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Social Media Advertising

How to Calculate ROAS and Assess Profitability for Paid Social Ads

June 18, 2021
Maurice Rahmey

High return on ad spend isn't enough to guarantee a successful digital ad campaign. Context matters, and so does profitability, according to a paid social media marketer and Facebook alum.

Table of Contents

Every marketer in e-commerce wants to attract new customers efficiently and at scale — and many of them want to do it through paid social ads. The strategy is ubiquitous at this point.

Through social media platforms like Facebook, Instagram and Snapchat ads, advertisers can reach roughly 4 billion monthly active accounts — and all three platforms offer ways to target audiences that have never bought from you before.

But what’s the best way to measure their success?

I’ve thought about this a lot in my work with Fortune 500 companies and DTC brands — first as a client solutions manager at Facebook, and now as a co-founder of performance marketing Disruptive Digital.

Often, marketers use their return on investment (ROI) for their ad spend, also known as return on ad spend (ROAS), as a proxy for their advertising efforts' performance. It pops up over and over on industry blogs: If you can keep your ad spend low — with efficient targeting, say, or low CPMs — and your conversion rate high — with incentives like flash sales and coupons — you can achieve a sky-high ROAS.

However, this approach can impact your profitability in a negative way.

High ROAS isn’t everything, and it doesn’t exist in a bubble; it should really be just one element of a more complex assessment that also includes other factors, like gross profit margin.

How can marketers calculate ROAS, and set realistic ROAS goals without getting ROAS tunnel vision? Why is profit ultimately more important than ROAS — and what does that mean for ubiquitous discount codes and flash sales we all see online?

Let’s get into it.

How to Calculate ROAS

Before we get into the nuances surrounding ROAS on paid social ads, here’s how to calculate it.

Essentially, ROAS is a ratio between the amount spent on an ad campaign and the total revenue it brought in, tabulated with this formula:

ROAS = Ad Campaign Revenue / Ad Campaign Cost

You can test out some example scenarios with our ROAS calculator:

ROAS is a bit of a short-term metric, in that it typically only counts the price of a new customer’s first purchase towards ad campaign revenue. Especially for online businesses working in the monthly subscription space, a customer’s lifetime value (LTV) can be much higher than this.

It’s important to consider both ROAS and LTV. For new companies that can’t yet robustly measure their customer LTV, however, ROAS is a great initial, real-time litmus test for whether an ad campaign is working out.

Calculating your ROAS, on its own, won’t tell you much, though; you need a goal ROAS to compare it to.

How to Set Realistic ROAS Goals

Maybe it goes without saying, but not every company should chase the same ROAS goal. An appropriate target ROAS will depend on factors like industry, average order value (AOV), average purchase frequency and more.

However, when you’re trying to come up with a realistic ROAS goal, it’s smart to start by considering your break-even point. That is, what is the ROAS target you need to hit to avoid losing money on a new customer?

Calculating Break-Even ROAS

To calculate your break-even ROAS, you first need to calculate gross profit margin.

To start, total up all of your variable costs on an average order — in other words, your average cost per unit, which will scale as your order volume does.

Variable costs might include, but aren’t limited to:

  • Manufacturing costs
  • Shipping costs
  • Payment processing fees
  • Discounts and other incentives (often neglected, which we’ll talk more about in a minute)

From there, calculate gross profit margin with the following formula:

Gross Profit Margin = (Average Order Value - Variable Costs) / Average Order Value

You can test out some example scenarios with our gross profit margin calculator: 

After calculating your gross profit margin, you can calculate ROAS targets with this formula:

Break-Even ROAS = 1 / Gross Profit Margin

You can test out some example scenarios with our break-even ROAS calculator: 

If you achieve this ROAS, your advertising spend will exactly pay for itself, and it's a good benchmark for marketers to keep in mind.

But it’s not the right goal for every e-commerce marketer.

Is Break-Even ROAS Enough — or Too Much?

