How to Calculate ROI on Advertising Spend
By Shelby Thomas
To accurately calculate ROI in digital advertising, you need a clear understanding of your marketing unit economics. This article walks you through essential calculations, including how to use an advertising ROI calculator effectively. This will prevent us from throwing spaghetti at the wall and having to clean it up later.
We need to get clear on how much a customer is worth to you, how much it costs to get one, and everything in between.
By defining these necessary terms, the ship can be sailed in the right direction. We can better choose the right advertising channels and audience targeting settings that have the highest likelihood of success.
In addition, we will go over targets you can set for each advertising metric. Keep in mind that these targets are just that, targets. The goal is to stay within that target range, and optimally, below.
Let's crunch some numbers, shall we?
A Step-by-Step Guide
Calculating Lifetime Value (LTV)
- One of the ways to determine the average Lifetime Value (LTV) of a customer is to take your total revenue divided by the total number of customers. This is sort of back-of-napkin math and not the most accurate.
- Calculate LTV by multiplying the average purchase value by purchase frequency, then divide by the average customer lifespan.
- Note: you may have different LTVs based on different categories within your business. If so, it's important to keep track of these as well.
Understanding Cost per Acquisition (CPA)
- Once you've figured out your average customer LTV, we need to know how much you would be willing to pay to acquire that customer.
- CPA is the costs associated with sales and marketing needed to acquire one new customer.
Understanding CPA is crucial when learning how to calculate ROI in digital advertising. Knowing this metric helps align your budget with your ROI goals.
Determining Your LTV to CPA Ratio and Target CPA
- This is where unit economics really starts to influence your marketing. We need to keep a close eye on the LTV to CPA ratio. While the first goal is always to have a higher LTV than CPA, a ratio of 3:1 or higher is generally considered healthy. But for our sake, we'll go with 4:1 to maximize profitability.
- To set a target CPA, you can start by dividing your LTV by 4.
Understanding Payback Periods
- Almost all profit generated from marketing is earned on the backend, not the frontend. Rarely will that first click or interaction produce enough revenue to pay back acquisition costs. However, through nurturing and delivering in your product or service, you can earn significant long-term returns.
- The payback period is the time it takes for a business to recoup the customer acquisition cost through generated revenue.
Lead to Customer Conversion Rate and Target CPL
- Your Lead to Customer Conversion Rate represents the percentage of leads that eventually become customers. By knowing this rate, you can calculate the appropriate CPL (Cost per Lead) to stay within your target CPA.
- To set a target CPL, multiply your lead to customer conversion rate by your target CPA.
Setting Target Traffic Channel Costs
- Once you know your target CPL, look at the percentage in which your website converts a new visitor into a lead, or your Web Visitor to Lead Conversion Rate. Multiply this percent by your CPL and you have your Target Cost per Click (CPC) on a traffic channel.
When you have this knowledge, it puts you at a high competitive advantage. While some businesses may glance at a channel and balk at the cost per click, you can swoop that market share knowing you could make 10 times the cost from customers coming through it.
Let's Look at an Example
Say you're a general contractor. After researching your customer history, you determine that the average LTV of a customer is $8,000.
So we can set a target CPA of approximately $2,000, or about a fourth of our LTV.
Knowing we would be willing to pay up to $2,000 to acquire a new customer, we can determine a target CPL by multiplying the target CPA ($2,000) by a lead conversion rate of 15% to get $300 per lead.
Assuming an average website visitor-to-lead conversion rate of 3%, that gives us a $9 target for our CPC.
With a $2,000/month budget and a $9 CPC:
- Target CPC: $9
- Target CPL: $300
- Target CPA: $2,000
- LTV: $8,000
- ROI: 300%
But here's where things get interesting. Say you get the CPC down to $4:
- Estimated CPC: $4
- Target CPL: $300
- Target CPA: $2,000
- LTV: $8,000
- ROI: 800%
The ROI nearly triples and CPA drops way down. That's the power of knowing your data and optimization.
3 Ways to Lower Your Acquisition Costs
Decrease your cost per click (CPC). Better targeting, copywriting, and design can be rewarded with lower traffic costs and more impressions.
Increase your LTV. Create new products and services to upsell customers, or revisit your pricing.
Increase your lead conversion rate. Nurture leads, improve your sales and follow-up process, ensure product-market fit, refine pricing, and provide more value up front through engaging content.
At the end of the day, regardless of what industry you are in, we are all in the math business — the business of making a profit.
A Few Notes on Startups and New Businesses
It can be difficult when just starting out to come up with these numbers without any previous data. In this case, research industry averages.
I also don't want to give the impression that marketing will or should always make a profit in the short term. For a new business, it's quite common and sometimes necessary to invest upfront to get the pieces of your brand together — a logo, a message, a website, and so on.
So take a deep breath, embrace the process, and remember that you're laying the groundwork for a thriving and profitable venture.