Marketing can be an incredible source of growth for your business, and you know you should probably be doing more than you are. You’ve already done your research, so you know that digital ads, social media, direct mail, and email campaigns are all valuable tools that are available to you.
And now you’re ready to start creating a marketing strategy, but there’s a problem. You don’t know how much you should budget. How are you supposed to create a marketing plan without knowing how much you can spend?
It’s a crucial crossroads. Too many times, businesses rush into marketing without first running the numbers, and it often ends up becoming an enormous drain on their bottom line. Fortunately, you have the common sense to search for the information you need before throwing your money away on an ill-planned marketing strategy. I’m glad you found this article.
So, how do you determine the right amount of money to spend on your marketing?
There are three primary calculations you need to make before deciding how much to allocate for your marketing budget:
- Customer Lifetime Value (LTV)
- Customer Acquisition Cost (CAC)
- Customer Profitability (CP)
These calculations are your greatest assets in determining the right amount of resources you should designate for your marketing strategy. You must take the time to check these numbers and verify the cost-effectiveness of your allocated budget. If not, you might fail to turn a profit from your marketing efforts.
At Scout, many of our first-time clients have never made these calculations and come to us with no idea how much they need to spend. That’s fine with us. We are experts at determining the appropriate budget for any ad campaign. After all, we succeed when our clients succeed, so it’s in our best interest to be knowledgeable.
In this article, I’ll share that knowledge with you. We’ll take a deep dive into customer lifetime value, the cost to acquire a customer and customer profitability. We’ll discuss what these calculations are and how they impact your budget.
And, oh yes, let’s not forget the math. I’ll also show you the methods to calculate the figures, and how you can apply the numbers to your company’s needs and goals. Be sure to grab a calculator. The math isn’t hard. But if you’re like me, it’s best to let the computers do the number crunching.
Before we get started, let me offer this disclaimer:
In no way is this article intended to be a comprehensive guide to how you should set your marketing budget. Instead, we will explore only three contributing factors. Please be sure to examine every aspect of your business before spending any money on your marketing. Also, be aware that the formulas and mathematics shown in this article are extremely limited in detail and intentionally simplified for readability. The math required for your business will likely be much more complicated.
One more thing, be aware that customer lifetime value has several abbreviations. In this article, you’ll see it written as LTV because that’s my personal preference. However, in other places, you may find it as CLV, CLTV, or LCV. Don’t be confused. They all mean the same thing. It’s only important that you understand the meaning of lifetime value and its impact on your business.
With that said, let’s get to it.
What is Customer Lifetime Value?
Simply stated, customer lifetime value is a prediction of the total revenue contributed by an average customer throughout their relationship with a company.
That’s quite a mouthful. Let me say it a different way.
The LTV calculation shows you the total amount of money you can expect to earn from your average customer.
For example, let’s pretend that you run a coffee shop. If you know that your average customer spends $100 per year in your store, and you also know that this person will most likely continue to get their coffee from you for an average of 2 years, then you can use these numbers to calculate your LTV. It only requires a little multiplication.
We’ll get deeper into the math a little later. But first…
What is Customer Acquisition Cost?
This isn’t a hard one. It’s exactly what it sounds like: The customer acquisition cost (CAC) is the predicted amount of resources required to convert a potential lead into a customer. If you have any expenses related to sales and marketing (and you probably do), then each new customer costs you money. It’s essential to know exactly how much you are spending on each one.
If you spend $100 on a one-month social media ad campaign for your coffee shop, and you gain ten new customers during that month, your CAC is $10. Make sense?
This metric is great for determining profitability. If lifetime value represents revenue, then customer acquisition cost is a representation of expense. All you need to do is keep your expenses lower than your revenue. That’s Business 101.
Keep in mind CAC is unrelated to your operating costs and the expenses necessary to maintain your current customer base. This value only represents the amount required to gain a new customer.
So how do you account for your operating expenses? All it takes is one more calculation known as customer profitability.
What is customer profitability?
It’s just another way to examine the relationship between your profits and losses. Customer profitability (CP) is the difference between the revenue and expenses associated with a customer over a specified amount of time. It’s the threshold you must cross before you can start earning a profit.
