Question

Should I calculate ROAS based on gross revenue or profit margin for better ad decisions? 

I’ve been calculating ROAS based on gross sales, but my profit margins vary across products. I’m starting to wonder if I should factor in profit instead to make smarter scaling decisions. What’s the best practice for ROAS revenue or profit-based?

Answer 1

While ROAS (Return on Ad Spend) based on gross revenue is a common and quick metric to assess ad efficiency (how much revenue you get back for every dollar spent on ads), it can be misleading when profit margins vary.

For better ad decisions, especially when profit margins vary, you should factor in profit.

Here's why and what's recommended:

1. Revenue-Based ROAS (Traditional ROAS):

• Calculation: Total Revenue from Ads / Total Ad Spend

• Pros: Easy to calculate, provides a quick gauge of ad campaign efficiency.

• Cons: Doesn't account for your actual costs of goods sold (COGS) or other operational expenses. A high revenue ROAS can still mean you're losing money if your profit margins are thin or negative on certain products. This is particularly problematic with varied margins, as a product with a low margin might have a great revenue ROAS but be unprofitable after all costs.

2. Profit-Based ROAS (Often referred to as POAS - Profit On Ad Spend, or simply incorporating profit into your ROAS analysis):

• Calculation: (Revenue from Ads - COGS - Other Variable Costs related to the sale) / Total Ad Spend. Or, more simply, Gross Profit from Ads / Total Ad Spend.

• Pros:

  • True Profitability: Gives you a much clearer picture of your actual profitability from ad campaigns.

  • Informed Scaling: Allows you to identify which products or campaigns are genuinely contributing to your bottom line, enabling you to scale profitable efforts and cut unprofitable ones.

  • Better Budget Allocation: Helps you allocate your ad budget to products or campaigns that generate the most profit, not just the most revenue.

• Cons: Requires more detailed tracking of COGS and other variable costs per product or sale, which can be more complex to implement.

Why it's crucial with varied profit margins:

Imagine you have two products:

• Product A: Sells for $100, COGS is $20 (80% gross margin).

• Product B: Sells for $100, COGS is $70 (30% gross margin).

If both products generate $500 in revenue with $100 ad spend, their revenue ROAS is 5:1. However:

• Product A: $500 revenue - $100 COGS = $400 gross profit. Profit-based ROAS: $400 / $100 = 4:1.

• Product B: $500 revenue - $350 COGS = $150 gross profit. Profit-based ROAS: $150 / $100 = 1.5:1.

Clearly, Product A is far more profitable for the same ad spend, even if their revenue ROAS looks identical. Scaling ads for Product B based solely on revenue ROAS could lead to significant losses.

Best Practice:

• Start with Revenue ROAS for a quick overview and initial optimization. It's still valuable for understanding the immediate return on your ad dollars in terms of top-line revenue.

• Always calculate (or at least consider) a profit-based metric for strategic scaling and long-term profitability. This is especially important when you have diverse product lines with different margins.

• Calculate your "Break-Even ROAS" based on your average or specific product profit margins. This tells you the minimum revenue ROAS you need to achieve just to cover your ad costs and COGS, before even considering other business overhead.

  • Break-Even ROAS = 1 / Gross Profit Margin Percentage

  • For Product B (30% gross margin): Break-Even ROAS = 1 / 0.30 = 3.33. This means you need to generate $3.33 in revenue for every $1 spent on ads just to break even on that product's ad spend and COGS. Your 1.5:1 profit-based ROAS means you are losing money on those ads.

By incorporating profit margins into your ad decision-making, you move beyond just "revenue vanity metrics" and focus on true business profitability.