Breaking down ROAS.
One of SabinoDB’s core values is embracing data. We believe that until you can measure something, you can’t learn and make progress.
In the context of our digital marketing services, we like to track and measure data points that provide insight into our performance. A key performance indicator we track and discuss often is ROAS.
WHAT IS ROAS?
ROAS stands for return on ad spend. It’s calculated by dividing total revenue by total advertising spend. If a company spends $10,000 on advertising and generates $50,000 in revenue, its ROAS is 5.0x. A ROAS of 5.0x can be interpreted as “every dollar spent on advertising generates five dollars in revenue.”
ROAS is widely used by marketers because of how simple it is to calculate (total revenue / total ad spend), how eloquently it captures performance (the higher the ROAS, the better), and its direct ties to a company’s income statement.
ROAS’s simplicity is also its limitation. Looking at ROAS can’t tell you why something happened. For example, if the same company spends $10,000 on advertising the following month and generates $60,000 in revenue, producing a ROAS of 6.0x, what drove the improved performance? Did advertising prices change, did the company have a sale, was a new advertising campaign launched?
Making sense of ROAS requires additional context. Using a framework inspired by the DuPont analysis of return on equity (ROE), we show how breaking down ROAS into its underlying parts is a useful technique to determine what’s driving marketing performance.
We first deconstruct ROAS into three parts and then four. For the sake of simplicity, we do not go into marketing attribution, segmentation, or timing.
3-STEP ROAS ANALYSIS
In a 3-step analysis, we express ROAS as the sum of three fractions, resulting in the following equation:
Splitting ROAS into three fractions illuminates that ROAS is the product of multiplying three standard digital marketing metrics together, including:
Average Order Value (AOV) – The average amount a customer spends on each order. AOV is mainly a reflection of a company’s pricing power, discounting strategy, and ability to sell multiple units per transaction.
Conversion Rate (CVR) - The percentage of clicks that result in an order. CVR can reflect the perceived value of a company’s product or service, the website performance and design, and the alignment of the landing page and product or service with the advertisement the customer was shown and their expectations or intent.
Cost Per Click (CPC) - The amount of money it costs each time an advertisement is clicked, or inverted, how many clicks are generated for every dollar of ad spend. CPC can reflect ad quality, type, placement, and targeting, as well as industry and competitive dynamics, among other factors.
The above framework implies that a company can increase its ROAS if it:
Increases its AOV
Increases its CVR
Decreases its CPC
4-STEP ROAS ANALYSIS
In the 4-step analysis, we express ROAS as the product of four fractions, resulting in the following equation:
We arrive at the 4-step ROAS by further expanding CPC from the 3-step ROAS into click-through rate (CTR) and cost per thousand impressions (CPM). The 4-step equation shows that ROAS is comprised of AOV and CVR (from the 3-step equation), and click-through rate (CTR) and cost per thousand impressions (CPM) inverted, where:
Click-Through Rate (CTR) - The percentage of ads displayed that are clicked. CTR hones in on ad quality and targeting, and to a lesser degree ad type, ad placement, and industry and competitive dynamics.
Cost Per Thousand Impressions (CPM) - The cost to display an ad 1,000 times, or inverted, how many thousand impressions are generated for every dollar of ad spend. CTM hones in on ad type, ad placement, industry and competitive dynamics, and to a lesser degree ad quality and targeting.
The above framework implies that a company can also increase its ROAS if it:
Increases its CTR
Decreases its CPM
EXAMPLE
Applying this framework to our previous example, and assigning numbers to each metric, we can now better understand which specific components of ROAS contributed to an improvement in ROAS from 5.00x to 6.00x.
Viewed through the 3-step lens, we see that AOV remained unchanged, CVR increased from 3.50% to 3.71%, and CPC decreased from $1.00 to $0.88. Viewed through the 4-step lens we further see that the decrease in CPC was driven by an improvement in the CTR from 1.11% to 1.26% since CPM did not change.
KEY TAKEAWAYS
ROAS is a simple and effective metric that e-commerce operators and marketers can use to measure their digital advertising performance.
Looking at ROAS alone is only a starting point. A useful technique to better understand what is driving performance is to deconstruct ROAS into 3 steps and 4 steps.
The 3 step ROAS analysis shows that ROAS is comprised of 3 standard digital marketing metrics multiplied together, including AOV, CVR, and CPC inverted.
The 4 step ROAS analysis shows that ROAS can also be viewed as 4 standard digital marketing metrics multiplied together, including AOV, CVR, CTR, and CPM inverted.
The above frameworks show that ROAS can increase due to an increase in AOV, increase in CVR, increase in CTR, or a decrease in CPC or CPM.
SabinoDB is an e-commerce and marketing solutions company committed to helping companies use big data, real-time analytics, AI, and machine learning to better understand their customers and grow their business. If you are interested in learning about how SabinoDB can help with your company’s digital marketing, please reach out directly to Ryan Hammon. Email - ryan.hammon@sabinodb.com Phone - (415) 847-8103.
