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Discover how to calculate which of your marketing strategies are most profitable
This article is for small business entrepreneurs who don’t have a marketing background and want to build a solid understanding of the economics of marketing.
That means: how to use marketing to grow your sales profitably.
You may be a solopreneur doing your own marketing or you may run an established business and employ an agency to execute your marketing for you. Either way, you need to decide which approaches will generate leads that will convert into customers in the most cost-effective way.
The problem is you’re not sure how to measure the success of your campaigns. If you spent £1,000 on Google ads, what would a good result look like? If you spent £1,000 on organic social media marketing, how would you understand whether or not your campaign was profitable?
You’ve probably heard of metrics like customer acquisition cost, conversion rates and the like. But you’re not completely sure what they mean and you may be frustrated by marketing industry jargon. Most of all you’d just like to know how you can use these metrics to increase your profits.
This article is not about specific marketing techniques. I’m not going to explain how to create a more compelling Google ad or a more engaging Instagram post. Instead I’m going to explain the building blocks that drive the profitability of any marketing initiative and how you can apply them in your business.
Put another way, I’m going to show you how to work out which strategies bring you the most profitable customers.
The building blocks are:
By breaking the process of winning a sale into its main parts you’ll be able to calculate which steps of your marketing strategy are cost effective and which aren’t. You’ll also be able to pinpoint the areas where you’re underperforming the norms in your industry and so could improve your performance.
Once you’ve mastered these concepts, you can use them to refine your marketing approach:
If something is profitable, you’ll be able to do more of it.
If something isn’t working, you’ll be able to change it so it performs better.
If you can’t improve it you can stop doing it and switch to a different approach with confidence.
In a nutshell, I want you to have a great mental toolkit for analysing the economics of any marketing strategy.
Lead acquisition cost: How much you spend to generate new leads
Your first step in making a sale to a new customer is to attract new sales leads. The first thing you need to measure is how much you spend to acquire those new leads. This is usually called your lead acquisition cost.
The type of costs you incur to acquire leads will vary according to the industry you’re in. Some businesses still acquire their leads through traditional analogue channels such as industry events, in person networking or PR. But these days many small businesses acquire their leads through digital channels.
Digital channels typically bring new sales leads to a landing page on your website or other platform you’re using to sell (e.g. Amazon). A share of those new leads will convert into paying customers, either immediately or in the following days or weeks.
A benefit of digital marketing is that it’s easier to quantify the results of your spending. This applies whether you’re using organic channels (e.g. Google search) or paid ones (e.g. Google Ads, social media ads, Amazon ads).
To calculate your cost per lead, you should use the following formula:
Average cost per lead = spending on attracting leads in the period/ number of new sales leads generated in the period
You should include in your lead generation costs your expenses for any paid ads as well as any spending on your website that relates to SEO (e.g. include the cost of new content creation but exclude hosting and other fees).
You may have heard of the term ‘cost per click’ (CPC). That’s the cost you pay for each lead you gain from a paid ad. If paid ads are your only lead generation tool then your lead acquisition cost will be the same as your CPC.
You need to pick a time period over which to measure your cost per lead. The best period depends on your business but monthly can be a good interval to choose.
We’ll see later how measuring your lead acquisition cost will help you understand whether your marketing approach is profitable or if it’s a cost you could reduce.
Lead conversion rate: How good are you at turning leads into customers?
Your second step in winning a new customer is to nurture the new leads that have entered the top of your marketing funnel. How you do that will vary according to the type of business you run. In most cases you should provide leads with value, build their trust, showcase your expertise and persuade them to like your brand. If you’re successful, some of them will over time convert into customers.
The second key metric that determines the profitability of your marketing strategy is the rate at which you convert leads into customers — your lead conversion rate.
Here’s how to calculate it:
Lead conversion rate = 100 x number of new sales leads that convert into new customers in the period/ number of new sales leads in the period
You should be able to track your number of new sales leads and new customers with the help of data from your CRM and other software tools you may be using such as Google Analytics, social media analytics and so on.
Measuring your lead conversion rate will feed into your analysis of the overall cost effectiveness of your marketing approach.
Customer acquisition cost: Your all-in cost to win a first sale
Customer acquisition cost is the total amount of money you spend, on average, to win a new customer (i.e. to persuade someone to buy from you for the first time).
Here’s how to calculate the metric:
Customer acquisition cost = Total spending on acquiring new customers in the period/ total new customers acquired in the period
Customer acquisition costs include all the money you spend on marketing and sales activities for the purpose of winning new customers. You should exclude your costs for servicing your existing customers, promoting repeat buying and so on.
Customer acquisition costs include all the costs for lead generation that we’ve already discussed. However you’ll probably also spend some money on trying to convert those leads into customers using techniques like e-mail marketing or — if you’re a B2B seller — direct 1-1 phone calls or meetings. You need to include those costs as well.
Knowing your average customer acquisition cost is crucial. You’re going to need to use it to analyse whether or not your overall marketing strategy is profitable by comparing it with the value of the customers you win.
Customer lifetime value: The payback for your successful marketing
The final step in analysing the profitability of your marketing is to compare your customer acquisition cost with the value of the new customers you’re winning.
