‘What should my ROAS target be?’ is a common question for advertisers new to paid search, but one that’s surprisingly difficult to answer. The difficulty lies in part in its subjectivity: There’s no right answer for all businesses; there’s no industry ‘best practice.’ Ultimately, the right ROAS target will depend on business priorities (growth versus profitability), as well as certain internal and external constraints that put limits on how — and to what degree of profitability — these priorities can be pursued.
To begin, what is ROAS? ROAS stands for return on ad spend and is calculated by dividing revenue by ad spend. It’s essentially the revenue you receive — on average — for each dollar spent. For example, if you spend $10 and generate $20, your ROAS is 2.0 or 2:1.
ROAS = Revenue / Ad Spend
Now that we know how ROAS is calculated, what is an appropriate ROAS for achieving your business goals? Before we answer this more complex question, it will help to consider a far simpler one: ‘What is my break-even ROAS?’ Break-even ROAS is the bare minimum ROAS that an advertiser must achieve to ensure the program isn’t losing money. To calculate this metric, we must factor in cost of goods sold (COGS) and other expenses (e.g., credit card fees, cost of shipping, etc.) by including them in the denominator of the basic ROAS calculation. This is the most aggressive target the advertiser can adopt, and theoretically maximizes top-line revenue.
Break-Even ROAS = Revenue / ( Ad Spend + COGS + Other Selling Fees )
But what if your goal is not just to break even, but to generate profit? Anything above the break-even level will generate profit. If we break even at a ROAS of 3:1, we must target something above that to be profitable. If we target 4:1, we’ll make a dollar in profit. So why not 5:1 and make two dollars? Or 10:1 and make $7 for each dollar spent?
This line of thinking implies we could make our paid search program more profitable simply by adopting increasingly higher ROAS targets, but in practice we run up against certain constraints that put a cap on the ROAS we can reasonably expect to achieve in paid search. These constraints give rise to a negative correlation between ROAS and conversion volume in competitive verticals (i.e., raising the ROAS target will decrease conversion volume for a given advertiser, ceteris paribus.)
So, while a profitable ROAS is definitional (anything greater than break-even), a profit maximizing ROAS can’t be known a priori. It will depend on a variety of constraints — many of which can vary across time — both internal (e.g., conversion rate, average order value) or external (e.g., total addressable market, cost-per-click.)
Paramount among external constraints is the competitive landscape. In most verticals, a 10:1 ROAS simply won’t be competitive; that is, it will fail to generate significant traffic to your eCommerce site. Rather than maximizing profit, setting one’s sights too high will mean losing out on impressions, traffic and ultimately conversions to competitors with more aggressive ROAS targets that yield better placement on the Search Engine Results Page (SERP).
Auction Insight Report
This example of a Google Auction insights report indicates a competitive vertical. While there are several competitors with lower impression share, there is a dominant advertiser in the market (Competitor D) who will likely absorb further impressions if you increase your ROAS target.
Setting a competitive ROAS target will generally mean hewing somewhat close to the average ROAS of the vertical in which you operate. While this average usually won’t be known (your competitors will tend to keep their program data under wraps), it can be estimated based on observable data and reasonable assumptions.
But what should an advertiser do if they find themselves in the unfortunate circumstance of having a break-even ROAS well above the vertical average? This would imply that — ceteris paribus — running a competitive paid search program means losing money. But an advertiser may enjoy certain advantages over competitors that enable them to maintain a foothold in the market even at a less competitive ROAS. For instance, they may enjoy higher conversion rates due to a faster mobile site, or generate higher average order values through more effective cross-selling.
Running an efficient, structured Google Ads account with intelligent applications of bid automation can also enable an advertiser to maintain market share against aggressive competitors. But these and other advantages will tend to be reduced over the long term as competitors adopt best practices and close the gap in capabilities. Over time, an uncompetitive ROAS target will mean losing auctions — and thus conversions — to others in your vertical.
Conversion Volume vs ROAS
While the curvature of will be different depending on the specifics, there is a strong negative correlation between ROAS and conversion volume in competitive verticals.
The ideal combination for winning in search pairs a competitive ROAS target with best-in-class account management. And in highly competitive verticals, a competitive ROAS may be well below break-even ROAS. Does this mean you can’t hang in search?
Assuming your profit margin, conversion rate, and other important inputs are broadly similar to your competitors, an obvious question presents itself: Why are they content to go below break-even ROAS? What do they know that you don’t?
A few potential answers:
- They’re focused on something other than near-term profitability, be it customer acquisition based on LTV analysis, gaining market share, raising brand awareness, etc.
- They’re accelerating data collection that will allow them to deploy more sophisticated, efficient, and profitable account structures to great effect in the future.
- They understand paid search plays an important role in assisting conversions in other channels; backing out of search would have a negative impact on other channels.
ROAS is an important metric for measuring paid search efficiency and providing a clear criterion by which account managers can be judged. But one shouldn’t lose sight of the role it plays within the larger ecosystem. Investment in paid search yields dividends in other channels. A narrowly focused concern with channel profitability can obscure this contribution to achieving overarching business goals.
Eight Oh Two Marketing is a boutique, search-marketing agency for enterprise. As the VP of Digital Advertising, Dan Pietrucha is an industry veteran. With degrees in commerce, finance and philosophy, Dan takes an analytical approach to any challenge, and you’ll often find him knee-deep in projection models and pivot tables. Click here to learn more about Eight Oh Two, our methodology and our team.
May 15, 2020
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