Why Customer Acquisition Cost (CAC) is the new rent

A few weeks ago Inc. Magazine wrote a fascinating article whose argument could be summed up in one phrase: Customer Acquisition Cost (CAC) is the new rent [1]. For those not reading tech reports for the past two-years, customer acquisition costs represent the cost of acquiring a repeat customer whether through Google AdWords (search advertising), social feeds (Facebook advertising), or even a marketplace such as Amazon or eBay (sellers’ commission). The crucial point is this concept can also be applied to the physical realm: CAC is a useful tool to compare online digital businesses to businesses which exist primarily in the physical world. I suspect these economic concepts can be extended beyond merely explaining the broad disruption of physical retail but also provide a framework for predicting what business configurations might flourish in the future.

Three ideas inform this discussion:
1. “There are only two ways to make money in business: bundling and unbundling” — Jim Barksdale, Netscape
2. Modularizing marketing: Customer acquisition cost is the new rent
3. The New Bundle: Only the paranoid survive - Andy Grove

Bundling and unbundling

I previously wrote Why Modularized Distribution Changes Everything which explored the eroding market-power of established consumer brands due to new technology distribution platforms in favor of direct-to-consumer (DTC) companies. In hindsight that explanation might only be partially true: rather, what used to be scale effects in customer acquisition and distribution became unit-variable costs opening the playing field to smaller upstarts. For instance, with Amazon Logistics sellers pay-per-package shipped; for online marketing, sellers pay-per-click.

In our simple retail example a physical store is a bundled product of: customer acquisition (customer walk-ins) + distribution (product on the shelves). Advertising also helped but the effectiveness of marketing spend was always unclear. Rent is the cost of maintaining the store-front from which new repeat customers are acquired (CAC). If total gross margin each month exceeds the largely fixed costs of rent and labor, the store is profitable. The total cost of maintaining the store + stocking the shelves represents the bundled cost of: customer acquisition + product distribution. There are some exceptions: mail order catalogues separated customer acquisition (mailings) from product distribution (parcels), but by and large this has been the dominant business paradigm for the last century.


Pricing power was derived from combining a scarce, constrained resource (real estate / distribution / shelf space) with an abundant resource (product) to create a non-commoditized offering. These bundled relationships can be depicted graphically below:


Modularizing marketing: CAC is the new rent

The death of physical retail is well-understood but the underlying mechanics are less obvious. At its core, technology and software changed largely fixed-costs into variable-costs thus unbundling customer acquisition from distribution and diminishing the power of incumbents. For a new direct-to-consumer brand like Warby Parker eyeglasses, acquiring the customer (search, social, Instagram, advertising) is a separate activity from distributing the product (3rd-party parcel logistics). Warby Parker also has a few retail stores but these might be viewed through the same CAC lens: with enough foot traffic a retail store in a dense city like New York might provide a lower cost of customer acquisition than comparable online advertising.

In Andy Grove’s book Only the Paranoid Survive he writes about how this “unbundling” occurred in the personal computer industry in the early-1980’s: vertically-integrated mainframe suppliers (IBM, DEC, Sperry Univac, Wang) were unbundled by unit-variable cost PC component manufacturers (Intel, Motorola, WDD, Micron). The winners of this age were those who created “new” bundles: for instance, Dell’s created a bundle of commoditized PC components + low-cost mail-order customer acquisition. The scarce resource was acquiring new customers cost-effectively, not transforming hardware components into personal computers.


Today Google Adwords has modularized online customer acquisition (CAC) away from fixed-cost TV advertisements or real estate storefronts. Likewise, Amazon Logistics and UPS / Fedex have modularized the fixed distribution costs of a national supply chain away from major retailers who operate their own supply chains at scale.

The problem for most established companies is their entire business model is configured around bundling two high-cost activities (physical customer acquisition + distribution) in a world where there are now a plethora of cheaper options. It stands to reason for this to equalize either store rents need to come down or online customer acquisition costs (cost-per-click) need to go up.


The New Bundle

In the analogy of 18th century post-office economies-of-scale favored high-cost, resource-constrained activities. In the 18th century it was the cost of physical mail delivery across a continent. In the 20th century it was the cost of specialized distribution (stores & supply chains). In the 21st century the costly challenge seems to be aggregating consumers across B2C platforms, such as Facebook, Google, Alibaba, Lazada and Uber. Venture Capitalists have spent billions of dollars building user-bases around these products. To monetize these costs more effectively these B2C platforms have continually introduced new products (Amazon books à music à electronics à consumer goods …) to sell new things to existing customers.

As Jim Barksdale said there are only two ways businesses make money: bundling and unbundling. Perhaps the dominant theme of today’s economic transition is the shift from the physical bundle of CAC + distribution to the digital bundle where both CAC / distribution are separate variable cost activities thus diminishing the advantages of entrenched incumbents. The fact that unit costs of distribution seem to continually decrease, as delivery density increases, only further reinforces these trends.

