This article is a part of our series: Key SaaS Metrics
As a SaaS entrepreneur, there are countless numbers, statistics, and metrics that you need to track and calculate to assess the health of your business, but the sheer number of acronyms can be overwhelming. In this series on key SaaS metrics, we walk you through the most common—and helpful—metrics you need to know to successfully run and grow your SaaS business.
How can you evaluate the success or failure of your sales and marketing campaigns? Are they worth the money you’re putting into them? Or is the payback period so long that you should shift tactics? There’s only one way to know for sure, and that’s by figuring out how long it takes to effectively pay back your costs with the money earned from the new sales generated by your sales and marketing efforts.
The Customer Acquisition Cost (CAC) Ratio is a comparison of two factors: the total sales and marketing expenses associated with gaining a new customer, and the incremental increase in the gross margin associated with those new customers during a given period of time.
Depending on which number you use as the numerator and which you use as the denominator, the CAC Ratio will either tell you the percentage of your expenses that will be recovered during a particular time period (annualized incremental gross margin / expenses) or the time it will take to recover the expense associated with acquiring the new customers in the first place (expenses / annualized incremental gross margin).
As such, the CAC Ratio is an important tool for understanding how long it will take to recoup your sales and marketing investment. In fact, that’s why the calculation uses gross margin rather than total revenue, because what really matters is how much you actually earned from that customer after factoring out the cost of goods sold.
Here is the formula for calculating your CAC Ratio:
[Gross Margin Q2 – Gross MarginQ1] × 4 Sales and Marketing Expenses for period Q2 |
Notice the numerator is expressed as an annualized number. We do this for a couple of reasons. When analyzing a company, we often look at how the company is performing each year and therefore use the year as the period for comparison. Additionally, products sold by most SaaS companies tend to have annual contracts. Therefore, it makes sense for our metric to match this time period.
Let’s look at an example:
In August, SaaS Co., an online social networking platform for SaaS entrepreneurs, spent $1,000 on pay-per-click advertising, $3,000 for print advertisements, and $6,000 for one Sales Representative to reach out to the leads generated from the new marketing campaign. Through the outreach and marketing, SaaS Co. generated 100 new customers, all of which purchased annual subscriptions for $5/month. We also know that SaaS Co.’s product is fully developed and only costs $50/month for unlimited hosting. Here’s a breakdown of their key financials:
SaaS Co. | ||
Jul-15 | Aug-15 | |
Revenue | ||
Monthly Subscription | 23,500 | 24,000 |
Total Revenue | 23,500 | 24,000 |
COGS: Hosting | 50 | 50 |
Total COGS | 50 | 50 |
Gross Margin | 23,450 | 23,950 |
Sales and Marketing | ||
Pay Per Click | 1,000 | 1,000 |
Print Ads | 3,000 | 3,000 |
Sales Rep Salary | 6,000 | 6,000 |
Total Sales and Marketing | 10,000 | 10,000 |
From this, we can see that the business has an increase in the gross margin of $500, or $6,000 when annualized. We also know the total sales and marketing expenses were $10,000 for the month. Based on these numbers, we can calculate the following:
Annualized Incremental Gross Margin: $6,000 Total Sales and Marketing: $10,000 |
= |
60% CAC Ratio |
What does this mean? It means that the new customers acquired that month will recover 60% of the month’s Sales and Marketing efforts in one year. It can also be useful to flip the numerator and denominator to see a different result. Doing so yields the following:
Total Sales and Marketing: $10,000 Annualized Incremental Gross Income: $6,000 |
= |
1.67 Inverted CAC Ratio |
The inverted CAC Ratio tells us how many years—in this case, 1.67 years—it will take SaaS Co. to recover its initial investment in Sales and Marketing for August. At Lighter Capital, we use the inverted ratio most often because it gives us a faster way to review the amount of time it will take to recover a company’s investment in Sales and Marketing.
Note that in this example, we assumed that all new customers acquired in August were a direct result of Sales and Marketing efforts in August. However, most businesses have a lag time between the sales and marketing efforts and actual sales. Directly matching the revenue earned with respective Sales and Marketing spend can be challenging and time consuming, so simplifying it as shown above can serve as a helpful proxy.
To learn about other key SaaS metrics, check out previous posts in this series: