How much should you spend to get new customers? When a deal or promotion opportunity comes your way that brings in new clients and grow your business, how do you figure out whether the deal will pay off?
Your gut feeling may have come through for you in the past. You let it dictate how much is just right, too much, or too little. What you think costs too much may end up bringing in more customers and profit than you expect.
Without knowing a client’s lifelong value, it’ll be impossible to determine whether an acquisition cost is too high or too low.
If the lifelong value of a customer is $10k. Does it make good business sense to spend $2k to get the client?
If you spend too little and miss out on the client, your competitor may win the opportunity that could’ve been yours.
So how much is your customer worth?
Doing the math
You can answer the question. It’ll require some math, but it pays dividends — literally and figuratively — once you figure it out. Knowing the answer helps you make the right decision on how much to spend to acquire new customers.
Here’s another way of looking it at. How would you do things knowing the average client is worth $1k, $5k, or $10k? The difference between the $1k customer and $10k customer is huge.
When you estimate a customer’s worth, then you can relax knowing you’re spending exactly the right amount to land new clients. Knowledge is power here.
Here are the three things you need to figure out a customer’s value:
- Average customer stay: How long clients stay with you.
- Average gross margin: If you provide a service, subtract the cost of the employee time and any materials the employee uses to provide the service. For products, subtract the cost to produce the product including payroll, commissions, materials, and utilities. Don’t include overheads such as rent, salaries, and administration.
- Average sales: How much the average client buys from you.
Here’s an example on how to figure out the gross margin for a $500 product. First, subtract the costs to produce the product:
- Payroll: $150
- Commissions: $50
- Materials: $30
- Utilities: $10
Total costs: $240.
$500 product – $240 costs = $260 profit
Then, calculate the gross margin. $260 is 52 percent of $500. The gross margin is 52 percent.
When you know exactly how much a customer is worth, it’ll be easier to make decisions about promotions and acquisition activities.
Let’s say you know that an average customer is worth $5k.
You receive an offer to advertise in a specialty magazine that targets your ideal customer. The magazine charges $2k per month for the ad, which would be $24k for the year. According to the magazine, its advertisers have gained an average of three new customers per issue.
Instead of using three new customers per month, let’s be ultra conservative and say the ad brings in one new customer per month. The total cost of advertising for one year is $24k. The total profit of getting 12 new customers — since we know the customer is worth $5k — in one year is $60k. So one ad for one year is $36k in profit. ($60k revenues – $24k for the ad = $36k in profit.)
What if the ad only brings in six new customers in one year? You still get $5k in profit. Remember, all of this uses conservative estimates.
Let’s put the three variables to work in another example. The average customer for Dave’s services business stays with him for seven years. However, industry changes have forced his clients to be more sensitive about costs.
As a result, Dave thinks they’ll stay with him for only three years. Customers pay Dave about $12k per year for his services. The business gets a gross margin of about 35 percent with most customers.
Calculate Dave’s average customer’s worth:
Stay x gross margin x sales = average customer lifetime value
3 years x 35 percent x $12k = $12,600
Now that we know the average lifetime value of a client, let’s see how this knowledge is power.
Dave receives a quote for a new website and promoting it. The quote includes $10k to produce the site and another $1k per month to promote it. That’s $22k per year.
That information alone will have most small business owners thinking that’s insanely expensive. Right?
Stick with me here.
We’ll use a very conservative estimate and say this brings in four new clients per month. That said, is this deal too expensive for Dave?
Let’s work this out. This means Dave will have about 48 new customers for the year. We already know the average lifetime value is $12,600 so we multiply that by 48. The new clients will bring in $604,800 in new revenue.
That $22k acquisition cost to acquire 48 new clients sounds like a bargain, doesn’t it?
This information has made it a lot easier to decide whether to spend the money on the website and promotion.
What if Dave meets a talented sales person with an impressive Rolodex who can bring in three new clients per month? Hiring her will cost $50k in fixed costs plus a few points off Dave’s gross margin.
That’s about $450k in new revenue.
What would you do? Hire her!
Make better decisions
Once you know the average lifetime value of a customer, it’s simplifies the decision-making process for acquisition costs.
If you don’t have the working capital to cover acquisition costs, it may be worth pursuing a small business loan, line of credit, or invoice financing. Your business growth may not stop there. Your new clients may like you so much that they become your biggest evangelists and tell others about you. After all, it’s cheaper to keep customers than to get new ones.
What is your customer worth to you?
Image credit: Daniel Sancho