The generalization of “tech” names as something-dot-com muddies the point: in every industry we are seeing the re-alignment of bundles from one oriented around the physical environment to a bundle created for the digital environment. Fintech are financial services provided digitally: the product is the same, but the methods of customer acquisition and product distribution have changed. Spotify is a digital music distributor, the same way Tower Records was in the physical era. Unbundling and re-bundling simply provides an opportunity for incumbents to be disrupted.

Taken to its logical conclusion it is possible that this same trend of modularization of costs and improved technological coordination between suppliers might even present some challenges to Nobel laureate economist Richard Coase’s 1937 justification for the corporation itself, to coordinate non-standardized activities with high costs of coordination:

… firms are a response to the high cost of using markets. It is often cheaper to direct tasks by fiat than to negotiate and enforce separate contracts for every transaction. Such “exchange costs” are low in markets for standardised goods, wrote Coase. A well-defined task can easily be put out to the market, where a contractor is paid a fixed sum for doing it. The firm comes into its own when simple contracts of this kind will not suffice. Instead, an employee agrees to follow varied and changing instructions, up to agreed limits, for a fixed salary.
The Economist: “Coase’s theory of the firm”, Jul 27, 2017

Software now allows the seamless and almost costless standardization of many activities including advertising, customer acquisition and distribution – activities which were formerly managed within a single firm.

When I think about the world in terms of this analogy of unbundling and re-bundling I see some logic in past events. The disruption today in asset management is the result of un-bundling beta (cheap, abundant) with alpha (difficult to access) through exchange-traded funds, the true disruption of un-bundling product + distribution (RIA’s, wire-houses) has yet to come. Direct-to-consumer brands such as Harry’s Shaving Club and Bonobos are merely the result of unbundling formerly high-cost CAC and distribution (store rent on scarce real estate). Music label unbundling could come about as new upstarts unbundle high-cost Artist & Repertoire + marketing + distribution with ala-carte solutions relying on data, which seems to be the scarce resource in the digital age.


The investment solution in this era of disruption might instead be to look for the new bundles. While market valuations for B2C platforms may be extreme, narrow market breadth may reflect emergent realities on the ground: the new bundles in a digital era are more powerful than their physical counterparts which faced friction costs of the physical environment (boxes to move, stores to staff, regions to manage, and diminishing returns to scale). A recent report from McKinsey showed profit tools in TMT are both narrower and greater than many other industries perhaps reflecting the frictionless scaling of software [15]:


When probability distributions of business profitability change, valuation metrics may also need to change. If winner-take-all outcomes are characterized by power law distributions, are certain “value” metrics implicitly rooted in the assumption of normal distributions and businesses whose efficacy decreases as they scale geographically? It is not inconceivable that today’s market environment already reflects these new realities [12].

End Notes

[1] “How Wharton Launched Warby Parker--and Dozens of Other Companies Just Like It”, Tom Foster, Inc. Magazine, May 2018.
[2] “The Hyperfragmentation of Retail and Why the Biggest Winners are Digital Ad Platforms, not Microbrands”, Namrata Patel / Medium, Apr 30, 2018.
[3] “Solving the Flight Centre enigma”, FindTheMoat.com blog, Jul 18, 2016.
[4] “Fake it till you make it: meet the wolves of Instagram”, Symeon Brown, The Guardian, Apr 19, 2018.
[5] “Friar Tuck Financial Services: A Classic Unbundle/Re-bundle Strategy”, 25iq blog, Mar 31, 2018.
[6] “The Strange Brands in Your Instagram Feed”, Alexis C. Madrigal, The Atlantic, Jan 10, 2018.
[7] “Only the Paranoid Survive: How to Exploit the Crisis Points That Challenge Every Company”, Andrew S. Grove, 1996.
[8] “How to Succeed in Business by Bundling – and Unbundling”, Justin Fox, Harvard Business Review, Jun 24, 2014.
[9] “The Master Switch: The Rise and Fall of Information Empires”, Tim Wu, 2011.
[11] “How bundling benefits sellers and buyers”, cdixon blog, Jul 8, 2012.
[12] “Network Effects, Origin Stories, and the Evolution of Tech”, a16z Podcast with W. Brian Arthur, Marc Andreessen, and Sonal Chokshi, May 16, 2018.
[13] “Breaking Smart: Season One: How Software is Eating the World”, Venkatesh Rao, 2018.
[14] “New valuation metrics for tech companies, and Spotify”, Lyall Taylor, lt3000.blogspot.com, May 29, 2018.
[15] “How tech giants deliver outsized returns—and what it means for the rest of us”, McKinsey, Sept 2017.