As I mentioned already, there’s no single, correct ROAS goal. A good ROAS in one industry might be a catastrophe in another; the right goal for you depends on an interconnected web of factors including your product, your average order frequency and your price point.

Which companies should shoot for break-even ROAS?

This is a popular benchmark for companies whose customers buy from them several times a year, but not quite routinely.

Under these circumstances, it’s sustainable to break even on winning new customers and then turn a profit on their second orders. DTC shoe and apparel brands, for instance, might shoot for break-even ROAS.

Which companies need more than 100% ROAS?

Profitable customer acquisition can be key for e-commerce companies selling long-term investments, like mattresses or furniture. Customers buy these expensive products so rarely that postponing profit until a new customer’s second purchase could leave a company in the red for years.

Which companies can afford less than 100% ROAS?

ROAS of less than 100% can work for companies that sell consumer packaged goods that people buy regularly (and rarely shop around for) — like daily contacts, seltzer or paper towels.

If customers buy frequently enough, and at a low price point, the company doesn’t necessarily need to break even on first orders; it can rapidly earn back the advertising costs involved in new customer acquisition.

The Key Marketing Metric: Profit

Plenty of early-career marketers will probably balk at this, but whatever ROAS goal makes sense for your business, it shouldn’t be your only focus — or even your top priority.

But if you aren’t prioritizing low CPAs and high ROAS, what should you be focusing on?

The answer is simple: gross profit margin.

I’ve seen marketers lose money that they never earned back on digital advertising campaigns by forgetting to treat profitability like the important metric it is. When you're fixating on the amount of revenue you're bringing in, it's easy to lose sight of your bottom line.

Ultimately, a business can’t scale without profit, unless it’s one of the less than 1% of startups with venture funding — and even venture capitalists like to see a path to profitability for their portfolio companies.

Gross profit margin offers essential context for ROAS stats. For example, a high ROAS tied to a steep discount or sale might actually be less profitable for an e-commerce business than a lower ROAS linked to a full-price product.

Remember, profit and break-even ROAS are inversely related:

Break-Even ROAS = 1 / Gross Profit Margin * 100%

That means focusing on high ROAS and ignoring profit margins can lead to serious losses.

If you have a 5X ROAS and a razor-thin gross profit margin, that campaign might not be a big-picture win — even though 500% feels like a big number.

Why Discounts Play a Crucial Role in ROAS and Profit

It’s common practice to tack a hefty discount code onto ads to entice new users to convert. This can be effective — but it can also eat into your profits, even if you don’t notice it at first.

That’s because the larger the discount you give a customer, the higher your ROAS needs to be in order to break even. Even if your ROAS goes up because your discount code got more users to engage and convert, it might not go up enough to hit your elevated break-even point.

Many advertisers try to lead with free samples, limited-time offers, and first-time discounts. They assume that the customer will try the product, love it, and stay on, but that just doesn’t always happen.

The Psychology of Deal Seekers

Discounts often attract price-sensitive customers who aren’t as loyal, sweeping in for the deal — and it can end up hurting your overall LTV as well as the profitability of a given paid social campaign.

For example, if a DTC retailer sells $100 organic pajama bottoms, they’re seeking a very specific type of customer: someone willing to invest in loungewear.

If their paid social ads offer new customers half off their first purchase, they’ll likely see a surge of conversions — but not necessarily from customers in the demographic the company seeks. The customers buying steeply discounted pajamas never purchase again; maybe $100 is out of their budget, or they only bought the set because it was a great deal.

This brand could ultimately spend a lot on ads and discounts, only to attract customers who will never convert at full price — because they were deal seekers, not value seekers. Deal seekers are notoriously fickle and often lack brand loyalty. They typically aren’t worth acquiring, and definitely not on a paid social platform where you’re taking on acquisition costs.

Let’s walk through another example, this time from a real company.

