer base is sensitive to trends and judges products or services based on products/services themselves, so it is possible to acquire customers without spending that much on advertising. In mainstream markets, however, as the competition and the number of customer channels increases, it is essential to expand measures such as advertising, campaigns, and events in order to communicate the appeal of products or services to a large number of customers.
Growing a business is not all about maximizing CLV. You also need to be aware of how much it costs to achieve that CLV at the same time.
A CLV/CAC of 3 or more is considered a healthy level for a startup. To achieve this, you need to categorize CAC and develop the necessary strategies for each.
CAC should be calculated over a set period of time (monthly, quarterly, yearly, etc.) to quantitatively measure the health of the business.
