Mastering the Economic Model: Understanding the Real Cost of Customer Acquisition

You might feel inclined to react to my title: Customers are a source of revenue, you should never think of the customer as a cost center.

For many early stage enterprise software companies, the cost of customer acquisition and service is a real, knotty problem that plague CFOs and investors alike.

Here are the reasons:

1. You typically have relatively few large customers whose pattern of usage and consumptions are so heterogeneous that there is no common way to understand the cost of service of each customer. Every single customer is an exception to the simple cost of customer acquisition and gross margin dependent economic and financial model that technology company typically build to manage their business.

Your economic model therefore has to make too many generalizing assumption about the cost and revenue of each customer, and is susceptible to unanticipated spikes in costs that you can not always plan for.

2. The cost is not always recordable/trackable. In many cases, the cost of acquiring or serving a customer is not really recordable. For example, if a company tries a mix of marketing initiatives from which it generates demand and ultimately clients, it is not always easy to carry out proper attribution to really understand the exact marketing cost associated with each of the clients.

3. The cost is not always easily quantifiable. The cost of serving a customer can be a missed opportunity to serve another customer that eventually leads to better product and better revenue. Below, I will highlight a few types of opportunity costs that are not easily calculable or even be estimated.

4. There are unquantifiable, non financial effects. Those effects nevertheless can negatively impact your company’s performance, growth, and ultimate success in the market.

Given the difficulty of doing so, we nevertheless should try our best to understand the cost of a customer and truly build it into the economic model. I want to start first with a checklist of costs that should be in a financial and economics models, and then identify those non-financial or non-quantifiable costs that you need to consider when thinking about your customer strategy.

Typical financial/economic costs incurred by acquiring and servicing the customer:

• Cost of goods sold: This should be straightforward enough to keep track of and calculate. Refer to our earlier blog post on COGS for a more detailed definition.
• Cost of sales: Would any sales manager be able to truly quantify the cost of managing a sales opportunity from the beginning to the very end? We can think of salespeople’s time, travel costs, software costs, sales engineers’ time, or costs of sales tools. But since the sales team’s time is not infinite, choosing to go after one deal but not the other is implicitly already incurring a cost, which as I mentioned above, may not be quantifiable but is very real
• Cost of marketing: We have already mentioned how hard it is to attribute the true cost of marketing to each customer
• Cost of customer support
• Implementation cost / professional services (that are not already considered COGS): this can be a major cost center for an enterprise software company. Even some SaaS companies require heavy upfront implementation work, such as integration with clients’ APIs or data interfaces, or customizing of software look and feel, or with other 3rd party providers. Check out our series of post on professional services costs accounting for more information on this.
• Account management

Some types of economic, non-financial costs that are often overlooked or not quantified

– Product roadmap “hijack”: A big customer tends to dominate the relationship with its vendor. Just like in the cautionary tale of Walmart suppliers, selling complex software to major clients are fraught with hold-up problems where the client applies economic and reputational pressure on the company to make it work like an outsourced development organization building a solution that is totally tailored just for the client’s need.

– Exclusivity cost: Some clients demand exclusivity so that a company cannot sell to its competitors, while others do not but because they have become your customer and their direct competitors are wary of buying from you as well.

– Management focus cost: Having major customers requires the whole management team to be actively selling and account managing constantly. This is definitely a major cause of distractions for the management team. Clearly, listening closely to the customer is important, but some clients seek far more than their share of attention. Interestingly, this is also an issue if you have a vast number of small, low value customers. Their feedback, inputs and requirements can also outweigh their share of the business, and will cause just as much distraction.

– Premature scaling cost: This is more or less the “failure” cost. In order to serve big, early customers, a company has to act bigger than it is. It has to scale up all of its functions and grow out of its current scale to serve the customers. However, building a scalable organization takes time and people, and scaling too quickly and prematurely can lead to major mistakes and painful redress.

– Opportunity cost: Given that a company’s capacity to add and serve customers is finite, sooner or later the company will need to make tradeoffs between potential segments, potential targets, and potential customers — one less customer you can support, one less opportunity. In a way, getting a customer means that the company lets go more of its own direction and priorities in the market.

Non-economic effects that will still impact your business

– Potential loss of top employee to customer: Some customers can lure away your star employees, especially those that work closely with them and have done great work for them. Given that they are typically big enterprises, they will have no problem offering a very attractive package for these employees.

-Having the wrong type of customer: This can cause your organization’s focus to drag, limit your ability to pivot when needed, and give you the wrong type of “revenue,” which can ultimately affect how the company values itself and its strategy.

photo by: Horia Varlan

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• Technically Speaking: Frequency/Severity Models or Loss Cost Models?