We’ve likely all heard the saying, “It takes money to make money.” Well, by determining your customer profitability, you can find out exactly how much money you’ll need to spend on each customer before you begin earning a return.
To make this calculation, you’ll need to add the total amount of all your costs together. This amount includes all goods purchased, service employee salaries, lease and utility expenses, and anything else you can think of. Add this all together and divide it by the total number of customers you have. The figure you arrive at is your CP.
Why are these values important?
The LTV is a prediction of revenue. If you know how much your customers are spending for your products and services, then you can assign a value to each customer. This is enormously helpful when making any plans for the future because it allows you to estimate how much revenue you’ll receive in the year(s) to come.
Likewise, the CAC is a prediction of cost and also allows you to assign a correlating value to each customer. Ultimately, your marketing budget will become a part of this calculation. I know that sounds strange considering the subject of this article, but it’s not the only contributing factor. Lots of additional data gets taken into account, as well. Your CAC goes a long way toward discovering how much you can afford to budget for marketing.
And lastly, CP is a representation of the relationship between your costs and profits. It’s a powerful metric that allows you to know the minimum value necessary for each customer, and it’s this value that helps in the final calculation you’ll make to determine your budget.
Armed with these figures, you can determine precisely how much each customer is worth to your company. I realize this sounds a little harsh because obviously, your customers are worth more than just their monetary value. But the fact remains that the numbers do matter. This information is invaluable for helping you determine how much you can spend on your marketing.
Let me explain a little further.
If you don’t know how much your customers are spending on you (LTV), then you won’t know how much you should spend on them (CAC). And with all your costs added together, make sure you are not paying more than your customers are (CP).
I realize how obvious that might sound, but it’s worth mentioning. Various sources may tell you that your marketing budget should be anywhere between 6%-12% of your revenue (depending on your business characteristics). And there is plenty of statistical evidence to support those numbers.
However, the problem with these types of “rules” is that they are far from sufficient on an individual level. They’re too broad. You need to get as precise as possible with your unique situation. Calculating the LTV, CAC, and CP is an excellent way for you to do exactly that.
How do you calculate LTV?
Before you can find your LTV, you’ll need to make a few other calculations. Yes, it requires a little bit of math, but it’s not hard. And, I promise it will be worth it in the end.
Here are the step by step instructions you need to follow to determine your customer lifetime value.
Step 1: Calculate the average purchase value.
What is the dollar amount of an average purchase by a customer? To determine this, divide the total revenue received over a period of time by the number of purchases made during that same time period. It’s generally best to span the scope of your analysis over an entire year because this will provide you with the most accurate results.
Step 2: Calculate the average purchase frequency rate.
You need to know how many purchases were made by repeat customers. To find this amount, divide the total number of purchases by the number of unique individual customers who made those purchases.
Step 3: Calculate the customer value.
How much is your average customer spending throughout one year? To calculate this, multiply the average purchase value (Step 1) by the average purchase frequency (Step 2).
Step 4: Calculate the average customer lifespan.
You’ll need to review your records carefully for this one. Find the total number of years each customer continues to purchase from your company. Add them together and divide that sum by the total number of customers. This is your customer lifespan.
Step 5: Calculate the customer lifetime value.
Now all that’s left is to multiply your customer value (Step 3) by the customer lifespan (Step 4). That’s it. Now you know your customer LTV.
Let’s head back to your coffee shop to put these steps into action.
By reviewing the accounting documentation, you determine that your shop brought in $100,000 in revenue last year from 20,000 purchases. This gives you an average purchase value of $5.00.
Then you take a look at your records to find that these 20,000 purchases were made by 1,000 different individuals. Now you can divide these numbers to calculate that your purchase frequency rate is 20 (Step 2).
Now, you need to multiply your purchase value (Step 1) by your frequency rate (Step 2) to find your customer value.
At this point, it’s important not to get ahead of yourself. There are still two more steps to go. This $100 amount is your customer value – not your lifetime customer value. You’re not quite done yet.
Continuing on, you refer to your records again, and you find that all 1,000 of your customers continue to shop at your coffee shop for an average of 2 years. How’s that for convenient math?
All that’s left is to multiply your customer value (Step 3) with your customer lifespan (Step 4) to determine that your customer LTV.
