Calculating and Optimizing Customer Acquisition Cost (CAC) for SaaS Businesses

Customer Acquisition Cost, or CAC, is the term used to define the total cost a business—or in this case, a SaaS business— is required to spend in order to acquire a new customer. This cost is usually financial in nature, although we can also calculate other resources (i.e. time) depending on your purpose in calculating CAC.

In this guide, we will discuss all the ins and outs of CAC for SaaS businesses: the definition, the key principles you’ll need to know, how to calculate CAC, and how to optimize it.

Although calculating and reducing CAC is important for just about any businesses, CAC is arguably even more important for a SaaS business. First, we will learn why.

 

Why Calculating CAC is Important for SaaS?

Most SaaS businesses today are using recurring revenue as their business model, especially the subscription-model. In this model, there are several factors to consider in relations to CAC:

  • Usually, in a subscription-based model, we are selling our product far below the usual value (i.e. selling a $1,000 software for $70/month). In most cases, this monthly value is even lower than your actual COGS. Meaning, you need to maintain cash-flow, hence lowering CAC is extremely important.
  • The actual purchase is not the end of your marketing efforts, and you will need to aim for a long-term relationship with each customer. Hence, we will need to consider customer lifetime value (LTV) and its relations to CAC.
  • CAC is usually one of, if not the most significant cost in a recurring-revenue model, especially for online businesses that are not selling physical products, including SaaS businesses. On the other hand, lowering your CAC too aggressively might cause a significant decrease in growth, creating the dilemma.

In a nutshell, if your CAC is too high, you won’t make any profit. On the other hand, if your CAC is too low, you might miss out on potential customers, revenue, and hence, growth.

So, in a SaaS business, finding the optimal amount of CAC is essential to maintain growth. Yet, how can we find this delicate balance? We will discuss it in the next section below.

 

The LTV/CAC Ratio

Especially in the SaaS environment, we can’t properly discuss CAC while neglecting LTV. Why? Because to really optimize our CAC, we will need to understand the “true” value each customer will bring, which will be calculated through LTV.

What is LTV? In its simplest term, Lifetime Value (LTV) is the amount of revenue generated by a single customer over the course of their relationship with your business. For example, if a customer subscribed for your software for 6 months before finally cancelling the subscription, and a 6-month subscription is worth $100, then this customer’s LTV is $100. For further understanding on calculating LTV for SaaS, you might want to check out this guide by ChartMogul (PDF).

Now, we have mentioned that in a SaaS business, we can’t discuss CAC properly without also discussing LTV. Why? Because the relation between CAC and LTV will determine the level of success of the SaaS business: if your CAC is sufficiently lower than your LTV, you are making profit. If you can’t recover CAC quickly enough according to your LTV— or worse, if your CAC is higher than your LTV— your business is failing.

So, what should we aim for when optimizing CAC and LTV? There are two things to focus on:

  • Your LTV should be at least 3 times higher than your CAC (A LTV to CAC ratio of 3). The higher, the better. Some of the best SaaS businesses have up to 8 LTV/CAC ratio.
  • You need to recover your CAC within a year. If you can recover your CAC in below 6 months, even better.

Achieving these two can be easier said than done, and it’s perfectly okay if you can achieve these in the early stages of your business. However, you should treat these as important goals, and aim to improve your efficiency. For the rest of this guide, we will learn how.

 

Calculating Your SaaS CAC

Before we can learn to lower our CAC, we must first understand our current state, which is calculating our current CAC. Depending on the complexity of your business/ product, this step can be really easy or really complicated.

First, however, we should reiterate the importance of understanding your CAC based on what we have discussed above:

 

1. Understanding your CAC helps to optimize your LTV/CAC ratio to at least 3

As we have discussed, increasing LTV to CAC ratio is essential for any SaaS business, and it can only be done by mainly two things:

  • Lowering your sales and marketing budget (lowering CAC)
  • Optimizing the output of your sales and marketing campaigns to increase LTV

We can’t lower CAC without first knowing our current number, and on the other hand, we might be spending too low and hence our current output is not optimized to maximize LTV.

 

2. CAC is an investment, so treat it like one

Since CAC is in essence, the cost of acquiring a customer, this simply means everytime you acquire a customer, you have lost money. CAC is an investment, and so the first thing to keep in mind is how to get this money back as soon as possible. The sooner you can recover your CAC, the healthier your SaaS business is. So, properly calculating your current CAC will help in achieving this goal.

 

3. Maximizing your SaaS business profit

In the end, the purpose of your SaaS business is to create a profit margin, not solely to generate more revenue. Obviously there are only two ways to achieve this: lowering your cost or increasing your price. The lower you can make your CAC, the better your chance at achieving a higher profit margin.

