Allowable Up-front Recruiting
Expense

Allowable Up-Front Recruiting Expense – How Much Can Be Spent Today To Acquire Customers Given Specific Financial Requirements And Other Business Constraints?

Small/mid-size business ownership and management often need a guide to size immediate marketing expenditures properly. These companies often lack the tools to make this kind of decision in a consistent and comparable way when different options are being presented.

How much a company spends to acquire a customer is defined by, among other things, the industry the company is in, and the company’s margins. However, there are certain factors that should be considered in all cases when evaluating this kind of expenditure.

This business case study, based on actual experience, puts forth a simple general method (a “backpack tool”, if you will) for small/mid-size business ownership and management to consistently determine the “allowable” amount of a marketing expenditure today to achieve a specific return expressed in present values.

Background

A small/mid-size company’s marketing leadership is preparing its semi-annual customer acquisition campaign which is designed to acquire customers from January through May (the Cohort Year = Time 0). The company wants to acquire 100 new customers. The question is this: What should the allowable fixed expenditure budget be today for the acquisition of 100 new incremental customers including the amount invested in the Cohort Year in promotional Marginal Profit? The company wants to achieve a 20% return today on the fixed investment it makes today (after the promotional rate of margin) to acquire 100 new customers.

Evaluation / Analysis

To answer this question and achieve the required rate of return the following factors need to be isolated:

What are the average new customer sales in the Cohort Year (Time 0) and in the following three years’ Time 1 through Time 3? Said another way, how do a new customer’s sales increase over time?
What is the company’s Net Promotional Rate of Marginal Profit – the net marginal profit incurred to acquire 100 new customers in the Cohort Year – Time 0?
What is the incremental Customer Retention Expense (Sales Promotion Expense) annually on average per a new customer acquired in a given Cohort Year?
What is the Attrition Rate of the group of new customers acquired at a given point in time from the date of acquisition through the end of the third year?
What is the incremental cost to the company to sustain increases in Capital Employed from the incremental sales generated from the new accounts (generally, opportunity cost/ financing cost)?
What is the Present Value Rate?

Cohort Year Sales & Beyond

For this business case the assumption is that customer sales in the first year reliably average $10,000 (normally a company should have good information on its Cohort Year sales). Because the $10,000 represents, on average, partial annual sales because of the timing of the customer acquisition process in the Cohort Year (discussed above), Year 1 sales are considerably greater due to things like full year effect, price increases, impact of sales promotion initiatives and greater sales from remaining new loyal customers. For this business case the assumption is that in Year 1 Cohort Year sales will grow 10% from the full year effect, 4% from price increases, 5% from sales promotion initiatives and 5% from the remaining new customer effect – a growth rate of 24% in total. In Year 2 and Year 3 sales will grow 14% over the prior year assuming the growth factors will be the same as in Year 1 in both of these years excluding the full year effect because, of course, that can only happen in Year 1.

Net Promotional Rate/Dollars Of Marginal Profit In Cohort Year

In the business case in this website section entitled, “Make Good Decisions About Spending Money on Marketing”, the topics of Incremental and Switched sales and different rates of Marginal Profit are discussed. Please refer to that business case to learn how normal course Marginal Profit and the Net Promotional Rate of Marginal Profit are calculated.

For the purpose of this business case the assumption is that the Net Promotional Rate of Marginal Profit is 5% in the Cohort Year. In Years 1 – 3 the Rate of Marginal Profit is assumed to be 36% (i.e the full “normal course” rate of Marginal Profit).

Sales Promotion Expense

In general, a company will have a budget from year to year to retain its customers and increase sales from its customers. Budgets vary by industry and the types of products being sold. For this business case the assumption is that the company will spend $2,500 annually per customer for Sales Promotion initiatives in Years 1 – 3.

Attrition Rate

The Attrition Rate or the fall-off rate of new customers after the first year of acquisition is a rate that will vary by industry and the product lines a company is selling. In a business that is influenced by fashion trends the Attrition Rate can vary significantly. This kind of company may be on target with its fashion offering in the Cohort Year but miss market fashion targets in subsequent years. In this case the Attrition Rate would escalate significantly in Year 1. In a company that is manufacturing deep system machine parts that do not change much from year to year the Attrition Rate of new customers would be much slower from year to year (especially if the company owns patents on the parts it manufactures and those parts are not available from other manufacturers).

Even small and mid-size companies should have some reliable history on attrition rates that are common for them given their industry and the products they are selling. A good generic Attrition Rate rule of thumb for the purpose of this analysis is 40% annually. That means that in Year 1, 40% of the new customers acquired in the Cohort Year will not make a purchase past Year 1 and conversely only 60% of the customers acquired in the Cohort Year will make a purchase or purchases in Year 1 and so on through Year 3.

