*This is the second part of a two part series. Access part one here.
In more than five years at AdVenture Media, I’ve had thousands of conversations about CPA and ROAS goals. However, I’ve only had a handful of conversations about profit and customer lifetime value. Nearly 30 percent of companies that I’ve worked with just don’t understand their own profit margins. This is either because they are a new company, or they don’t have the proper tools in place to track such information. We’ll label these companies Startups.
An additional 30 percent of companies I’ve worked with are businesses that care more about new customer acquisition and taking market share away from the competition. These companies might have the tools in place to calculate profit margins, but it’s sort of a non-factor. They have a long-term outlook and, in theory, care more about customer lifetime value (LTV). However, this data is hard to come by, and their customers often have large variances in behavior, so it is unhelpful to assign an average LTV. This goes back to the problem with averages that we discussed in Chapter 10, and I can both respect and appreciate this reality.
There is nothing wrong with this model. However, the key is to have clear, meaningful marketing goals that can be measured. There are times where a client in this category is volatile, and their goals change on a moment’s notice. They might be impacted by a sudden change in the market, new legislation, a competitor going out of business, an upcoming trade show—and the company wants to move fast to take advantage of this opportunity, but they don’t have the time or the ability to define their profit goals in such initiatives. We’ll refer to these companies as Opportunists. [LG1]
A third category of companies, roughly 20 percent of the ones I’ve encountered, specifically choose to not share profit margin info with agencies out of lack of trust or fear. Some withhold this information because they are insecure and fear that their agency will do something nefarious with their information. Others feel that their agency might use this information to make excuses about poor performance—simplified CPA/ROAS goals remove this from the equation. I am bewildered by the fact that these companies trust their agencies to spend their advertising budgets on their behalf but are afraid of sharing the basic data that allows the agency to assess whether or not these investments are generating profit.
I’d refer to these companies as Bad Clients and advise you to avoid working with these companies.
The remaining 20 percent are clients who have actual data about profit margins and are willing to collaborate with their agencies on what that data means. These numbers are never perfect but are often helpful. I refer to these clients as Partners. The feeling is typically mutual. When we have a true partnership with a client, there is shared interest, complete transparency, candor, and a foundation for optimal success.
When I refer to profit, I am referring to the net result, in dollars, as a result of our advertising efforts. I am not referring to a percentage, nor am I referring to the net result of all company activities. Your travel and entertainment expenses should not be factored into this calculation, as it should not impact the goals that you convey to your advertising agency.
Profit, and your goals, should be derived from taking the total value that you earn from advertising—current revenue plus the incremental revenue you expect to earn over a customer’s lifetime—and then subtracting the specific costs that you incur to acquire that customer. These variables include your actual advertising spend, your COGS, and the fees you pay your agency.
Most companies use COGS to estimate their profit margins. In this case, a 35 percent margin would indicate that for a product sold for $100, it costs the company $65 to produce that product.
Profit can be calculated as:
Profit = ((Revenue—COGS) + (Expected Incremental LTV – COGS)) – (Advertising Spend + Agency Fees)
Let’s assume that we’re an ecommerce company that has a 35 percent profit margin, 65 percent COGS. Additionally, our expected incremental LTV is 20 percent, meaning that 20 percent of customers come back and purchase again.
We plan to spend $100K in advertising and have agreed to pay our agency an additional 12 percent of ad spend. After the month is over, their efforts resulted in $1M in revenue, a 10x ROAS.
We’d calculate our profit to be:
Profit = (($1M – 65 percent) + ($200K – 65 percent)) — ($100K + $12K) = $308,000
As we are happy with these results? Should we assume that a 10K ROAS is a reasonable goal to set henceforth? No! The 10x ROAS was a variable of profit, but it was not the determining factor of profit itself.
Here’s a second example where the agency spent an additional $20K in advertising, averaging a 10 percent lower ROAS:
Profit = (($1,080,000 – 65 percent) + ($216K – 65 percent) – ($120K + $14,400) = $319,200
Not only did this scenario yield more profit, it significantly increased top-line revenue and our share of the total addressable market. These are metrics that many companies value as well. In fact, many aggressive Opportunist companies would be willing to sacrifice total profit in favor of winning a larger share of the addressable market and increasing their top-line revenue.
However, in these circumstances, the Opportunists still care about being profitable overall. They want to ensure that the bottom-line profit number is greater than zero and high enough to cover the rest of their business expenses and appease any investors.
Here are five different scenarios in which an increase in spend and lower ROAS resulted in either more bottom-line profit or a drastic increase in top-line revenue—the preferred outcome for Opportunist companies.
So many clients fail to respect the math involved in this simple spreadsheet and, instead, set their goals based on greedy expectations they’ve developed from a small sample size. Many clients, after seeing the results of Scenario 1, will say to their agency: “We’ll increase our budget to $1M/month if you can continue to return at 10x ROAS!”
Generally, that is neither possible nor practical. As outlined in Chapters 14 and 15, there are a finite amount of customers who can be purchased at such favorable returns. At some point, you need to lower your ROAS goals if you wish to increase your market share. A goal that can only be achieved profitably if you embrace a true partnership with your agency and outline realistic goals based on profit, such as the example above.