We think you want your Target ROAS to be set such that you are optimising your lifetime CM3 (contribution margin 3).
CM3 is the money you get to keep after all costs associated with servicing a conversion have been accounted for.
For an ecommerce store lifetime CM3 is the revenue minus the cost of goods, fulfilment and shipping and marketing – across all orders in the customer’s lifetime (which is usually considered to be 2 or 3 years).
For say a monthly software subscription (saas) company it might be the monthly subscription fee times the average subscription length minus any costs directly related to servicing that customer (server costs, customer service, marketing).
The ideal ROAS is such that the incremental marketing spend to acquire one more customer equals the lifetime CM3 of that customer – i.e. you make no money on that last customer acquired.
If you acquire more customers beyond that point then you are losing money on each incremental customer; if you acquire fewer customers than that then you are leaving money on the table.
That should give you the maximum total CM3 across all customers. Without that last customer, your total CM3 is one pound less. If you acquired one more customer that loses you a pound over their lifetime then your total CM3 across all customers is also one pound less.
We can work out a theoretical Target ROAS which assumes a ‘normal distribution’ of number of orders versus cost per order, but in real life the curve will be different.
The best way to find the optimal Target ROAS of a campaign is to run a 50:50 experiment – with both experiment and the original identical bar the Target ROAS set. Even this is going to be an approximation as it depends on how you attribute conversions and a forward-looking estimate for repeat orders.
How to calculate a theoretical Target ROAS from LTV and the proportion of paid repeat orders
Let’s imagine you acquire 8 new paid customers.
Over two years from the initial purchase (the lifetime) half of the customers don’t buy again; two customers buy once more, one customer twice more; and one customer three times more.
Each order (new or repeat) has an AOV of £100 and CM2 of £50. [Note: Definitions of AOV and CM2 are at the bottom of this article]
The average lifetime value (LTV) of your customers is the average CM2 of your customers across all their orders = total CM2 across all customers divided by number of customers = (CM2 of an order * total orders) / (number of customers) = (£50 * (1 x 4 + 2 x 2 + 3 + 4))/8 = £93.75
Our best guess for ideal marketing spend across the lifetime of the customer is LTV/2 (read more about why it’s LTV/2 here).
The proportion of this marketing spend that should be in the first customer order = number fisrt customer paid orders / total first and future paid orders.
If all the repeat orders are paid then the proportion of marketing spend on the first order would be 8 / 17.
We can calculate the theoretical Target ROAS for an order as = Revenue in order / ( All Marketing spend * proportion in current order) = AOV / [LTV/2 * (number first paid orders / total lifetime paid orders) ] = £100 / [£93.75 / 2 * (8 / 17)] = 100 / 22 = 453%
If however half of all repeat orders are free then the Target ROAS would change to equal = AOV / [LTV/2 * 8 / (8 + 7/2)] = 100 / 32.61 = 307%
If more of the repeat orders are free then a higher proportion of the total marketing can be spent on the first order ⇒ lower ROAS.
How do I work out what Target ROAS to set on a campaign?
The theoretical Target ROAS calculated above is a good starting point, but the best way to work out the ideal Target ROAS for a campaign is to run an experiment.
Let’s say the original campaign has a Target ROAS of 500%. Create an experiment with a Target ROAS of 600%.
Let’s say the Campaign with 500% ROAS delivers 100 orders with AOV of £100 and CM2 per order of £50. The lifetime number of orders is 2 and a quarter of repeat orders are expected to be paid.
Estimated lifetime CM3:
= LTV – Marketing spend first order + expected marketing spend on repeat orders
= (#orders * CM2 per order * orders in lifetime) – [(#orders * Revenue per order / ROAS) * (expected paid orders in lifetime)]
= (100 * £50 * 2) – [(£100/5 * 100) * (1 + 0.25)] = £10,000 – £2,500 = £7,500
The experiment with 600% ROAS delivers 90 orders with all other metrics the same:
Estimated lifetime CM3 = (90 * £50 * 2) – [100/6 * 90) * (1+0.25)] = £9,000 – £1,875 = 7,125
So with these assumptions, the campaign with 500% ROAS is driving more lifetime CM3.
We would now lower the Target ROAS of the original campaign to 450% and the experiment to 550% to see if the 450% Target ROAS campaign drives better lifetime CM3 than the 550% Target ROAS experiment.
>>> Read the next article: ‘Is a new customer worth more than a repeat?‘
>> Purchase an ANALYSIS OF YOUR GOOGLE ADS ACCOUNT
The interactive video below highlights some of the analyses we cover:
Please be really careful making changes to your Google Ads account
- Google doesn’t always respond how you (or we) think it will. The way we think about Google Ads may not be the best set-up for your account.
- Only change one thing at a time.
- If possible, always use an experiment to test a change – particularly for significant changes such as moving bidding strategy to Maximize conversion value (Target ROAS).
- Protect your financial downside by testing with limited spend in the experiment/change. Note that moving to a smart bidding strategy requires a learning phase where Google may not be efficient.
- Be careful if adding/removing primary conversion actions – changing what Google is converting to can radically change what and who Google targets and how much it’s willing to spend.
- Remember, all changes to your account are at your own risk. Mapflo shall not be liable for any damages; losses; lost revenue or lost profit.
Glossary of Terms
AOV = Average Order Value
CM1 = Contribution Margin 1 = revenue minus COGS (cost of goods sold) in an order.
CM2 = Contribution Margin 2 = margin on an order after all costs directly attributable to that order such as COGS, shipping, payment fees, customer service etc. (except for marketing).
CM3 = Contribution Margin 3 = CM2 less marketing spend. An ‘Estimated CM3’ value uses an assumed CM2 %.
CPA = Cost Per Action. In this report taken to mean cost per conversion or cost per order.
Keywords = words or phrases (assigned to an ad group) that match a user’s search term and trigger Google to bid to show an ad.
Lifetime CM3 = CM3 from all orders (or subscription payments) for a customer.
Profit = CM3 less all fixed overheads (such as salaries and office rent). Hence Optimising CM3 also optimises profit at the same cost base
ROAS = ‘Return On Ad Spend’ = conversion value divided by cost. A ROAS of 400% means you get four pounds of revenue back for every pound of ad spend.
Search term = the word or phrase that a user searches for on Google.