Freedom Mathematics: Lifetime Customer Value & Cost of Customer Acquisition

February 12, 2016.TomM.0 Likes.1 Comment

When you first start trying to wrap your head around how you might derive an online income that will free you from a job and give you location independence, the whole thing seems very amorphous. It seems like some sort of dark magic, and breaking it down to formulae and guidelines can feel like an impenetrable task. That’s certainly how it was for me at the beginning.

This is in large part due to the fact that many of the books and much of the content on the web about “lifestyle business” or location independent income are very vague – deliberately so.

They are happy to pump up the dream – usually in the interests of selling you a course – but when it comes to the details of how it all actually works, specifics are scarce. (A total lack of specifics before asking for a purchase, by the way, is a hallmark of an Internet scam).

The simple reality is that your ability to create a successful location independent business – or any business, in fact – comes down to a handful of key numbers.

If you understand these numbers – what they mean, how to alter them – you’ll be able to engineer yourself an income.

If you don’t, you will constantly struggle and fail to even understand WHY you’re failing.

There are two numbers I want to focus on today: customer lifetime value, and customer acquisition cost. These two numbers are absolutely crucial to making any venture profitable.

Breaking Down the Cost of Customer Acquisition: How Much It Costs to Buy a Sale

If you’ve read Four Hour Work Week, you probably remember Tim’s breakdown of working out the profit on your product, then reverse engineering from that how much you can afford to spend on advertising.

Here’s a quick refresher:

Let’s say you sell an ebook for $20. The ebook is digital, so the cost of producing and shipping a unit is zero. So for the sake of simplicity, let’s call every sale a $20 profit.

If your goal is to make $4000 per month from your ebook, you need to sell 200 copies per month to hit your goal ($20 x 200) – assuming all your traffic is free.

That’s possible, but you’ll need to put a lot of time and effort into building a website that generates a lot of free traffic, and at the end of the day time does have a value – it’s not really ‘free’. (When first starting out, price your time according to the amount of money you could earn at the best paying extra part-time job you could get).

The more likely scenario is that you’ll need to advertise, and Tim recommends doing this via Google Adwords. You can also do Pay Per Click advertising through Facebook, LinkedIn and other sites like Reddit.

So now you have a cost involved.

The Cost of a Sale

Let’s say you’re paying 25 cents per click for traffic. Every $1 you spend gets you 4 visitors.

If you spend $100, you get 400 visitors. Not bad.

Problem is, if only 1 out of 100 of those visitors buys your ebook, you’re losing money. You’re paying $25 to get a $20 sale.

The percentage of visitors who buy is called your conversion rate. In this case, the conversion rate is 1%.

Now, in this scenario you’d have a few options to become profitable:

  • Boost your conversion rate
  • Get cheaper traffic
  • Raise your price and hope sales volume stays high enough to become profitable

In other words, you’d need to a) reduce the cost of acquiring a customer, or b) raise the amount of money you’re making from each sale.

If you’re still paying 25 cents per click but you manage to double your conversion rate to 2%, you’re now only paying $12.50 to sell your $20 ebook. Suddenly, you’re profitable, making $7.50 per sale.

To get from there to $4000/month, you would have to be able to buy enough sales at $12.50 to hit that target.

4000 / 7.50 = 533.33333

In other words, you need 534 ebook sales per month to hit your target.

You can further work out how much traffic you’re going to need to buy from these numbers.

If you’re only converting at 2%, you need 50 x 534 in order to get enough sales. In other words, 26,700 visitors per month.

Now, this is far from the ideal situation. You’re spending a total of $6675 per month on advertising to generate $10680, for a little over $4000 in profit. You’re making money, but you’re definitely not at optimum efficiency.

The smart move at this point would be to focus on further increasing your conversion rate. If you can go from 2% to 4%, suddenly you’re only spending half as much to acquire the same number of sales – a $3337.50 ad spend for $10680 in sales. It now costs only $6.25 to acquire each customer, and you make $13.75 profit per sale. In this case, you’re now making $7342.50 in profit each month.

If you only wanted your $4000/month here, you’d only have to generate 291 sales and spend $1818.75 in the process, for a total of $5820 in sales.

(Bear in mind as your volume increases, your profitability will tend to decrease as you use less and less targeted, ideal traffic sources. This is why it’s easier to have a high conversion rate and low customer acquisition costs when you have a highly targeted, small niche market product.)

The Secret Sauce: Customer Lifetime Value

Now, here’s the important part of the equation that Mr Ferriss left out of his book:

Very few online businesses actually make much money from the first purchase a new customer makes.

MOST of the profit is made AFTER the first purchase – when satisfied customers buy more products from the same company.

Understanding this can be completely game changing, because it means you don’t even have to make a profit on that first $20 ebook.

Let’s pretend again you’re paying $25 to sell each copy of your $20 ebook. On the surface, you’re losing $5 on every sale.

But, what if you have a high value, $200 advanced video course on the back end that you ONLY sell to people who have bought your ebook?

Let’s assume again that the video course is 100% digital, so that $200 is completely profit.

Let’s pretend one out of every 20 buyers of your ebook then buys your video course (a 5% conversion rate from your pool of ebook buyers).

Here is the breakdown:

  • 20 customers acquired at $25 each paying for your $20 ebook = $500 spent, $400 in, you’re -$100 at this point
  • 1 of those 20 then buys your $200 advanced course. -$100 + $200 = you’re now $100 up

Now granted, those aren’t great numbers to be working with and ideally you want to be making money from the first product as well, but the point is: it’s not just about that first sale.

Selling to Existing Customers Vs Selling to New Customers

The bulk of your money in any business is made from selling MORE to your EXISTING CUSTOMERS, not by acquiring a ton of new customers. It’s always easier and cheaper to sell something more profitable to someone who has already bought from you and had a good experience.

So it goes like this:

Understand the lifetime value of every customer you acquire. This is the long run value over YEARS.

Let’s say, when you average it out, that the average lifetime customer value is $300.

Remember, this is AVERAGE. Most people may only buy your $20 ebook. But a small percentage will buy your advanced course, your personalized coaching program, and every other thing you put out. Some customers may spend only $20 with you, others may spend $5000. Let’s say the average across them all is $300.

Do you see why this is powerful to understand?

Now you don’t just have to acquire customers for under $20 to make a profit.

You can pay $150 per customer just to sell that first $20 ebook, and still make $150 profit per customer on average over the long run (as long as you have the cash reserves to get you through to recouping the initial cost of acquiring the customer – this is where another number, knowing the average time it takes for the average customer to give you back $150, becomes important).

Suddenly, you can pay a lot more per click for advertising. Suddenly, you can jump way above your competitors. Suddenly, much more VOLUME is available to you so you can scale up a lot more. Suddenly, new traffic streams which were previously unprofitable become profitable.

All because you know your cost of customer acquisition, and you understand that it’s about customer lifetime value, not just that first sale.


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Comments (1)

  • Silviya Dineva . June 1, 2016 . Reply

    I would also add AOV and repeat purchase rate, especially as CLV depends on their performance as well. Great article.

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