The simplest and most conservative figure for the value of a new customer is the profit you make on a first sale (before deducting your cost to acquire the customer). If the profit on that first sale is more than the cost to acquire the customer, your marketing has been immediately profitable.
For many companies the cost of acquiring new customers is larger than the profit they make on a first sale. In plain English, their first sale to new customers is loss making.
That’s not the end of the story though. A loss-making first sale isn’t the same thing as a loss-making new customer. To work out whether or not acquiring new customers will really prove profitable we need to consider lifetime customer value.
Lifetime customer value is the sum of the profits you make from a customer over the whole period in which they keep buying from you.
Lifetime customer value is an important concept because a new customer will hopefully buy from you more than once. And repeat sales from existing customers are more profitable than sales to new customers because they tend to require little or no extra marketing expenditure.
Here are the key components you need to estimate lifetime customer value:
Assumed length of the customer relationship — how long you expect they will carry on buying from you.
Customer purchasing frequency — how often you assume they will buy from you over that period.
Average transaction value — how much you assume they will spend each time they buy.
Assumed profit margin on each sale.
If you’re an established small business you should find it quite easy to estimate lifetime customer value. You can just gather the data on how your existing customers behave and assume your future new customers will behave in the same way. Unless there’s a good reason not to take this approach, that would be a sensible way forward.
If you’re a startup or a very young business and you’ve gathered limited customer data so far then you’ll need to make some assumptions to fill in the gaps.
As a general rule, don’t assume customers will stay with you for a very long time even if you’re well established and you’ve found other customers to be more sticky. It’s better to err on the side of caution and not take anything for granted. Overall, it depends on your business but a few years would be sensible as a maximum assumption.
A worked example makes the calculations clear
Here’s a worked example of how to calculate customer acquisition cost and lifetime customer value. This should illustrate how the maths works and how you can use the analysis in this article to investigate your performance and pinpoint the areas where you can improve.
A B2C brand uses Google Ads to generate sales leads and then uses e-mail marketing to nurture those leads and convert them into customers. In a month the seller spends £300 on ads and £50 on e-mail marketing. As a result the brand wins 10 new customers in the month.
The brand’s total customer acquisition cost is therefore £35 (being £350 / 10).
The brand wants to come up with new ideas for making its marketing more effective. By breaking down its marketing data from the past month the seller finds the following:
The £300 of ad spend brought 100 new sales leads to its landing page — a lead acquisition cost of £3.
Of those 100 new leads, 10 made a purchase — a lead conversion rate of 10%.
This enables the brand to calculate that its total customer acquisition cost of £35 comprises £30 for lead generation using Google Ads (being £300 / 10) and £5 for lead conversion using e-mail marketing (being £50 / 10).
To find opportunities to improve its performance the brand decides to focus mainly on its lead generation cost and its lead conversion ratio. The lead conversion cost of £5 per customer is too small to make a big difference.
Armed with this information, the brand does some market research. It finds that average lead acquisition cost in its industry is £3, so it’s performing exactly in line with its peers on that metric. On the other hand it finds that the average lead conversion rate for its product category is usually 15%. This suggests that its website landing page is doing a poor job.
The brand redesigns its landing page to sharpen its focus on the needs of its target customer and more effectively show how its product USP solves the customer’s problem. It also reorganises the page so that the visitor’s eye is drawn to the call to action, which it now displays more prominently.
The following month the company again spends £300 on ads and £50 on e-mail marketing. The ads bring another 100 new leads, for an average lead generation cost of £3. This time though its lead conversion rate improves from 10% to the industry norm of 15% through its win of 15 new customers.
Thanks to the improved lead conversion rate, it’s customer acquisition cost has fallen from £35 to only £23.33 (being £350 / 15).
The brand now compares its improved customer acquisition cost with its customer value.
First, the brand calculates its profit or loss on a first sale. It has already checked and found that its average transaction value is £40 with an average profit margin of 30%, i.e. £12 per sale. That’s well below its customer acquisition cost of £23.33 so its first sales are clearly loss-making.
The brand then estimates its average lifetime customer value. The brand assumes its customers will stay with it for two years, while hoping they will stay longer in practice. It doesn’t yet have good data on purchasing frequency but it thinks twice per year would be reasonable.
From this it can estimate that its marketing approach should be clearly positive in the longer term. Its lifetime customer value comes to £48, based on four sales and an average profit per sale of £12. That more than offsets its customer acquisition cost of £23.33.
Conclusion: Customer profitability analysis helps you choose the most profitable marketing strategies
Key ratio analysis is a crucial part of running any aspect of a small business successfully and marketing is no exception.
This article has hopefully given you a useful introduction to the economics of marketing and shown you how to use concepts like customer acquisition cost and lifetime customer value. That should help you identify which strategies will bring you profitable customers and which won’t.
If you’d like to dig deeper into the marketing performance metrics you can track to evaluate how well you’re executing individual marketing approaches, try reading our article on on marketing performance metrics.
If you’d like to zoom out and read more about building or refining a marketing strategy, here’s a link to our complete guide to designing a marketing strategy for your small business.