We believe there is an optimal return on ad spend (ROAS) for advertising profitability. But before we talk about that, let’s make some things clear. ROAS isn’t the same as ROI (see How Digital Marketers Misunderstand ROI). ROAS numbers themselves are not at all correlated with profit. And the complexity of your business will dictate the complexity of the calculations needed to find the sweet spot.
ROAS Numbers Are Distinct From Actual Profit
It is the basic nature of ad auctions that every additional click you buy in a given time period will cost more than the clicks you already bought. That means as you scale up and increase ad spend, your return on ad spend decreases. ROAS and spending levels have an inverse correlation.
As we increase the ad spend from point A toward point B, the ROAS drops because marginal costs increase to get that additional scale. But that’s not to say your profit is decreasing. The total profitability is still going up as long as the increasing ad cost isn’t eating all of the product margin.
Point C on the graph reflects the budget level where the benefit of increasing sales volume is completely counteracted by the increase in ad cost of getting those additional sales. Of course, the real world is messier than this graph. But theoretically, there’s a point where the ROAS is a perfect balance between the rising costs and the amount of profit you gain from an additional sale. Any less ad spend and you’re losing the profit from those sales. Any more, and you’re in the zone where marginal costs outweigh the profit of those sales and you lose money on every additional sale.
Finding the Sweet Spot
So how do you calculate for that sweet spot? The rule of thumb is that point C is somewhere around 2 divided by your gross profit margin.
If you have 2/3 cost on a product sale, that’s 33% gross profit margin. 2 divided by .33 is roughly 6. So, your optimal ROAS for maximizing profits with 33% profit margins would be roughly in that neighborhood. Maybe higher or lower — it’s just a ballpark. But there are other considerations to take into account.
You may have higher variable costs than you think. Have you factored in free shipping costs, processing costs, etc? All those things contribute to the overall cost of the sale. So, it’s not just 2/GPM in a general sense, but 2/GPM plus all the variable costs related to the sale.
You could also have lower conversion values than you think. In some situations, there are multiple platforms claiming credit for a sale. Say, you’re advertising on both Meta and on Google and the same person clicks on your ad on both platforms before making a purchase. Each platform may claim credit for the sale in the conversion value they report. So, your revenue may actually be lower than the total you arrive at when combining reported results from all the ad platforms.
There are other sneaky costs you may not be taking into account, if you want truly accurate numbers. Even if you’re not outsourcing your ad management, you’re probably paying an employee to manage it for you, and that’s an advertising cost as well.
Other Factors & Exceptions to the Rule of Thumb
Now let’s talk about a completely different consideration. Sometimes there are reasons to set a lower ROAS target. In particular, a business with a subscription aspect (say, a supplement company selling monthly resupplies on a product) or products with consumable parts (filters that need regular replacement, printer ink, etc). Or even when there is a high likelihood that a first-time customer will become a regular, on-going purchaser once they’ve had a good experience with their first purchase. In this case, it’s worth considering the lifetime value of the customer rather than limiting your view to the immediate conversion value of a single sale.
Other factors can affect your perception of ad revenue.
An increasing issue we’ve seen is the underreporting of conversion tracking. The amount of conversion data reported by these systems can be wrong, without any way to identify the margin of error. For example, your real revenue per ad as seen by human eyes might be higher than reported because ad blockers keep some of your ads from being seen, even though the ad platform counts the ad as displayed.
Or what about this scenario? Say your product requires a human to close the sale, so it doesn’t happen online after an ad is clicked. Or if you’re using a financing system where purchasers are redirected from your normal checkout to a different site for approval and never hit your normal conversion tracking. In situations like this, you may want to pursue a more aggressive ROAS target than what your conversion value would otherwise suggest.
Another time you may want to “overspend” for a period of time is when you’re starting a campaign. Investing more at the beginning allows you to gather data faster so you can train the machine learning algorithms that are controlling your campaigns to achieve more profit down the road.
Still a Good Place to Start
These are just a few examples of many possible exceptions to the 2/GPM rule of thumb. That’s why it’s so important to combine a comprehensive knowledge of your particular business and an understanding of the subtleties of the advertising platforms you’re using.
But if all this is new territory, the 2/GPM rule of thumb is a good place to begin a search for your business’s optimal ROAS for profitability.