Sales & Marketing

How much should you pay for a customer?

9 min read

05 December 2013

For many new companies, the biggest decision they have to make is how they price and sell their products. While the traditional approach would be to put a price on something at the start, many organisations are now opting to provide their product as a service for a monthly fee.

Rather than being able to see your profitability straight away, companies that either shift over or start with recurring revenue in mind, have a very different approach to the customer. This is reflected in the financial metrics that the company should be tracking over and above standard sales.

For companies that run based on recurring revenue, there are several key metrics to bear in mind. The first of these is Customer Acquisition Cost, or CAC. This is the average amount that it costs in marketing or sales activities in order to convert a prospect into a new customer. For this, you have to take the cost of all your marketing and sales activities and apply this to the number of sales generated over the same period.
 
While this tells you how much it costs to win those customers, it also provides the basis for further metrics and management decisions. If it costs you a lot to acquire your customers, how many more of them do you need in order to continue growing at your current rate? Can you afford this, or do you need to re-think your strategy?
 
For example, one customer I am working with looks at how their CAC compares with the amount of time taken to push a prospect through the sales cycle. This includes the cost of search and advertising for their prospects, as well as the average amount of time it takes to convert a customer once they have hit the initial landing page, interacted with content assets, and then responded well to inside sales follow-up. To get this simple Customer Acquisition Cost value, it involves adding up the Search Marketing, Content Marketing and Inside Sales expenses for a given time period and dividing it by the overall number of customers secured.
 
It is possible to get more granular on this and assign percentage of revenue to specific activities, such as events or sales campaigns. However, the most important action that can be taken using CAC is to look for opportunities to reduce the cycle, either through streamlining actions or providing more innovative ways for customer prospects to educate themselves.
 
The most important follow-up question is how long are those customers sticking with your business? This forms the second critical metric: Customer Life-time Value, or CLV. While traditional product sales provide a level of profit at the very start above any cost of materials, recurring revenue sales have to recoup all those costs over time.
 
As a rule of thumb, any customer sale should recover its costs within one year of the sale being completed; after this, what the customer pays is profit back to the organisation. CLV is therefore hugely important: it provides an overview of how much customers are paying during their time using the service. For the company to be successful, you obviously want to keep customers for as long as possible; however, the profitability objective is to keep CLV higher than CAC.
 
All this information can be used for management decisions and opportunity spotting as well. Can making changes to how customers are acquired also change the lifetime value for a certain group of customers? Are there certain types of customer that show greater lifetime value or more willingness to buy additional products?
 
Looking at these data sets and doing more analysis can show up more opportunities for the future that will increase your revenues, often without increasing spend. For another customer I have worked with, they see a specific customer type that is more valuable to them – but only once that prospect has interacted with the product. The emphasis turned from simply acquiring more prospects that fit with that customer profile and instead concentrated on improving the quality of interaction instead. This led to a lower number of prospects, but much higher CLV being achieved.
 
Borrowing from the telecoms world, the third metric to look at is churn. How often do customers leave your service for competitors? How difficult is it for them to switch? What percentage of your overall customer base leave over a given time-frame?
 
For the incumbent company, analysing the propensity of customers to move involves making a fundamental decision on whether to resist churn as much as possible in order to maintain CLV, or whether to focus on lowering their CAC in order to replace those customers. In an ideal world, companies would invest in both, but that may not be possible.
 
Putting together these numbers can be a difficult process: information can be held in the financial or ERP systems, but it can also come from CRM or support applications as well. Piecing together this information can be a time-consuming and manual process, which can make it difficult to spot when changes in CLV or churn are taking place. At this point, relying on gut feel and instinct can see you through, but it is definitely not ideal.
 
There is also the challenge of how often this data analysis can be completed. Traditional businesses tend to run on a quarterly basis, which can be fine when the profitability of current sales will pay for the running of the organisation. For recurring revenue businesses, this may not be often enough. If an issue around churn is only seen after three months, then the impact on future cash-flow and revenues may be spotted too late.
 
Looking at key metrics on a monthly, weekly or even daily basis is more likely to provide the management team with the information they require. This not only helps with management decision-making, but also helps to make sure that customers become profitable investments for the company.
 
At this point, it is also worth looking at how to automate some of that data analysis. If you are looking at reporting more metrics that rely on information from across the organisation and they are more difficult to compile than stand-alone finance data, then any steps to streamline that process should be considered.
 
Options here include building more reports in your sales, CRM and finance reports to capture as much of those numbers as you can. However, in most cases getting these key metrics involves linking information from across multiple applications. The other approach is to look at getting that information into a separate data analytics tool to take care of that reporting requirement.
 
When it comes to running your business, the old metrics of profit and loss can take you so far. If your business earns its money through recurring revenue, then the challenge is to make use of all the additional information that is available. By looking at these more in-depth metrics, it can be easier and faster to see where there are both challenges and opportunities in future.
 
David Gray is VP International at cloud business intelligence company Birst.