Strategic insights
Calculating the Return on Investment of Your Advertising Campaign

Too many marketing managers don't follow the money all the way to a transaction. They just calculate the cost per click and as such neglect to consider that only a fraction of each click actually results in a sale.

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Avinash Kaushik
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Too many brands buy online advertising the same way that they did with print. They buy it based on level of exposure instead of real things like how many products are likely to sell. In the past, this was measured against the number of times an ad was exposed to the readers. Today, we do something very similar, we just measure impressions and click-throughs.

But the problem with all of this is, that it doesn't tell you anything about how much money you will actually make (or won't make) from advertising. Most brands still don't follow the money, and it is causing all kinds of problems in other areas, including in social media. Brands get caught up on boosting engagement, sometimes by using fancy tactics that are actually lowering your conversion rate. I wrote much more about that in 'Social Conversion Rates: Where The Real Value Comes From'.

We also see it with brand blogs, where brands are more concerned about page views than actually converting readers into customers. Instead of posting insightful and inspiring content, they post funny pictures of things completely unrelated to your brand's purpose.

Exposure, click-throughs, engagement, and page views are all very nice things, but they are all a means to an end. They are not the end itself.

The following is my simple guide for calculating the actual value of display advertising, and more so, what the maximum allowed CPM or CPA/CPC (cost per action/click) can be.

First, you need to ask yourself five simple questions:

1. What is your revenue per transaction? Let's say it's $99
2. How much of that is cost? Let's say it's half: $50
3. What is your online conversion rate per referred visitor? Let's say that is 5%
4. How much of your profit are you willing to lose to advertising in return for a sale? Let's say that's 10%
5. What is your click-through rate? It's usually 0.5%

With these five numbers we can now start to calculate a whole bunch of interesting things. For instance, we can calculate the maximum allowed advertising cost per conversion. This is the maximum amount of money that your advertising can cost, per sale. You take the revenue, subtract the cost, and multiply that with how much of your profit you are willing to lose to advertising:

• (transaction - cost) * 10% = $4.9

You now use this number to calculate your maximum acceptable CPM and CPA/CPC. Remember, that with a conversion rate of 5%, you need 20 clicks to get just one sale.

• CPA/CPC: $4.9 * conversion rate = $0.245
• CPM: (($4.9 * conversion rate) * click-through rate) * 1000 = $1.225

You can now use this to work the other way.

A $4 CPM campaign

Let's say you have agreed to an advertising campaign at $4 CPM ($4 dollars per thousand views). And by the end of the month, your ad has been seen by 1.2 million people.

You can then calculate your expected number of transactions, by first multiplying the 1.2 million views with your click-through rate and your conversion rate.

• (1.2 million * click-through rate) * conversion rate = # of transactions
• (1.2 million * 0.5%) * 5% = 300 transactions

Now we need to figure out of the cost. With a CPM at $4 you simply multiply that with your views, divided by 1000 (since CPM is 'cost per thousand'). The result in this example is $4,800.

• Total cost = (1.2 million / 1000) * $4 = $4,800

Now we take this number and divide it by the expected number of transactions, and we get the actual advertising cost per sale.

• Cost per sale = $4,800 / 300 = $16

As you can see, this is an extremely expensive campaign, and it's well above the 10% maximum threshold you had set.

paying $2 per click?

We can also measure it based on a CPA campaign, like paying Facebook or Google $2 per click. This is probably what most people do, because then you only pay for each click and not how many times an ad might be viewed. The idea is that this is more valuable, because of an assured result (a click).

It also makes your calculations much simpler, because all you do is that you divide your costs per click with your conversion rate.

Cost per sale is then: $2 / conversion rate = $40 per sale

Again, it is much higher than your maximum allowed limit of $4.9.

Too many marketing managers don't follow the money all the way to a transaction. They just calculate the cost per click and as such neglect to consider that only a fraction of each click actually results in a sale.

Advertising vs lifetime customer value

Some will say this is simplified way to look at it, because what about the life-time value of a customer? Great question! Let's consider that.

To calculate the lifetime customer value, you need to ask three more questions:

What is your life-time customer rate? The number of people who return after their first transaction. This will vary greatly from one brand to another, and the time frame will vary greatly as well. For instance, I bought myself a Ford Focus back in 2004, and I might buy myself a new Ford Focus Electric in 2014. I also bought groceries for $150 a week ago, and I plan to buy more, from the same place, next week.