Got it? See, I told you it wasn’t so bad! Now, let’s move on to the cost to acquire a customer.
How do you calculate CAC?
This process is much more straightforward than LTV. Merely add up the total amount of resources spent on sales and marketing during a given year and divide that sum by the number of new customers acquired during that same time year.
Don’t let the easy math fool you. Determining your CAC requires a thorough examination of your expense records. It is vital that you are careful in determining related marketing and sales costs.
You need the grand total of every penny spent on the efforts you’ve made to grow your business — literally everything. If you leave off a dollar here or a dollar there, it will skew your data and produce inaccurate results. And what good will those do you?
Here are some examples of Sales and Marketing expenses you should consider:
- Employee salaries (including commissions)
- Travel expenses for field reps
- Ad spend
- Content creation and publishing
- Management time
- Technology and software investments
What other costs would you add to your list? Once again, every company and industry is different. So be sure to scrutinize your situation to make sure you get your numbers exactly right.
To drive home the point, we’ll continue with our coffee shop example.
Let’s say that last year you ran a direct mail campaign and monthly social media ads for an annual total of $5,000 of ad spend. Since you don’t have sales and marketing staff, we’ll assume that $5,000 is the total amount you paid in your attempt to attract new customers.
Next, you review your purchase records and determine that you gained 100 new customers last year.
All that’s left is to divide the $5,000 you spent by the 100 new customers you gained to find that your CAC is $50.
So, with an LTV of $200 and a CAC of $50, things are looking pretty good. Your coffee shop stands to make a $150 profit per customer. Right?
There’s one more calculation you need to make: Customer profitability.
How do you calculate CP?
There are different ways you can solve for this metric, but I’m going to keep it simple. Right now, it’s more important that you understand the broad idea. I’ll let you explore the math variations on your own.
Essentially, all you need to do is take your total costs of goods for the year and add it to your overall operating expenses. Then divide that value by the number of unique customers who purchased from you during that same year.
For example, your coffee shop spends $50,000 per year in goods that you receive from your vendors, and you spend another $30,000 per year in operations costs like lease payments, utility bills, and employee salaries. This brings your total costs to $80,000 per year.
Next, divide your $80,000 in costs by the 1,000 customers who purchased from you, and that dividend is your customer profitability.
This means that it costs your business $80 to provide goods and services for each customer. Let me say that a different way, you need to bring in more than $80 in revenue per customer in order to become profitable.
Is that amount good or bad? It all depends on your situation. Take a look at your numbers and determine what you consider to be an appropriate customer profitability.
However, I will say this; what matters most is the relationship between your customer profitability and the other calculations. Think about it, if your CP is higher than your LTV, your company is in serious trouble.
So, now you know what LTV, CAC, and CP are and how to calculate them. But the question remains: How can you leverage these three equations to help decide what your marketing budget should be?
Let’s put it all together.
But first, we need to review the figures from your fictional coffee shop:
- Your customer’s lifetime value is $200.
- Your customer acquisition cost is $50.
- And your customer profitability is $80.
Your average customer brings in $200 in revenue, and it costs you $50 to acquire each customer.
And since your CP is $80, that means you make a $70 profit for each customer.
In reality, you’ll need to take a salary for yourself in order to keep a roof over your head and food on the table. But everyone’s circumstance is unique, and I can’t account for the multitude of variables in this single article. So, for the sake of simplicity, we’ll assume that all $70 is available for you to invest in your business.
Let me be clear; you should not spend all of your profit on marketing. You must save money when possible in order to prepare for the unexpected expenses that are sure to arise. There will always be new equipment to buy and repairs needed. And if your company grows, you’ll need the resources to help scale your business. Always spend wisely.
So, after allocating the profits to where they need to be, you decide that you have $10 per customer left that you can spend on your marketing. Since you have a total of 1,000 customers, your maximum marketing budget is $10,000.
That’s it. That’s how you determine how much your company should spend on advertising. Pretty simple, huh?
Please remember that these steps and formulas are highly simplified. When it comes time to determine your budget, make sure you explore these ideas further and gather all your relevant data together before doing the math.
If you have any questions at all, Scout is here to help. As I mentioned at the beginning of this article, we’ve assisted many companies in determining appropriate budgets that fit their needs while also achieving their desired marketing goals.