For those who do not want to get immersed too much in the unit economy, and at the same time set relevant tasks for the marketer. We calculate the payback with indicators of fixed and variable expenses, average receipt amount and repeat orders.
Our approach is to focus on business indicators in advertising, not leads or orders. We build a unit economy according to the project and make a payback forecast. Let’s consider the formula for how to calculate the profitability of online advertising, using the data that the business owns: expenses, revenue, average check amount. There will be no synthetic metrics, such as CTR, only those related to money.
First, an overview of the mechanics will be presented, and then we will explain how to use the data. Over the years, we have created principles for an approach to advertising management that will help increase its profitability and achieve a positive ROI (return on investment in advertising).
The content of the article:
- Expenses
- Income
- Results for the period
- Totals taking into account LTV
- Principles of advertising profitability management
So, what does the return of advertising investment consist of? – Expenses and income. Let’s figure out how to calculate the return of paid traffic.
Memo with formulas:
ROI: Return on investment
ROI = (Income − Costs) / Costs x 100%
ROMI: Return of marketing expenses
ROMI = (Revenue − Marketing costs) / Marketing costs x 100
ROAS: Advertising Payback
ROAS = Advertising Revenue / Advertising costs x 100
CAC (Customer Acquisition Cost) — the cost of attracting a customer
CAC = the cost of the traffic channel / the number of new customers
Average receipt amount = Total revenue / Number of purchases
LTV Lifetime Value LTV = average cost of sale × average number of sales per month × customer retention period in months
Cost structure
Fixed costs are are expenses you pay each month, regardless of your business’s sales or profit These costs include office rent, hosting fees, payroll.
Variable costs depend on the output and sales of products. These are the costs of purchase, delivery and, in the case of digital products or services, the cost of labor hours.
The advertising budget and the cost of the contractor’s services. We separate them, because a budget is not always available, it may just be a payment for SEO or SMM services.
The cost of an advertising contractor’s services is also variable expenses. With a budget of 50,000 and 2,000,000, the cost of services will be different, depending on the amount of work.
Revenue structure
It consists of the number of acquired customers and the average purchase value.
It is also worth considering LTV which is the estimated average number of purchases for the entire period of the client’s relationship with your company. Advertising may be loss making in the first month, but it will pay off over time due to repeated orders.
So, we have introduced the indicators that we are aware of: expenses, the average purchase value, and the estimated number of customers. Eventually, we calculate the return on investment.
Final calculations
The amount of expenses includes both fixed and variable costs.
Revenue is the sum of all monthly payments: average purchase value * number of customers.
The cost of acquiring a customer or CAC (Customer Acquisition Cost).
The CAC formula = Cost of Sales and Marketing / the Number of New Customers Acquired It can be calculated in different ways: sometimes the CAC includes all the expenses of the company, sometimes only advertising.
We believe that fixed costs should not be included in the cost of the client, since they are not tied to the number of goods or services sold.
If you need to scale, then you need to increase the margin profit and the number of sales. This is one of the principles of growth: it is necessary to make such a sale that would pay for all the new costs of the sale.
Often the business does not grow because it calculates the total payback, not the marginal profit.
We do not include fixed costs when we calculate the customer acquisition cost. But we include them in the calculation of net profit.
Margin profit is revenue minus variable expenses. This is exactly the indicator that ensures growth. It is necessary to focus on it if the business wants to develop.
We display two fields in the calculator: profit with and without the advertising budget.
We take into account LTV
The number of purchases for the entire lifetime value affects the final payback. The bigger LTV is, the more you can pay for the first customer, and gradually advertising will pay off due to repeated orders.
What is important to know about LTV is that repeat orders seem to not cost anything, but this is not true.
LTV is not equal to “free clients”. Resources for processing orders are still used: for example, shipping costs. Sometimes you pay for re–acquiring the same client – SMS mailings, phone calls, retargeting.
Here we have included the costs of retaining one client during his “lifetime”.
The formulas give a clear understanding of what you need to optimize in order to increase profits.
We put in data on our project, and experiment with different indicators to see how they affect the final margin profit.
Principles of advertising management
- We focus on the customer acquisition cost (CAC)
We optimize advertising by business profitability metrics. We are interested in customers who pay, not leads or orders. The CPC, the number of clicks, and CTR are of secondary importance.
- LTV is also important to take into account when calculating the customer acquisition cost
Especially in the case when LTV >> ARPC. The customer acquisition cost for the first purchase should be paid off with revenue for the entire lifetime.
Here is a case of an online pet food store we worked with. The numbers have been slightly changed, but the principle is clear: advertising does not pay off in the first month. But it is profitable in the long run, because the customer continues to buy food while his or her pet is alive.
- The revenue for the entire lifetime of the client must exceed the costs of retention
Otherwise, a situation may develop, as is shown in the screenshot below. The first sale from advertising pays off, but the retention of the client is too expensive.
For example, we work a lot with the florist businesses: online delivery of bouquets. In this niche, almost all purchases are one-time and spontaneous, it is useless to catch up with customers.
- It is more profitable to get more customers than to reduce the price of acquisition
Marketers often try to reduce the customer attracting cost, but the number of customers does not cover the costs.
If there is a margin profit, it is more profitable to increase the budget and get more customers.
While you have a return on sales, it’s better to sell more than to reduce costs.
Roughly speaking, it is better to have 4000 clients for 200 rubles than 2000 for 100.
The problem is that the optimization of the client’s price depends on the cost, or on the average customer acquisition cost in this niche. Scaling is limited only by the volume of the market: it is easier to increase the number of customers than to reduce their cost.
For example, in the last three columns we compare the decrease in the customer acquisition cost and the increase in the number of customers by 20%.
Compare the last three columns: the profit is higher, although the customer acquisition cost has not decreased.
We use the cases to demonstrate that our approach works well. We can advise marketers to do the following:
Recommendations: how to make advertising profitable
- In calculating the profitability of advertising, we rather take into account the customer acquisition cost but not a lead or a target action.
- We take into account variable costs per unit of goods. This may be the price at which you purchase the product, or the labor hours spent on the service.
- Fixed costs should not be included in the cost of customer acquisition, since they are not tied to the number of goods or services that were sold. It is more correct to include variable costs in the customer acquisition cost.
- The cost of an advertising contractor’s services is also considered a variable cost. With a different amount of work, the price of services will be different.
- We take into account LTV Advertising may be unprofitable in the first month, but it will bring return on sales over time due to repeat orders.
- Repeat orders can rarely be considered completely free. Consider the cost of repeat marketing touch.
- It is more profitable not to reduce the customer acquisition cost, but to increase their number.
Of course, the calculation does not take into account the nuances of each business, but on its basis it is possible to calculate the return on investment in advertising (ROI and ROAS) taking into account fixed and variable costs and LTV.
If there is a non–standard case, let’s discuss it. Please contact us for advice.