In order to calculate your life-time customer rate you have to first define what timeframe to look at. But let's say it's 20% within whatever timeframe you define. In short, 20% of your new customers turn into repeating lifetime customers.

What is your lifetime customer value? Again, this will vary greatly depending on what kind of product you sell. But let's say it's one transaction every two months.

Then we have to define how many years do we want to calculate 'our investment' for, but let's say that whatever we invest in getting a customer today has to be fully repaid in 3 years.

So let's say you agree to an advertising campaign where you reach a million people, what would that result in? It's a bit tricky to explain, but let me visualize it:

First we calculate the number of clicks and transactions, like before. One million multiplied by our click-through rate is 5,000 clicks, multiplied by our conversion rate which is 250 transactions.

We take those 250 transactions and divide them into one-time vs lifetime transactions. Remember the life-time customer rate was 20%.

Now we need to calculate the profit from each group, which we simply do by multiplying it with revenue minus the cost.

We then take the maximum acceptable loss of profit to get a sale, the 10%, and that gives us the one-time acceptable advertising costs. This is the maximum amount of money that we are allowed to spend on advertising, if people only bought something once.

Now, we have to calculate the lifetime acceptable loss to advertising. Of course, the one-time transactions don't accumulate any life-time value, so that stays the same at $980. But the 50 lifetime customers continue to buy every two months for the next three years (and hopefully more, but that was our investment period). So we multiply the lifetime value by 18 (the number of transactions they will have over the next three years).

And when we then add these two numbers together, we get the total acceptable advertising cost for this campaign. That is the maximum amount of money you can spend on this campaign - taking into account the lifetime customer's value.

And remember, this cost has to include the cost of producing the campaign itself, the time you spend making the creatives, and the cost in time you spend setting it up.

The final step is then to calculate your CPM and CPA/CPC. With the CPM, you take your total acceptable cost and divide it by the number of views, per thousand. In this example, it gives you a CPM of $5.39.

For CPA/CPC, it is slightly simpler. You just divide your total acceptable cost with the number clicks, which in this case is only $1.08.

This is just an example, you now need to do the same thing but using your own numbers. Obviously it will change a lot depending on your product and your lifetime cycle.

For instance, if you are an author trying to sell your books for $9, online display advertising rarely makes any sense. If your revenue is $9 and your cost is $6, but the rest is the same, your total acceptable advertising cost for exposure to one million people drops to only $330, or a CPA of 7 cents.

On the other hand, if you products sell for $499 (with a cost of $200), and you sell one to lifetime customers once every two years, with a 5 year lifetime investment cycle, you can suddenly be able to afford a lot more for your advertising. The acceptable CPA cost increases to $3.06, and the acceptable CPM cost increases to about $15. This is why it makes sense for Apple to buy so much advertising.

It also demonstrates the enormous power there is in your lifetime customer value. Too many brands only think of that one sale, but as you can clearly see, the value of the one-time transactions are irrelevant compared to what you can earn if you focus on building up a relationship with your customers.

What about social?

One big thing that is missing from this example is the effect of social. What about the viral effect of the people sharing your products? That is a great question, but I won't go into that in this article because it's quite complicated.

You have to look at things like:

• Do people share your products without buying something?
• How many of your clicks also result in a social story?
• How many of your transactions result in a social story?
• Is there a difference between one-time and lifetime customers?
• Will the act of following you increase the social effect of you advertising? Or will your advertising increase how many people follow you? Or both?
• How often will your lifetime customers share what you do? With every transaction, with every 4th transactions, with every 10th?
• What is the social share rate per transaction?
• What is the social reach per share?
• What conversion rate do you get from the result of social sharing?
• Is there actually a correlation between the social effect and advertising exposure/click-throughs ...or is the correlation actually based on other factors?

It's also worth remembering that social is not a pre-conversion activity, it's a post-conversion activity. Social happens *after* people have been influenced by what you do, and that then results in a viral effect that loops back to a new pre-conversion.

This makes social very special, because unlike traditional advertising, where you start with a mass market and end with a targeted converted audience, social starts with a converted audience. If you do it well, it can spread to a much larger mass market, which leads to a new conversion, which then leads to a new mass audience. So you get this modulating effect from pre-to-post conversions and back again.

One day I would like to improve the above illustration to include the effect of social and show you the potential impact of all these social touch points. But until then, see my other article: Social Conversion Rates: Where The Real Value Comes From.