If you pay for a customer, but it is taking a little too long for their subscription revenue to exceed their cost of acquisition— you will often find yourself wondering whether they are even being beneficial towards your company’s growth.
It’s not the customer that’s giving you grief, it is the payback period. As growth experts would attest, the longer the payback period (which refers to the time it takes for the customer to pay back their cost of acquisition), the longer it would take for profitability to kick in. The inverse here also rings true—the shorter the payback period, the faster your company’s growth and profitability.
What led to the need to shorten payback periods
Companies previously thrived on the growth-at-any-cost approach—that is up until just a few years ago. The numbers looked good, and investors were quick to give companies high valuations based on that growth that they saw on paper. The bad news? It ultimately didn’t lead to profitability because customers were quick to churn. Because of this focus needed to be placed on profitability instead of growth. While that sounds good in theory, it became a bit of a pain in practice for growth teams.
These days, marketing and growth teams have to perform the same or more with smaller marketing budgets. As such, to get the most bang for their buck, they have to maximize each marketing channel’s performance. But investors want more than just profits alone. They want their investments to bring in the big money, pronto. Companies need to know when the ROAS and ROI kick in full throttle.
This is exactly why growth teams have been placed in the position to revamp their strategies, to facilitate shorter payback periods, all while also increasing profitability. At the very least, growth teams want to significantly improve the confidence in knowing what that period would be, for each of their campaigns.
Payback is more than just another metric
The payback period holds more value than what meets the eye. It has become an important metric for growth teams to optimize for—with the goal to have as short a payback period as possible. It is particularly critical because the faster the payback period, the less the need to raise money, and the more runway companies would have. The payback period determines the efficiency of your acquisition model, and let’s not forget that if you pay for a customer, you don’t benefit from the acquisition until the customer’s subscription net revenue exceeds their cost of acquisition. This is why growth teams need to be aware of exactly how they can calculate their payback period in-house, so they can take additional steps going forward as needed.
The simple ways to calculate payback period
In its most basic form, calculating the payback period calls for dividing the cost of acquiring a customer, by the revenue they generate over a period of time.
So based on this formula, if it costs $100 to acquire a customer, and their subscription is worth $10 per month—that means in 10 months they will have generated enough revenue to cover the cost of their acquisition: $100 / $10 per month = 10 months.
But there’s a little more context that needs to be factored here. For instance, what is it that your company is wanting to diagnose and improve? This is where variations in calculating the payback period come in—either with, or without the gross margin.
Calculating payback without the gross margin is the simplest way to go, because figuring out the exact gross margin of a campaign is just operatively tricky:
CAC Payback Time = CAC ÷ MRR
If you ask me, I’d say that the biggest benefit to adding a gross margin into the equation here is that while it does increase the payback period, it also shows a more realistic number in terms of the profitability of your company’s customer acquisition efforts.
The equation for calculating gross margin is: GM = (ARR – COGS) ÷ ARR
And the formula to calculate the CAC Payback Time = CAC ÷ (ARR*GM%)
So what’s the best payback period for different verticals? To be honest, the best payback period is the shortest payback period possible. Based on my work with many D2Cs, payback periods of two years were considered acceptable in the U.S. That later shifted down to one year, and now it is nine months. The cost of capital and rising interest rates play a big role in impacting payback periods.
Top ways to reduce your payback period
Without further ado, here are a few ways you can reduce the payback period for your DTC, with each having varying levels of ease.
- Reduce your customer acquisition costs: You can start off by reducing your customer acquisition costs. That can easily be done by reducing marketing and sales figures.
- Increase your average revenue per user: By increasing the average revenue per user, per month, it can significantly boost ARPU and contribute to quicker payback. And let’s not forget—improving the ARPU directly affects MRR and ARR.
- Reduce churn: Churn reduction is another way to reduce your payback period. This is because if you have a healthy number of customers who successfully cover their CAC payback and end up sticking around for an extended period, you will be able to maintain a positive revenue.
- Optimize for high LTV users: Now this is an approach which acts like a gift that keeps on giving, because of the range of business value that comes from optimizing for high LTV users. This includes the discovery of audience potential, identification of the highest value customers, the optimization of revenue forecasts, and so much more.
If you decide to turn to the assistance of a codeless predictive AI solution for greater efficiency, you will be able to use your LTV data to appeal to users who are more likely to stick around for the long run. You would also be able to use your LTV data to further optimize user acquisition campaigns, coupled with the payback you are looking for, and when you want it. By taking this approach, you would be targeting more customers that align with the persona of your most loyal base. In turn, you will increase your ROI, and shorten your CAC payback period.
Now is the time for your team to set things in motion internally, to shorten your payback period. This approach will give you an added edge now, but based on the state of the market, it will certainly become the industry standard very soon, and the only way to drive sustainable growth.