A Case Study in How Discounts Can Hinder Your ROAS

This example comes from one of my agency’s clients in the consumer packaged goods space, and it shows how discounts can impact your ROAS, LTV, and profitability.

This client had what I lovingly call “Bed Bath & Beyond syndrome.” Their marketing team always ran coupons and flash sales, trying to leverage that buyer’s FOMO. As a consumer, you were expected to buy with a coupon.

This can work. In the early days of Bed Bath & Beyond, the company’s giant blue coupon was cheaper to produce than a catalog — and it lured people into the store, where strategic merchandising often got them to buy more than they originally intended.

In 2020, though, even Bed Bath & Beyond began moving away from the constant-discount strategy. Coupons can have diminishing returns over time; they quickly go from an exciting opportunity to a constant expectation.

We suspected that in our client’s case, the discounts-for-everyone approach was limiting their ability to scale not only their ad campaigns but their entire business — so we set up a split test to find out.

Using Facebook ads, we promoted four different versions of their hero product at four different price points:

  • $90 (their initial offer)
  • $95
  • $99 with a gift card
  • $99 with no gift card

For each price point, we set the following ROAS goals:

ROAS goals based on price point

We ran the test at scale, and the results were surprising.

While the $90 offer was the ROAS winner, the $99 offer with no gift card was the second-best performer and had the greatest chance of profitability.

ROAS goals at scale - and the best performing price points.

The $90 offer, which had the lowest gross profit margin offer, looked most promising based on raw ROAS — but it was closer to its break-even ROAS goal, and we thought the customers who spent $99 might be the higher-value customers.

We waited, and after two weeks, we looked at the LTV on the new customers the campaign had attracted.

Not only did the customers who spent $99 spend more upfront — two weeks later, they had spent 20% more than their counterparts who spent $90.

Two week LTV by price point

While ROAS was higher at the $80 price point than the $99 one, the $99 one had a better gross profit margin — and the customers who bought at that price point seemed more likely to buy again. With a 10% price increase, Facebook’s algorithm showed the ad to higher-quality users. LTV and profitability improved.

In other words, the more profitable campaign paid off in both the short- and long-term, as you can see above.

Four Non-Discount Incentives That Won’t Destroy Profitability

Incentives and discounts still have their place, of course, and can result in more loyal customers. However, the goal should be to create incentives for value seekers rather than deal seekers.

If you incentivize purchases by giving people more product, instead of by charging them less money, you’re unlikely to attract purely deal-seeking customers.

That means it might be worth replacing a trendy discount with a value-based incentive, like these four — all of which provide value to customers without dramatically eating into your profit margins:

  • A gift card with a purchase, which incentivizes repeat business
  • A free product or product sample with a purchase, which can lead to a bigger order next time
  • A free product upgrade with a purchase, like having a product customization or monogramming, which can boost brand loyalty
  • A lightly discounted bundle of complementary products, which can boost average order value

These value-based incentives can function as a win-win for you and your customer. Too often, steep discounts are a win-lose — a win for consumers, but a losing proposition for e-commerce retailers.

Final Thoughts

In my professional experience in online advertising, it’s easy to focus narrowly on a metric like ROAS and miss the bigger picture.

Yes, if you steeply discount your product ROAS will likely rise. But that might not be important, or even helpful, to your bottom line.

High ROAS alone can’t guarantee a profitable, successful, scalable marketing strategy. Before you achieve that, you need to have all the necessary pieces in place, including a scalable price point and gross profit margin.

To set the stage for a successful marketing effort , focus more on profit and LTV, and test some full-price ads — you never know what you’ll find.

In digital marketing, a lower ROAS may deliver more valuable audiences and your real, long-term goal: sustained profitability. Not 5X ROA.

Maurice Rahmey
about the author

Maurice spent 5+ years working with Fortune 500 and direct-to-consumer brands at Facebook and is now co-founder of Disruptive Digital, a performance marketing agency specializing in helping brands acquire new customers.

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