Chapter 10:

Working out your costs

Before we start working out our costs per acquisition, click calculations and formulas, let's take a moment and think of business basics. The purpose of a company is to create a return on investment on every euro we spend. If we invest 1 euro, we should expect to make more than that in return. If we don't, it's really bad business. Following that train of thought, it's quite obvious that the cost per acquisition has to be lower than the value of the acquisition.

The purpose of a company is to create a return on investment on every euro we spend.
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All businesses have some kind of new business funnel either by direct advertising or being found by potential customers. This audience is your total reach. If so you should have some idea of the percentage of those deals you can win. This is your acquisition ratio. Your CPA is the value of acquisition multiplied by the acquisition ratio. Also, since you will not convert 100% of your prospects, your CPC must be your CPA multiplied with your conversion ratio.

Let's take a simple business to business services example. If your average customer is worth 1000 euros per year and you're able to win 1 out of 10 proposal requests sent, your cost per acquisition is your value (€1000) times by your ratio (10%). This results in a maximum CPA of €100. If your cost per acquisition is higher than this you are losing money. Let's say that you are able to convert 5% of the people who clicked your advertising to send a proposal request, your cost per click would be your CPA (€100) multiplied by your ratio (5%) to a CPC of €5.00 total.

This is the simplified version of working out your CPA. It assumes that the client value includes some profit. If it doesn't, then you'll have to keep on reading. It is crucial to understand the importance of understanding acquisition costs. You would not believe how many hardened professionals do not pay any attention to this, even though it should be the only number you care about. So, how do you work CPA and CPC into your objectives?

Working CPA and CPC into your objectives #

Richard runs a company selling software online. Richard had a marketing budget of €150K last year and a revenue of €2.5M with a 10% profit margin.

So what is the maximum he can pay for a customer? As Richard made a profit of 10% last year from his customers when he spent 6% of his revenue on marketing. It means that overall if he can spend €150K (6% of his revenue) on driving new customers to his website he should retain his current profitability levels while gaining more customers. Indeed if his staff do a good job he should increase profits longer term as he retains his old customers.

Richard knows his average customer is worth €1000 per year so to retain a profitable level he just needs to spend 6% of €1000 or €60. He will spend €60 to make a profit of about €100 per customer. This means his CPA is set at a maximum of €60 to remain at his current profit levels and double the amount of customers next year.

As he wants to increase his profit he sets himself a target of €50 CPA meaning his profit per customer acquired from his marketing might rise to €110.

Now he has decided on €50 CPA he can work out his CPC accordingly. If he has a 10% conversion rate he can have a €5 CPC but if his conversion rate is 1% then his maximum CPC is €0.50. As his conversion to sale was 2% he sets his top level CPC at €1.

What if you're not making a profit? #

Basically what you should determine is what it would take to make a profit and therefore what your top cost level can be.

Let's say Richard made a loss last year of 10% instead of a 10% profit. He only had 2000 customers paying him 1000 a year on average instead of 2500.

Everything now gets harder because he has to reduce his costs. His CPA could still be the same provided all the costs were reduced at the same level. Richard would just have less to spend to acquire new customers. However the reality is that Richard is running out of cash. So he only has €25K to spend on marketing this year.

His objective this year is to increase the amount of customers to be profitable (make up €500K) and this means we're talking about a much more challenging situation. With €25K he would need to bring in 500 new customers and retain all of his old ones. His churn last year was 20% meaning he lost 500 customers so Richard thinks he needs 1000 new customers this year to become profitable. That means he has a more simple but much more difficult target.

25000/1000 is €25. So his maximum CPA is €25 and no longer €60. His CPC again then depends on his conversion rate. Assuming his conversion rate was only 1% (as he had a bad year) then his maximum CPC is €0.25 (€25x1%). This means his job should focus on improving conversion to get the most out of his limited budget.

It's not about the ROI, it's about finding out the maximum your company can afford.
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Remember at this point it's not about figuring out what the ROI should be it's about finding out what's the maximum your company can afford to spend. That's all.

What if you're a start up? #

If you have no "last years figures" you have to start somewhere. Again you should know the answer you want first in terms of cost. If Richard was just starting his business he might be wise to err on the side of caution.

He knows his go to market strategy is gonna be a critical success or failure factor. He is hoping in his first year for 100 customers to pay him about €1000 a year each. That would be a good return on his initial investment (€50K), allow him to start paying a couple of employees a low salary, learn what his customers are looking for, develop his product and apply for a second round of seed funds to kick off his companies growth.

As he is a start-up he has hardly any cash to spare and he is faced with the tough reality that his product requires people learn how to use it. He decides to use 25% of his start up cash to market a free version of the software in the hope he can get 10% of them to buy it.

That means he needs 1000 free customers. His max CPA for one of those free customers is therefore 12500 (25% of 50K)/1000 = €1.25. Erring on the side of caution as this is the first year he has run this he assumes the conversion rate of his ads to be 1%.

It means his CPC is max 1.25x1% which is 1.25 cents. He is going to have to focus on improving his conversion rate and getting a lot of earned traffic because there is no bought media where you can get 1.25 cents a click. It's gonna be tough, but then who thinks starting a new business is supposed to be simple? If this isn't feasible then Richard has decisions to make, does he up his conversion rate? Lower his targets and slow his growth? Or does he spend more?

Why this is important #

It's the most important question you will have to ask yourself. Until you've done a benchmark you probably won't know the answer however you should know the answer you want first in terms of cost.

If you can't calculate your CPA, you're bound to fail.
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The answer you want and the answer you get are usually different. Everyone wants a cost that is low and a high return on their investment. However what you should do is set out your cost top limit which gives you an answer on what the maximum you can spend is. This should be worked out based on the profit margin of your company, product or service.

You need to understand what the maximum you can pay for a customer is and then the maximum you can pay for a click based on what you hope your conversion rate will be or as we say what your average conversion rate should be based on your benchmarks.

If you can't at least estimate this then think a bit harder because you haven't spent enough time sharpening your business idea.

If you liked this chapter, please recommend it to others.

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About the authors

We have a single goal together, to make our customers a billion euros in profit. This won't happen in one year, it might take five years, but we will not stop until we have generated a billion of provable profit for our customers.

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