I’ve been thinking about customer acquisition cost a lot lately. From an economics standpoint, most startups seeking explosive growth (including Proper Cloth) are seeking one thing: customer acquisition cost < customer value.
(Theoretically) when this is realized, the startup can quickly scale by “buying” more customers, making a profit on each one.
Proving that you’ve achieved this (or creating a compelling story that you will be able to achieve this) significantly increases your valuation, increases your revenues, and increases the number of VC’s that want to take you out to lunch.
There are probably great books on this topic that I have not read, but from my own experience, this is how I see it. (I appreciate comments to clarify/correct my approach.) The simple way to calculate customer acquisition cost is:
Cacq = A/( Ttotal*Rconv)
Cacq = Customer Acquisition Cost. How much you spend to get a new customer.
A = Advertising budget. How much you spend to drive traffic to your site to get new customers
Rconv = Conversion rate from traffic to customers. The percentage of your site’s visitors that you are able to monetize.
Ttotal = Total traffic to your site in some unit of time. Let’s say, per month.
Good so far, but we should also consider that a site typically gets traffic from a variety of sources each having different costs and effects. For this post, I want to focus on how viral sharing affects customer acquisition cost, so I’ll introduce the following variables.
Tbase= Traffic that comes to your site from organic search, press coverage, bloggers, gift guides, product directories or really any other links to your site that you don’t need to pay for.
Tpaid= Traffic that comes to your site as a direct result of your advertising.
Cpc= The effective cost per click you spend by advertising. Advertising may be purchased as CPM, but you can still calculate the cost per click by dividing the amount you spent by the number of clicks that resulted.
Twom= Traffic to your site as a result of ordinary users sharing it with their friends (word of mouth). They find it interesting and email a link to someone, post it on their Facebook or Twitter profiles or mention it to someone at a bar.
Based on these new variables, define the following:
Tpaid = A/Cpc
Ttotal = Tbase+Tpaid+Twom
Furthermore, seeking a better understanding of of Twom, we would see that it is probably a function of how many visitors our site has and some viral coefficient “V”
V = Viral coefficient. Practically speaking this is the average number of additional visitors that each visitor recruits.
Twom= (Tbase+Tpaid)*V
Solving for Total Traffic, we get:
Ttotal = (Tbase+Tpaid)(1+ V)
Thus, solving for Customer Acquisition Cost, we could say:
Cacq= A/(Rconv* (Tbase+Tpaid)(1+ V))
Identically:
Cacq= (A/(Rconv* (Tbase+Tpaid)))*(1/(1+ V))
Now – that was a lot of math – but if you think about this equation a little bit, you can see the huge value that customers word of mouth brings to the table.
Suppose you have a viral coefficient of 1, meaning each site visitor recruits just one additional visitor. The result is that you cut your customer acquisition cost in half.
IN HALF!
(*Note1: This is even before we take into account the second order effects of referred people referring even more people. A viral coefficient greater than 1 would theoretically result in a naturally exponential growth – so called “viral growth”. Depending on the time delay between referrals, and your target growth rate, this could potentially drive your customer acquisition cost to zero. )
(*Note2: You might point out that this equation calculates “average” customer acquisition cost, rather than your marginal customer acquisition cost. This is correct, as you scale up advertising, Tbase+Tpaid will approach Tpaid, so you could calculate marginal costs this way to be more precise.)
(*Note3: Please excuse the implication that Rconv is a constant. I realize that it tends to vary widely depending on the nature of the traffic and corresponding intent. However, for this exercise let’s assume a general, mass-market conversion rate.)
It can come down to pennies per customer, but for many startups this can be the difference between having an exciting, scalable startup and a failure.
Just 5 years ago (ok maybe 10), Word of Mouth for most people meant sending an email or actually mentioning something face to face. A good analytical marketing person might have even ignored the Twom component because it was so small – better to just consider it a nice little bonus.
However, things are changing. With the growing influence of social networks, this viral coefficient is becoming increasingly significant. It’s increasingly convenient to post things on Facebook and the average person’s number of friends and followers is also growing. We may be more choosy with what we share to our friends, but with more followers, an AVERAGE person’s post on Facebook or Twitter can now generate your site hundreds of additional visitors.
Two recent startups that have shown explosive growth: Groupon and Zynga are great examples. While their ability to monetize customers is itself very awesome, without a doubt they are relying on fairly large viral coefficients to keep their average customer acquisition costs low. If you’ve played with their products, you’ll see that they aggressively push you to refer additional people to their services.
Of course, we cannot forget about SEO, press, usability design, conversion funnels and optimizing ad campaigns, but I predict that increasingly this viral coefficient will be the metric that startups rely on to justify the economics of their businesses.