September 15, 2022

The Wrong Metric

You've probably been in this situation as well.

The Marketing Executive is struggling with a mostly unprofitable business. He sends me his customer data, I perform an analysis, and I show him that he is spending a fortune acquiring customers and then is generating very little future profit. He's losing $25 of profit acquiring a customer, and then over two years he makes maybe $30. That's a net of $5 variable profit. You cannot survive when your customer base delivers $5 of variable profit - there's not enough profit to cover fixed costs.

The Marketing Executive gets a terse look on his face, and he says the following.

  • "Profit is an outdated metric. We look at ROAS."

You couldn't possibly say something that communicates the fact that you do not understand your business more clearly than by saying you analyze customer acquisition via ROAS. He's clearly using the wrong metric. And he doesn't like it that I'm pointing this out to him.
  • "ROAS as a metric is a best practice. All the smart digital folks use it. Profit is a relic of a time gone by."

ROAS, as you know, is not a best practice, and not all of the smart digital folks use it. ROAS is simply the ad-to-sales ratio, inverted. Maybe you spent $100 on a paid search campaign and got $250 of sales as a result.
  • ROAS = $250 / $100 = 2.5.
  • Ad-To-Sales-Ratio = $100 / $250 = 0.40.

Both metrics are identical. One was used in the 1980s. One is a best practice used by all of the smart digital people.

Neither metric matters.

What matters is this:
  • Did you generate enough profit on this transaction to align with future profit, allowing your business to thrive?

Let's assume that your "Profit Factor" (you know what that is, right?) is 40%. How much profit did the $100 of marketing expense generate?
  • Profit = (Sales) * (Profit Factor) - (Ad Cost).
  • Profit = $250 * 0.40 - $100 = $0.

In the example above, your marketing efforts broke even. You're fine.

What happens if your profit factor is 35%?
  • Profit = $250 * 0.35 - $100 = ($12.50).

You lost $12.50.

Now you count how many customers ordered (pretend it is 2), and you divide your loss by the number of customers ... ($12.50) / 2 = ($6.25). You lost $6.25 per customer.

If the customers you acquired generate $30 of future value, you are fine. You net out at $23.75 of total profit over time.

If the customers you acquired generate $5 of future value, you are not fine.

ROAS doesn't tell you any of that, does it?

The more "canned" our analysis software has become ... the more reporting we accept from vendors as truth ... the less sophisticated and nuanced our work becomes. We're looking at the wrong metric(s) ... all the time. It's clear when we're looking at the wrong metric that we do not understand the business we are managing. When we look at profit, we understand the business we are managing.

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