One of the biggest questions I’m asked is how much should you spend on marketing. The answer lies in knowing two numbers:
- How much does it cost to acquire a new customer?
- How much will a customer spend with you over her lifetime (until she stops doing business with you)?
Many small business owners don’t know these numbers, yet they are essential to deciding how much money to spend. Let’s look at each.
How to Calculate New Customer Acquisition Costs
To calculate a quick estimate of what it costs to acquire a new customer, you will need to know two things:
- How much did you spend on all marketing last year?
- How many new clients did you do business with last year?
Your cost to acquire a new customer will be #1 divided by #2. Now, this number isn’t 100% accurate – it doesn’t take into consideration the customers who were referred to you – but it provides a good estimate of what it costs.
Example for Product Business:
Let’s say you spent $10,000 on marketing and you sold 500 products to new customers. Each product cost $50, so you made 500 x $50 = $25,000.
Take $10,000 divided by 500 and you an average new customer acquisition cost of $20. In other words, you spent $20 to make $50.
Example for Service Business:
Let’s say you spent $10,000 on marketing and you netted 25 new clients. Let’s say you made $50,000 from those new clients, for an average of $2000 each ($50,000 divided by 25 = $2000).
Take $10,000 divided by 25 and you get an average new customer acquisition cost of $400. In other words, you spent $400 to make $2000.
Note: Any outliers can dramatically skew your results. For instance, if you made $50,000 but $30,000 of that revenue came from 2 clients, you may want to consider leaving those numbers out of your calculations and focus on the $20,000 that came from the majority 23 customers, or about $870 per new customer. Use your discretion.
How to Calculate The Lifetime Value of a Customer
Every paying client or customer has a lifetime value – the total amount they’ll spend over however long they’ll do business with you. When you know that amount, you can calculate how much you can afford to spend to bring in a new client.
The lifetime value of a client is calculated by figuring out:
- The total revenue a client will give you. To calculate this, look through your customer database and calculate how much revenue each client has paid you since you started your business. Then, divide that number by the number of clients you have to get an average amount people spend with you.
- From that number, subtract the cost of services provided (how much it costs to make the product or deliver the service).
- Now, add the monetary value of the referrals they provide you.
Lifetime Value = Revenue – Costs + Referral Value
Example for Product Business:
To use the previous example and to simplify our calculations, let’s say.
- It costs $10 to make each product.
- On average, customers who bought this product also buy 3 other products from you over their lifetime for a value of $150.
- Each customer refers one new customer.
Calculate Total Revenue
Initial Product Sale: $50
3 Additional Product Sales: $150
Subtotal: $200
Calculate Costs
Customer Acquisition Cost: $20
Product Cost: $10 x 4 = $40
Subtotal: $20+$40=$60
Calculate Referral Revenue (Assuming 1 per customer)
Additional Revenue = $50
Subtract Initial Costs=$10
Subtotal = $50-$10=$40
Calculate Lifetime Value
The formula looks like: [revenue ($200) - costs ($60)] + the referral revenue ($40) = $180.
Example for Service Business:
To use the previous service business example, let’s say.
- In addition to the initial $2000 client spend with you, they also pay you a monthly retainer of $150/month for the next 12 months.
- Your costs to deliver the initial service are $1500.
- Your costs to deliver the retainer service are $50/month.
- Each client refers one new client.
Calculate Total Revenue
Initial Product Sale: $2000
12 Months Retainer: $150 x 12 = $1800
Subtotal: $3800
Calculate Costs
Customer Acquisition Cost: $400
Initial Service Costs: $1500
Retainer Costs: $50×12=$600
Subtotal: $400+$1500+$600 = $2500
Calculate Referral Revenue (Assuming 1 per customer)
Additional Revenue = $2000
Subtract Initial Costs = $1500
Subtotal: $2000-$1500=$500
Calculate Lifetime Value
The formula looks like: [revenue ($3800) - costs ($2500)] + the referral revenue ($500) = $1800.
Conclusion
By determining your new customer acquisition costs and your average lifetime value of a customer, you can determine how much you can spend marketing your business. In the case of the product business, each new customer is worth $180 over their lifetime. In the case of the service business, each new client is worth $1800 over their lifetime. Those numbers represent the most you can spend to acquire a new customer without going broke.
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