Thinking of cutting back on marketing? You won’t be alone. In July this year, Marketing Week reported a record decline in budgets, dwarfing previous recessions. But before you start slashing your budget, consider this. Is your lack of faith in marketing driven by poor planning? Do you have the right metrics in place to properly track the effectiveness of your expenditure?
It’s pretty frustrating. I sit down with clients who have big, bold aspirations for growth. We start digging into their data. After a while, we discover they’re spending money on marketing but to no end. Because there’s no coherent plan. It’s like they’re shooting in the dark. There’s no idea of what’s working and little comprehension of where to focus. It’s not surprising they’re disillusioned. Quite often, they have no tangible sense of what they want to achieve. Let alone the investment that’s needed to do this.
A while back, I blogged about the sales velocity equation. For me, this neat little formula is all you need to transform your sales operation. Well – here’s another for marketing with similarly magical properties. CAC (Customer Acquisition Cost) and LTV (Lifetime Value). Never heard of them? That’s the usual reaction I get. Well, read and learn! Every business should track them. These metrics will transform your understanding of the value of marketing. They may even persuade you to increase your budget.
What are CAC and LTV?
As its name implies, CAC (Customer Acquisition Cost) is the cost of winning new customers. To calculate it, you need to know your total sales and marketing expenditure including salaries, bonuses and overheads over a given time period. You then divide this by the number of new customers you gained during the same period. So, if you spent £300,000 on Sales and Marketing in a year and added 30 customers, your CAC is £10,000.
Then you need to look at the payback of these new customers – this is where LTV (Life Time Value) comes in. For fixed-term contracts, this is straight forward. But if you don’t know how long you’re going to retain them, work out how much revenue you can expect in a certain period. Then subtract out the gross margin and divide this by your estimated churn percentage for that type of customer over the same period. Still with me? So, for a type of customer who pays you £100,000 per year where your gross margin on the revenue is 70%, and that customer type is predicted to cancel at a rate of 16% per year, then the LTV is £437,500 (70,000 divided by 16%). Don’t believe the number? If your annual churn is 10% then the customer LTV is 10 years. If you think this is too high, gross profit over three or five years.
How do these metrics bring clarity to marketing?
Once you’ve worked out CAC and LTV, you’ll have some really useful benchmarks that can guide your future marketing strategy in the following ways:
- Working out how much you’re prepared to spend
A true understanding of the value of a customer will mean you can work out how much you’re prepared to spend to generate that revenue over their estimated lifetime. Most of my clients have monthly recurring revenue. What are they prepared to spend to win this?
If they’ve worked out that the first year’s value will be £100,000, they might be happy to invest this amount. Or if the gross profit is 30%, they might spend a third of first-year revenue. If you can get a return from expenditure in a year and you have a good retention rate, you’d be happy to do that as you’ll be generating a good incremental gross profit in year 2.
If your revenue growth aspiration is in the 20% range, are you going to double in three years how many new customers do you need? Then your sales (just new business folks) and marketing budget is this number multiplied by £30,000. WOW!
- Making strategic decisions
Once you have a good handle on your CAC and LTV, you’ll find it easier to make sensible strategic decisions. Here’s a great example. I was talking to a client in Poland recently. He was weighing up increasing his marketing budget versus making an acquisition. The acquisition would give him 1000 new customers, so we started to put that in the context of his current business. We discussed his total sales and marketing budget for the previous year and how many new customers this had generated.
It soon became clear that his marketing had a better ROI than shelling out for the acquisition. Why was he looking at paying through the nose for these new customers when his existing marketing generated a better return? In his case, he’s prepared to strategically overpay to prevent his competitors from gaining market share. But now he knows how much he is overpaying by.
- Enabling organic new business growth
As MD of Rackspace, I always knew what our CAC was. It guided so many decisions. My feeling all along was that organic growth was best for us – finding new customers that genuinely liked us. We didn’t believe in buying customers in – I’d learned the hard way that it could result in clients that weren’t the perfect fit and, as a result, higher churn rates. When you’ve bought customers, they can also be too expensive to serve. So, we built a powerful marketing team that helped us build our business organically. These customers were attracted to us and we invested time and effort in retaining them. It was a huge factor in our stratospheric growth, helping us scale into a highly sustainable and profitable business.
- Showing where to focus your marketing budget
My view is that if your sales and marketing are consistently generating a return on investment, they should have an unlimited budget. When we were in our pomp at Rackspace, spending on marketing resulted in exponential return – it was like a license to print money. If we spent £10 on marketing in a month, it would generate £5 of monthly recurring revenue leading to a return in two months. By looking at our CAC and LTV, we could work out how quickly we’d see a return and then drill down to the activity that was driving this. Was some of it quicker than others? What was our lead flow? Did we generate these leads? Were they inbound or channel? We got really clear on the way revenue came into our company.
CAC and LTV enable you to look in really granular detail at what’s working and what isn’t. Not only is it the value on the way in, but also the value once they’re a customer. So, a customer who lands at £100 might be £150 at the end of Year 2. This might also be different by channel. By comparing the cost of acquisition on the way in and LTV, you can come up with a ratio across your channels. This finetuning and experimenting will really drive results.
- Enabling detailed planning based on data
So few of my clients have a marketing plan that’s based on proper data. They don’t model things through. If they did plan effectively, they’d probably find the money they’re currently spending is having no impact. They could stop right now and add that money back on the bottom line. If you genuinely want marketing to make a contribution, you need to calculate the value of bringing in a client. And then spend up to the first year’s revenue on winning them. At Rackspace, we aimed to spend around three months revenue but knew we’d spend up to six if we had to. You need to get your marketing flywheel spinning. Recognise that many types of marketing activity can have longer lead times.
Say you wanted to grow your business by 25% and you knew this needed to come from new customers rather than expansion of your existing base. The CAC and LTV will tell you how many customers you need to be aiming for and the average revenue per customer. Once you know this, you can also work out your close rate. How many customers might you need to target to generate these opportunities? Are you clear on your core customer? If you are, you’ll find that the number you need to talk to isn’t huge to drive a meaningful volume of revenue.
This is why I spend so much time helping clients get clear on their positioning in the market and the identity of their core customer. It’s so important. If they can work out the CAC and LTV for these specific customers, they can then work out how much they are prepared to spend to attract them. And it’s often much more than they’d previously thought. For some hosting businesses or MSPs, it might mean 15% of revenue as a minimum spend. If you’re a smaller company, it may be more. Particularly if you’ve got growth aspirations.
- Working out future resourcing and infrastructure
Another rule of thumb is that your salespeople should generate at least 3x their total cost in gross profit each year. So are your targets high enough? This is incidentally the same as I expect from 100% billable heads – is their day rate high enough?
Over time your LTV and CAC may change or be different by product or customer cohort. So, once you have your data, you can break it down. It will start to tell you where you might want to invest and where you can divert resources from one thing to another.
It’s time to get real on how much you really need to spend on both marketing and sales. Tempting though it is to cut back in tough times, is this a good idea? I admit some of my clients have. But the ones who are pushing their sales and marketing are seeing good results in a market where their efforts stand out as there’s less noise. Make sure you’re clear on what you want to achieve and the investment you need to make to get there.