Looking for some information on return on ad spend benchmarks? We’ll discuss the key factors to help you figure out what your goals should be, and what your competitors are doing. For most businesses, there really is an optimal return on ad spend level that will result in profit maximization. Let’s explore!
What Is Return on Ad Spend (ROAS)?
ROAS is a simple ratio, defined as the conversion value divided by the ad costs. So if you spend $1 and get $5 in sales, the ROAS is 5X or 500%.
It’s important to note that this ratio is absolutely not a traditional financial measure of returns. If you spend $1 and get $5 back, that’s really a 400% return, not a 500% return. But in the PPC space, all of the ad platforms use ROAS in one form or another.
How Auctions Affect ROAS
All of the major ad platforms sell you ad impressions in some form of auction. In order to get your ad shown, you must outbid other advertisers vying for the same ad impression. This matters, because if you want to scale up to more impressions, you must spend more money on each additional ad impression. Similarly, if you drop your spending, you will let go of some of the ad impressions you are currently getting–but only the most expensive of them.
Because we buy ad impressions in auctions, this means that every marginal click costs more than the last. So as we scale accounts to higher volume, returns drop. If we cut back on volume, returns increase.
Of course, we can do all sorts of things to optimize and improve accounts to increase returns over the long haul. But for short-term decision making, remember this key fact. There is a direct tradeoff between volume and returns. If volume goes up, average return on ad spend will go down. If volume goes down, average return on ad spend will go up.
The Best Return on Ad Spend
Microeconomics gives us the answer to what an ideal ROAS level is, if we want to maximize our profitability. We want to keep spending, and get more volume, so long as we are getting some additional marginal profit on each sale. When the increasing ad costs reduce that marginal profit to zero, we should hold right at that level.
In simple terms, this optimal ROAS level is going to be roughly 2 divided by your product margins. So if you have 33% margins, your ideal ROAS to maximize profit is going to be around 6X or 600%.
Why is this the best return on ad spend? It is the approximate point where increasing your budget would result in unprofitable additional sales. But it is also the point where decreasing your budget would let go of sales that are driving some profit. If your ROAS moves in either direction, the profit flowing to your bottom line will decrease.
When the Rule of Thumb Is Wrong
It’s important to know that such a simple rule of thumb for calculating an ideal return on ad spend target is a vast oversimplification. Many other factors may play into the correct decision for your business.
If you want to be a bit more conservative, then nudge your targets up a bit, or tolerate a range, like 6X to 7X. The calculation should also really be done on your variable costs of sales, not simply your product gross profit margins. If you eat shipping and payment processing costs, you may want to factor these in, for example.
But the opposite is also true. You might want to nudge down your goals from the level this rule of thumb gives. Perhaps new customers from ad clicks tend to become repeat purchasers? You might want to target a lower ROAS since the true returns are not captured in the initial conversion. What if you know that your conversion tracking is missing some actual sales? In situations like this, you might nudge your ROAS targets down or target a slightly lower range like 5X to 6X.
Industry ROAS Benchmarks
There are natural selection effects in play that dramatically impact you. Your competitors are probably buying from the same suppliers. Or they have similar manufacturing costs. And you are all competing against each other for the same ad clicks. This drives competitors towards seeking very similar ROAS goals.
If a firm sets ROAS targets too far outside the optimal range, it becomes starved for profit. Firms that set their ROAS more optimally thrive and grow over time. Most importantly, those firms survive.
If you are a mature business in an industry with a healthy level of competition, those businesses that have survived have all arrived at similar ROAS targets for their advertising, based on the typical margins in the industry. Even if they don’t know why those return on ad spend levels are optimal, everyone will be clustered around them.
What this means is that if you know what typical gross margins and variable costs of sales are in an industry, you know what the return on ad spend benchmarks are for that industry.
How to Set a Good Return on Ad Spend Target
So what is a good return on ad spend? Remember the simple formula of two divided by your margins. That is the starting point. Nudge it up a bit depending on the other factors specific to your situation.
Above all, don’t make the mistake of thinking that a higher ROAS is better than a lower ROAS. This is one of the most common mistakes in reasoning that marketers make. There is an optimal ROAS. But it is not a number where higher means better. If you set your ROAS targets dramatically higher, you will have higher profit margins on fewer sales. But you will be leaving money on the table from sales that would have been profitable. Total profits will go down.
If you are trying to generate the most profits possible from your paid advertising, you really don’t have much control over how much you should spend. Your profit margins and your competitors set the boundaries for you, at least in the short run.
The good news is you can increase your profitability immediately by making shifts to a good return on ad spend level if you are currently too high or too low.
If you would like to work with an ecommerce advertising agency that understand what it takes to achieve profitable growth, consider getting in touch with us.