“Cost Of Capital” Expense Associated With Capital Employed

This factor is harder to understand and generally requires a “rule of thumb” from the Finance organization in the company. The origins of this cost come from the mechanics of the company’s Balance Sheet and the correlation of increases in Capital Employed to increases in sales.

Generally, an increase in sales requires an investment from the company in the form of Capital Employed to support that sale. For example, assume a company needs to buy $1,000 more of inventory to support some level of incremental sales. Also assume because of the company’s terms with the vendor, that the company needs to pay a 20% deposit or $200 to buy the inventory and the vendor terms allow the company to pay for the rest of the inventory – $800 – in 30 days. This means that over a 30 day cycle and in perpetuity (until the incremental sales finally no longer occur) the company has employed $200 of capital to support the increase in sales ($1,000 – $800 = $200).

For this business case a further assumption is that increases in Capital Employed to support incremental sales is measured at a rate of 3% of incremental sales.

Beyond the above “3%” assumption it is possible there could be a Cost of Capital assumption attached to the incremental dollar value of Capital Employed. A discussion about this topic is beyond the scope of this business case but to hold a place for the concept, in this business case, the assumption is that the Cost of Capital associated with the incremental Capital Employed is 5%.

Present Value Rate

The rate of Present Value is the factor that equates the value of a dollar received in the future with the value of a dollar received today. Eight percent (8%) is considered an appropriate factor for this kind of analysis. This factor is 8% in Year 1 and compounded by 8% in Year 2 and Year 3.

Solution

After the factors discussed above are isolated the following analysis can be prepared:

Time	Present Value Solution	Year 0 (Time 0)	Year 1 (Time 1)	Year 2 (Time 2)	Year 3 (Time 3)
Number of New Customers		100	60	36	22
Sales Per Customer ($)		10,000	12,400	14,136	16,115
Total Sales ($)		1,000,000	744,000	508,897	354,530
Net Promotional & Normal Course Rate of Marginal Profit (%)		5.0	36.0	36.0	36.0
Marginal Profit $’s		50,000	267,840	183,203	127,631
Sales Promotion Expense ($)			150,000	90,000	55,000
Cost of Capital On Incremental Capital Employed ($) (a)		1,500	1,116	763	532
Year Profit ($)		48,500	116,724	92,440	72,099
Present Value Factor			1.08	1.17	1.26
Present Value Year Profit ($)		48,500	108,078	79,009	57,221
Present Value Project Profit (Sum of All Values of Year Profit) ($)	292,808
Allowable Up Front Recruiting Expense ($)	244,006

(a) (Total Sales x 0.03) x .05

In summary, in this business case, given all of the factors and constraints impacting this decision, the company can spend $244,000 today in addition to the cost of the promotional rate of marginal profit and all other incremental expenses to acquire 100 new customers. This equates to $2,440 per new customer. Of course, any change in any of the factors can have a significant impact on the project economics. However, with this system there is a rational game plan and a good estimate for how to measure and evaluate the economics of a customer acquisition project.

It is important to note that the company must have $244,000 of cash to invest in Time 0 and this expense is fully expensed in the company’s P+L during the short-term customer acquisition interval. The short-term optics of this expenditure might not always be favorable or desired in the company’s profit plan for a number of reasons. Additionally, it is possible that other company initiatives may be competing for marketing dollars.

Ownership and management will always evaluate the comprehensive business situation regarding where to spend money to maximize business growth and investment returns. In most cases, the profitable acquisition of new customers is a priority and always part of the conversation.

Implementation/Conclusion

The method discussed in this business case is a reliable way to evaluate the financial potential to be generated by new customer acquisition initiatives and ultimately to make good decisions about spending marketing dollars. The company’s marketing leadership should be asked to challenge their customer acquisition assumptions in the context of this financial tool and present this analysis when putting forth a proposal for customer acquisition dollars. Additionally, the company’s financial leadership should be asked to determine certain factors relevant to the accuracy of the analysis.

Before marketing spend proposals are put forth for approval both Marketing and Finance need to agree on the factors discussed in this business case.

This business case is an example for illustrative purposes only. FEOD is not responsible for company results or other actual results that could occur as a result of using the methods and observations discussed in this business case example.

Other Case Studies

Make Good Decisions About
Spending Money On Marketing
Campaigns & Promotions

Analyzing/Planning the P&L Using Marginal Profit

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Allowable Up-front Recruiting
Expense