If you are a marketer, growth hacker, revenue officer or an owner working at an online Direct-To-Consumer (DTC or D2C) brand, investing part of your promotional budget in digital advertising is inevitable.
One metric often used to measure the efficacy of your advertising is Return On Advertising Spend (or ROAS). ROAS measures how much revenue you are getting back from money spent on digital advertising, and is typically calculated as:
ROAS = Revenues from Ads / Cost of Ads
It is either expressed as a percentage (250%) or an absolute value (e.g. 2.5); we will use the latter in the rest of this post. In this particular example, it would mean that for every $1 spent on advertising, you are getting $2.5 of revenue.
If you are not familiar with it, we invite you to check this post before reading further.
ROAS is a revenue metric, and it does not tell you anything about the profitability of your advertising.
In most instances, and especially for young consumer brands trying to generate some product trials and brand recognition, advertising will often feature an enticing offer in the form of a discount on particular product(s). The discount is here to encourage customers to try the product(s).
Consequently, not only does the company have to pay for displaying the ad, but it also loses some portion of the retail price through the discount given, thus eating away its margin ...
While working with clients, we at Olari Consulting noticed that marketers tend generally to focus on ROAS. For the more cost-conscious ones, they try to get an idea of the profitability of the various offers they have in mind by keeping on doing back-of-the-envelope calculations to estimate it.
To help them, we came up with a simple tool that gives the ROAS according to the discount level offered in the ad for a given Gross Margin and a given Targeted Net Profit … a bit of a mouthful, so let’s take an example.
Let’s say you are planning an ad featuring a product with a Retail Price of $50 and a Gross Margin of 70% (i.e. $50 x 70% = $35 of Gross Margin). To make the ad attractive, you want to offer a discount. At the same time, you do not want to lose your shirt, and you would like to make a Net Profit on the Retail Price (i.e. the money you would have left after the discount is applied and after the money spent on the ad).
Then the question becomes: for a certain Targeted Net Profit (let’s say 10%), what should be your ROAS for each discount level you could consider? You can do the (tedious) math for each discount level or use the tool on the button below.
Simply:
Enter the Gross Margin % of the product(s) in your offer
Enter the Targeted Net Profit %
The graph gives you automatically the ROAS (on the vertical axis) needed for discount level varying between 0 and 50% (on the horizontal axis). For the example above, your Gross Margin was 70% and the Target Net Profit was 10%. You get this graph:
In this setup, you would need a ROAS of 2.00 with an offer at 20% off.
Let’s verify the number with the example above. The product featured in your ad was $50, with a Gross Margin at 70% or $35, so the cost of the product (or COGS) is 30% or $15.
You are discounting this product by 20%, so the discounted retail price (i.e. the revenue made from the ad) will be $40. Then, your ROAS is 2, meaning that you had to spend $20 on your ad to get your $40 of revenues (40 / 20 = 2).
You made $40 of revenue minus the cost of your ad ($20) and minus the cost of your product ($15) i.e. 40 - 20 - 15 = 5 or $5 of Net Profit. The retail price was $50 so the % Net Profit is 5 / 50 = 10% THE TARGETED RETAIL PRICE ABOVE! Voilà.
Let’s go back to the graph above. As a (now) astute marketer, you can see the various ROAS to achieve for a given discount level.
If you want to be aggressive and get that sell, you can go with an offer at 45% off, but you will need a ROAS of 3.7 to get your targeted Net Profit of 10%.
If you want a smaller ROAS around 1.8, you will have to stick with an offer at 10% off.
Now, let’s change your Targeted Net Profit. You still have the product at $50 with a Gross Margin of 70%, and you want a Targeted Net Profit of 20%! Plug the number in and … You will never make a profit at any ROAS with a 50% discount. NE-VER! You may offer 45% off but you will need a ROAS of 11. Good luck with that (you can get an idea of ROAS across categories here).
Further comment on profitability: unfortunately, not all costs are incorporated in your calculation. As an online DTC business, you need to ship this product to your customer; shipping materials, picking and packing labor costs and postage cost are not included … So, if you are working with a Target Net Profit of $0 in the tool above, you will be losing money on the transaction, for sure. But we did not say it was not worth it. After all, this customer might come back …
If you like this post, we invite you to share it by clicking the social logo icons below. As always, we can help you think this through or develop it further and incorporate your own products cost,retail prices and 3PL costs to get a more accurate calculation, so do not hesitate to contact us.
Thanks to Armand Saramout for reviewing the content of this post.