How to Calculate the CAC:ARR Ratio

It’s critically important for a SaaS company to understand, calculate and manage customer acquisition costs (CAC) through each phase of its lifecycle. If its CAC is too high in relation to the customer lifetime value (CLTV) or compared to its peers, it won’t be long before the SaaS business is in financial trouble. Given this, it’s no surprise that many of the most important SaaS metrics involve or are derived by first calculating the CAC, including the CAC/ARR Ratio. 

 

CAC:ARR Ratio –  What is It?

 

The CAC/Annual Recurring Revenue (ARR) Ratio, also known as the Cost of ARR, examines the relationship between annualized new and expansion revenue against the sales and marketing expenses needed to acquire incremental revenue. Unlike CAC, which calculates the cost of acquiring net new customers, the CAC:ARR ratio focuses on the cost of acquiring annualized recurring revenue (ARR). It quantifies the CAC on a dollar basis rather than on a new customer basis.

 

Why is the CAC:ARR Ratio an Important SaaS Metric?

 

The cost of acquiring revenue is an important consideration for s SaaS businesses to measure and manage. Overspending on marketing and sales to acquire new clients and to increase revenue from existing customers can result in prolonged customer acquisition costs payback periods. Lengthy payback periods can tie up a significant amount of working capital, especially if customer churn rates are high, leading to inefficiencies that impact cash flow, profit margins, and Earning Before Interest Taxes Depreciation Amortization (EBITDA).

By ensuring an efficient CAC:ARR ratio, resources can be used to generate further ARR and not remain tied up in CAC yet to be recovered over an extended payback period.

 

How to Calculate the CAC Ratio

 

The CAC Ratio relies on two key inputs: new and expansion ARR, and the sales and marketing expenses to acquire the new incremental AR. 

The numerator includes fully burdened Sales and Marketing Expenses that may include, in part: salesperson wages, taxes, benefits, commissions, travel, and trade show expenses. In the denominator, we consider the New and Expansion ARR. If ARR can’t be determined or the customer’s subscription is renewed once per month, you can alternatively calculate ARR by taking the Monthly Recurring Revenue (MRR) and multiplying it by 12. 

 

CAC:ARR Ratio Calculation Example #1

 

Suppose the fully burdened Sales and Marketing Expenses are $750,000, and the New and Expansion Annual Recurring Revenue (ARR) for the same period is $1,500,000. In this case, the CAC:ARR Ratio would be:

$750,000/$1,500,000 = 0.50

This tells us that it took $0.50 in Marketing and Sales expenses to generate $1.0 in New and Expansion ARR. Put another way, it will take six months to generate enough recurring revenue to recover the Sales and Marketing Costs and 12 months to double the Sales and Marketing Costs. It’s important to note this is similar to the CAC Payback Period; however, the CAC Payback Period would multiply the ARR by the gross margin to derive the profit generated rather than revenue.

 

CAC:ARR Ratio Calculation Example #2

 

Assuming the fully burdened Sales and Marketing Expenses amount to $1,250,000 with a corresponding New and Expansion Annual Recurring Revenue (ARR) of $1,500,000, the resulting CAC:ARR Ratio would be as follows:

$1,250,000/$1,500,000 = 0.83

This indicates that it required $0.83 in Marketing and Sales expenses to generate $1.0 in New and Expansion ARR. In other words, it will take nearly ten months to recover the Sales and Marketing Costs through recurring revenue and nearly 20 months to recover double the Sales and Marketing Costs. 

If the gross margin is 75%, it will take over 13* months of ARR to recover the Marketing and Sales Expenses (($1,250,000 /($1,500,000 x .75 = $937,500)) = 1.11 x 12 = 13.33.

 

Time Period to Measure

 

In a perfect scenario, a SaaS business can easily determine what Sales and Marketing expenses were incurred during the sales cycle by acquiring each new customer and AAR. However, this is difficult as each new customer follows their own path to subscribing and contributing to ARR. Given this, A SaaS business can use its average sales cycle to better understand the Sales and Marketing Expenses required to generate incremental AAR.

For example, suppose it takes on average six months from when a prospective lead enters the sales cycle before becoming a subscription customer. In that case, you can use the sum of these lagging Marketing and Sales expenses when calculating the CAC:ARR Ratio. 

 

Summary

 

It’s critical for SaaS businesses to understand and measure how much it costs them to acquire incremental revenue and how long it will take them to recover these costs. If it takes too long to recover these expenses, the SaaS business is inefficiently acquiring new customers and new revenue. With low customer acquisition efficiency, the SaaS business is more susceptible to the negative impacts of customer churn, which is compounded if the customer churns prior to the payback period.

 

Here are three more articles related to customer acquisition:

Calculating Your Acquisition Costs
The CLTV/CAC Ratio
Calculating the CAC Payback Period

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