 

The Main Factors of Calculating SaaS CAC

When calculating CAC, there are three main factors to consider:

  • CAC is about calculating the cost of acquiring a new customer, and not about the cost of retaining an existing customer. Seems fairly simple, but it is surprisingly a common mistake made by many SaaS business. While customer retention is undoubtedly an important aspect of SaaS businesses’ profitability and growth, keep in mind that when calculating CAC, it’s not our main focus. Instead, CAC will focus on the acquisition aspect.
  • Sales and marketing expenses are the key elements of any CAC, which can further be divided into three: tools and infrastructure expenses, human resources costs, and other spendings. The more detailed you can calculate all of these costs, the better you can calculate CAC. Remember that your goal here is to optimize your CAC, and avoid hiding flaws and bad expenses. You are not approaching stakeholders and investors here, but you are calculating CAC for your business’s sake. Be honest and transparent.
  • Since it is quite common for SaaS businesses to adopt the freemium model. Keep in mind that you should only calculate the cost to acquire paying customers. You can still measure the cost to acquire a free registrant, which can be a good sales and marketing indicator. However, it should not be included in a CAC calculation.

 

Calculating CAC: The Simple Formula

The formula to calculate CAC is fairly simple, which is:

CAC=The total sales and marketing costs / Total number of acquired (paying) customers

So, the hard part is figuring out the total costs of sales and marketing expenses that contribute to acquiring a customer. As mentioned above, there are generally three key components here: human resources costs (the salaries of your sales and marketing employees), tools and infrastructure costs, and other expenses (advertising costs, cost to start a specific marketing campaign, and so on). The more detailed you can break down these costs, the more accurate your CAC calculation will be.

For example, if the total cost for sales and marketing is $50,000, and if within the same period you spent this money you acquire 1,000 paying customers, your CAC is $50. Meaning, if you aim to have an LTV/CAC ratio of 3, your LTV should be $150 or higher.

 

Reducing CAC, Optimizing Profit

CAC is a metric designed to evaluate the performance of your sales and marketing efforts, and the end goal is to maintain and maximize profitability. Above, we have mentioned that one of the keys to a successful SaaS business is a healthy LTV/CAC ratio: you need to spend—at most— one third of your customer’s LTV or less.

So, if you can reduce CAC, you can optimize your LTV/CAC ratio, and hence your profit. Here are four main ways you can do it:

 

1. Optimizing your pricing strategy

Above, we have mentioned how we need to treat CAC as an investment, and so the sooner we can recover CAC, the better. If we increase the price of our product, we can have the up-front cash to immediately recover some part of CAC. However, if our product is too expensive, it might hurt our conversion rate instead.

So, the key here is finding the right balance between price and value, a thing we know as value-based pricing. In a SaaS setting, we should especially aim to recover the CAC as soon as possible. We can implement pricing tactics like including mandatory training, installation and setup costs, cross-sell and up-sell, and so on.

 

2. Maximizing your sales funnel

The more effective and efficient your sales funnel is, the cheaper your CAC will be. Analyze the number of traffic that actually convert into actual prospects, and the number of prospects that convert into actual customers. You should effectively assign a marketing attribution model (link) to track the effectiveness metrics of your sales funnel.

Maximizing your sales funnel can require many trials and errors, but the key here is a proper understanding of your audience: the better you understand their behavior, need, and problems, the better you can capture them. You might want to check this guide by Brian Balfour on achieving growth through your sales funnel.

 

3. Optimizing sales and marketing spend

The biggest aspect of CAC, as we have discussed, is sales and marketing expenses. The better you can manage these costs, the better you can optimize your CAC.

Again, the best way here is to measure the effectiveness of your marketing channels by implementing attribution, so we can properly track the number of conversions of each channel, as well as the contribution to revenue.

With this, we can better plan our marketing and sales budget, and eliminate the ineffective ones.

 

4. Implementing inbound marketing

Inbound marketing, in essence, is regularly publishing relevant, valuable content pieces for your audience. The purpose is to attract prospects “inwards”, hence the name inbound marketing.

Inbound marketing is now the core of many SaaS businesses, as we can see many big players like HubSpot and MOZ are focusing on their inbound activities, building awareness and credibility in the process.

The key to a successful inbound marketing, again, is knowing your audience’s needs and delivering the relevant content to address this need. Don’t focus on selling your products through the content, but focus on delivering valuable.

Why is implementing inbound marketing important to reduce CAC? First, because it’s fairly low-cost compared to other marketing efforts. Second, it is very effective especially in generating leads.

You might want to check out our previous guide on inbound marketing to learn further about this. (link)

 

End Words

Understanding the CAC of your SaaS business, and especially its relations to lifetime value (LTV), is especially crucial in achieving profitability. If you can maintain a good LTV/CAC ratio above 3, you are virtually guaranteed to make profit.

It is also important to optimize how you can recover CAC as soon as possible, which is especially more important in the SaaS model where you are generally selling products well below their actual costs (through a subscription model). If you can optimize this, you can maintain a healthy cash-flow.

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