This is the first article in a three-part series on business basics, and how the apply to digital advertising.
When we began our agency in 2005, some of the best advice we received was this: the first goal of business is to stay in business. And, to stay in business: have a plan, and avoid blunders. Avoiding math blunders in client work is a basic and useful business concept.
Today, we will focus on three commonly misunderstood metrics: Markup, Margin, Return on Ad Spend (ROAS).
Below are practical definitions in business math. Understanding their differences is key to avoiding mistakes that would certainly be embarrassing, and could potentially be devasting business math blunders.
Markup and Margin are two different perspectives on the same process: the costs a business bears, and how that cost relates to the selling price received from their products or services.
Markup (cost perspective)
Definition: In commerce, Markup is the amount added to the cost of goods or services a business bears. Together, the cost of goods (or services), plus the markup equals the selling price.
Margin (selling price perspective)
Definition: In commerce, Margin is the portion of the selling price (usually expressed as a percentage) that was added to the cost. Stated another way: Margin is the percentage of the selling price that is profit.
A business math mantra: Markup on Cost // Margin on Sell.
To remember forever, chant the following mantra over and over to the cadence of “follow the yellow brick road” from the Wizard of Oz: Markup on Cost – Margin on Sell.
Simplified Scenario for Markup and Margin of a product:
Cost of a product to sell is simpler to determine than costs of providing a service to customers. So, in the simple example below, our Merchant buys a product for $10 and sells it for $20. How much is their markup, and how much is their margin?
Markup = 100%. (The merchant’s product cost of $10 has $10 of markup added, to create a selling price of $20. ($20 – $10) / $10) x 100 = 100%
Margin = 50%. (The merchants selling price is $20, with cost of $10. The retail margin is $10/20 x100 = 50%.
Return On Ad Spend (ROAS)
There are many levels at which ROAS can be calculated. The reason: there are direct and indirect costs of operating a business to sell a product or a service. These are sometimes called hard and soft costs, respectively. Therefore, profits can be stated in different ways, including Gross profit and Net Profit.
$Value of a Transaction (actual selling price, or lifetime value of a customer) divided by the $cost to generate that transaction. This can be expressed as either a multiplier, or a %. Also, it can include only the direct cost, or deeper costs can be included. And it can be calculated at a granular level, or as an average of transactions in specific period of time.
Examples of ROAS: Product and Services
Ecommerce is the purest form of PPC advertising, and ROAS can be tracked, down to the keyword level. For both products and services, PPC ROAS — correctly done — is an amazingly powerful tool. In PPC advertising, the metric named Conv. Value / Cost provides a basic, high-level view of Return on Ad Spend or ROAS.
A product being advertised online has a selling price of $90. If it takes $10 in ad traffic cost to generate the sale of one item, then $90/$10 = a top line ROAS of 9x or 900%. Each dollar spent in ad traffic generates $9 in top line sales.
For deeper reporting and goal setting, the cost of goods and other business costs can be included in the calculation, and also the agency cost. There are other variables to keep in mind, such as the fact that receipts (a.k.a. “tickets”) often include multiple-item purchases, product shipping costs, etc.
Generation of Leads
ROAS can also be calculated on lead generation, but it is more complex. For this, we compare the cost of generating a lead, transaction or customer, to the average $value of a transaction. Or better yet, to the average lifetime value of a customer.
Calculating the initial cost per lead is first step. For many businesses, including incoming phone leads for ad traffic along with online leads helps complete the picture of cost per initial (raw) lead. The next step is the average of how many leads it takes to generate a lead that meets certain sales criteria (qualified lead). And finally, calculating the cost to generate a sale or customer. For services or products with longer sales cycles, this is a reason to have a customer relationship management (CRM) system
TopSide Media’s Top 5 Tips
- Memorize the Markup / Margin / Yellow Brick Road Mantra.
- To correctly frame discussions and reporting related to Markup, Margin, and ROAS, gain a deeper understanding of direct and indirect cost of operating businesses you are involved with, along with their categories.
- Ecommerce ROAS is the purest calculation, and can be done at a top line, or deeper levels.
- To calculate ROAS in PPC advertising, conversion tracking must accurately capture the $value of the transaction. This often requires programming skills, can be complex.
- ROAS can also be calculated on lead generation for products and services, and that requires longer and more involved tracking. Depending on the length of the sales cycle and customer lifetime value, a CRM can be set up.
The next two articles in this series will be on discounting, and customer intent.
We hope you find these useful. If you have questions or comments on these topics, please let us know.