Why Customer Acquisition Cost is a Better Metics Than ROAS
Why playing the long game can help you scale - fast!
This post is going to branch out from my Amazon-only typic content and talk more broadly about digital marketing. I am going to walk you through the two most commonly used metrics for measuring digital advertising and explain how they have changed over time.
We will detail why the tide is shifting away from the traditional Return on Ad Spend (ROAS) model to a ratio of Customer Lifetime Value (LTV) compared to Customer Acquisition Cost (CAC), and how you can use this data to grow your business.
Introduction: ROAS vs. CAC
The beauty of digital marketing is that you can track everything. You can measure performance across clicks, conversion and revenue which means that you can directly attribute sales to your marketing spend.
Gone are the days of John Wanamaker famous saying: “Half the money I spend on advertising is wasted; the trouble is I don't know which half!”. We now live in a world where we don’t have to wonder if our marketing spend is working. The question now is not if it is working, but how efficient is my marketing.
Introduction to ROAS
The most commonly used measurement in digital marketing is Return on Ad Spend, or ROAS. Spend a $1, generate $3 and you have a $3 Return On Ad Spend. While having a ROAS focus approach to your advertising can drive profitable sales, it’s an imperfect metric.
Why is ROAS a problem? Because it shows the efficiency of your ad spend at driving a single purchase rather than acquiring a customer. ROAS is an in-the-moment metric and only measures the immediate revenue and does not capture the full value of acquiring a new customer.
Why is this important - if you are limiting your spend levels to achieve a specific ROAS target, you are most likely leaving incremental customer growth on the table. We are going to explain why focusing on your customer acquisition cost is a better method of measurement. If repeat purchase is the engine of a company, new customers are the oil. To set the stage, I’ve included an sample of the internal dashboard that we use to manage our business.
Definitions
Before we dive into the details, we need to understand the definitions of a few key terms.
Return on Ad Spend (ROAS): The ratio of sales generated from your advertising spend. Spend $100 and generate $200 in sales, you have a $2 ROAS.
Customer Acquisition Cost (CAC): The amount of spend needed to generate a new customer. If you spend $200 and generate 10 new customers, your CAC is $20.
Lifetime Value (LTV): LTV is the amount of money a customer spends with you over a given period, typically measured in yearly increments. The formula for LTV is Purchase Frequency (how many times a customer purchases per year) X Average Order Value X Avg. Life of Customer = LTV.
LTV:CAC Ratio: In an attempt to keep the metrics apples to apple, it has become increasing common to look at the ratio of LTV to CAC. Think of this metric as your yearly ROAS.
What these metrics do not consider is your profit. Most advertising metrics are sales-focused in nature and do not consider things like your product cost or fulfillment charges (typically your variable cost structure). To gauge the profitability of your spend, you will need to do little more math. Here is a ‘cheat sheet’ formula to help you find a break-even level of efficiency.
Efficiency target = 1/(1-Variable Cost %))
Let’s assume you have a 50% variable cost structure so (1 / (1-0.5%)) = 2 so your target efficiency would be $2 — either measured as a ROAS or a $2 LTV:CAC Ratio.
Why are Advertisers Shifting Away From ROAS?
There are two major reasons why brands are shifting away from ROAS and towards CAC and LTV.
The Cost of Traffic is on the Rise: According to a recent Marketplace Pulse study, Amazon cost per clicks have increased by more than 50% compared to the same time period last year. This increasing cost of traffic is making it more challenging to show a strong ROAS, but brands knows that they need to advertise and are taking a longer-term view of their marketing investments.
iOS 14 Update: Apple’s new privacy update has unleashed chaos on all of us in the world of digital marketing. Facebook’s ad products (including Instagram) offered unmatched targeting options based on demographic and behavioral data. This level of granularity enabled advertisers to quickly find a niche and scale with strong conversion and efficiency metrics, but those days seem to be gone. Since Apple rolled out their most recent iOS update, users can opt out of tracking which is a major issue for Facebook. A recent study by FLURRY shows that 94% of US iPhone users have opted out of ad tracking which puts downward pressure on ad-attributed revenue, making it almost impossible to manage to a ROAS target.
These major industry changes have caused marketers to rethink how they are measuring media. Without adapting to the new world, advertisers will find themselves with a shrinking ice cube. Lower efficiencies lead to a reduced ad spend, which leads to lower sales, which leads to additional ad spend reductions — and the cycle continues.
Determining a Lifetime Value
Determining CAC in a vacuum without considering LTV is like going on a diet without tracking your calories. It is surely a positive to eat healthier foods, but without knowing how many calories you are consuming it’s hard to make meaningful progress. This is where Lifetime Value comes into play.
What is Lifetime Value? It’s how much a typical customer spends with your brand over a given period. By determining an LTV, you will be able to understand if your customer acquisition cost is at a profitable level, or if you need to further optimize the spend.
The next question is how do I determine customer lifetime value? For this exercise, we are going to keep it as simple as possible and avoid the use of a (SQL) database1.
Purchase Frequency: To calculate this metric, you will need to sum your total orders over the past year / total unique customers2.
Average Order Value: This is as straight forward as can be….revenue / orders.
Years in a Lifetime: In my experience, we have always used 1 year when calculating LTV, but if you work in an industry where items have a multi-year lifecycle you will need to determine an ‘average lifetime’.
Do the Math: Purchase Frequency x AOV x Years = LTV!
Now that you have a LTV, you can start to understand the ratio of LTV to CAC that needs to be achieved. Let’s use the example data above and assume our benchmark for returns is a 2:1 ratio. This means that if we continue to drive sales at 2:1 or better, we will be driving incremental sales and margin dollars for the business. It might be challenging at first (could cause issues from a cash flow or budgeting POV), but this formula will enable you to scale your business at a much fast manner versus focusing on ROAS in isolation.
In Conclusion
While I use LTV:CAC metric to drive decision making for my business3, this strategy might not work for everyone. If you need to focus on immediate profitability or cash flow, ROAS (or another short-term efficiency metric), might be a more appropriate measurement of your goals. However, if hyper-growth is the goal, shifting to a CAC-based metric will undoubtedly help grow customer count and sales in a hurry!
Like what you read? Upgrade to paid…
A better way to do this is through a cohort analysis to see how the cohorts trend and change over time.
Shopify can export this data easily, however Amazon is a challenge. You will need to use the marketplace email address for each customer as the unique identifier.
It is not *literally* my business, I’m the VP & GM of the business with a heavy Amazon focus.