Dear Jeff,

My partner and I disagree our sales and marketing expenses. He thinks we spend too much and are wasting money. I think we need more revenue and the only way to generate it is to land more customers. How do we figure out who is right?

--Name withheld by request

You both could be right. In large part the answer depends on the efficiency of your sales and marketing spending, so let's work through some simple calculations. (Much of the following comes from the free e-book 6 Business Metrics Every CEO and CMO Needs to Care About provided by Denamico, a HubSpot Certified Inbound Marketing Agency. And if you're unfamiliar with inbound marketing here's a quick primer.)

Let's start with a simple metric. Customer Acquisition Cost (CAC) is used to determine the average cost of acquiring a new customer.

Determining your CAC is easy. Add up all your sales and marketing costs for a specific period and then divide by the number of new customers landed during that period.

Spend $100, acquire 10 customers, your CAC is $10.

What's a good number? That depends on your industry and business model. It's also important to understand how CAC fits into your overall operating budget. The leaner your operation the more you can afford to spend to acquire a customer.

Plus the higher the Lifetime Customer Value (LTV) the more you can afford to spend.

Why? Unless your transactions are truly one-off, some percentage of customers will turn into repeat customers. The more repeat customers you have, and the more those customers spend, the higher CAC you can afford. (Some business models are built on breaking even or even losing money on the customer's first purchase under the assumption that future purchases will be profitable since the CAC for those transactions are at or near zero.)

LTV is often tricky to calculate and does involve making a few assumptions, especially if you're a startup. But once you've built a little history you can start to spot customer retention and spending trends. Then the math gets a lot easier: determine what the average customer spends over a specific time period and calculate the return on your original CAC investment. Sense-check that against your profit and loss statement.

Roughly speaking, the greater the LTV, the higher CAC you can afford.

Why do these two metrics matter so much? A rising CAC means you'll need to start cutting costs or raising prices--or do a better job in marketing and sales. A falling LTV indicates the same measures are necessary... and means you're failing to leverage the most important and least expensive customers you have: current customers.

Now let's go one step farther. If yours is a subscription business--meaning you charge monthly or annual fees--then the time it takes to pay back your CAC is incredibly important. Subscription models are great, but they also space out revenue over long periods of time. (Once your business is rolling that's great: you get predictable, consistent revenue streams. But in the beginning when cash is tight...)

A basic rule of thumb is that the payback period on CAC should be under twelve months. But that's just a guide: depending on the working capital and cash flow generated from other areas of your business you might need that period to be much shorter... or if your customer retention rate is incredibly low (here's how to calculate that) and you have deep pockets you might be able to afford a longer payback period.

Where CAC payback time is concerned, make sure you do the math and know what's right for your specific circumstances.

So which of you is right? It depends. If your time to pay back CAC is short and cash flow isn't a huge issue you can probably afford to spend more. If your LTV is high and cash flow isn't an issue you can probably afford to spend more.

But that doesn't mean your marketing and advertising expenses are as efficient as they can be. The old line, "Half of our advertising dollars are wasted... we just don't know which half," is often sadly true.

The key is to track your CAC over time, test different approaches, measure the results... and rinse and repeat.

But never forget that it's often impossible to save your way to profitability, and sometimes making cuts--especially in marketing and sales--makes it even harder.

Sometimes Randolph Duke is right: the answer is to get back in there at once and, "Sell, sell!"

More financial and performance measurement articles:

Published on: Feb 6, 2015
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