How to Calculate ROI on Advertising Spend

Marketing Unit Economics Overview

To accurately calculate ROI in digital advertising, you need a clear understanding of your marketing unit economics. This article walks you through essential calculations, including how to use an advertising ROI calculator effectively. This will prevent us from throwing spaghetti at the wall and having to clean it up later.

We need to get clear on how much a customer is worth to you, how much it costs to get one, and everything in between.

By defining these necessary terms, the ship can be sailed in the right direction. We can better choose the right advertising channels and audience targeting settings that have the highest likelihood of success.

In addition, we will go over targets you can set for each advertising metric. Keep in mind that these targets are just that, targets. The goal is to stay within that target range, and optimally, below.

Let’s crunch some numbers, shall we?

How to Calculate ROI in Digital Advertising: A Step-by-Step Guide

Calculating Lifetime Value (LTV)

• One of the ways to determine the average Lifetime Value (LTV) of a customer is to take your total revenue divided by the total number of customers. This is sort of back-of-napkin math and not the most accurate.
• Calculate Lifetime Value (LTV) by multiplying the average purchase value by purchase frequency, then divide by the average customer lifespan.
• Note: you may have different LTVs based on different categories within your business. If so, it’s important to keep track of these as well.

Understanding Cost per Acquisition (CPA)

• Once you’ve figured out your average customer LTV, we need to know how much you would be willing to pay to acquire that customer.
• CPA is defined as the costs associated with sales and marketing needed to acquire one new customer. 

Understanding CPA is crucial when learning how to calculate ROI in digital advertising. Knowing this metric helps align your budget with your ROI goals.

Determining your LTV to CPA Ratio and Target CPA

• This is where unit economics really starts to influence your marketing. We need to keep a close eye on the LTV to CPA ratio. While the first goal is always to have a higher LTV than CPA, a ratio of 3:1 or higher is generally considered healthy, indicating that the business has enough funds to cover operational costs, invest in growth, and generate profit. But for our sake, we’ll go with 4:1 to maximize profitability.
• To set a target CPA, you can start by dividing your LTV by 4.

Understanding Payback Periods

• It’s important to realize that almost all profit generated from marketing is earned on the backend, not the frontend. Rarely will that first click or interaction with your business produce enough revenue to pay back acquisition costs. However, through nurturing and delivering in your product or service, you can earn significant long-term returns.
• The payback period is the time it takes for a business to recoup the customer acquisition cost (CPA) through generated revenue.

Figuring Out Your Lead to Customer Conversion Rate and Target CPL

• Your Lead to Customer Conversion Rate represents the percentage of leads that eventually become customers. By knowing this rate, you can calculate the appropriate CPL (Cost per Lead) to stay within your target CPA.
• To set a target CPL, you can multiply your lead to customer conversion rate by your target CPA.

Setting Target Traffic Channel Costs

• Once you know your target CPL, I like to look at the percentage in which your website converts a new visitor into a lead, or your Web Visitor to Lead Conversion Rate. Multiply this percent by your CPL and you have your Target Cost per Click (CPC) on a traffic channel.

So, let’s look at this practically from a marketing perspective.

When you have this knowledge, it puts you at a high competitive advantage, because while some businesses may glance at a marketing channel and balk at the costs per click on a given channel, you can come in and swoop that market share knowing that you could make 10 times the cost from customers coming through that channel.

Let’s Look at an Example:

Say you're a general contractor.

After researching your customer history, you determine that the average LTV (Lifetime Value) of a customer is $8,000.

So, now we have our LTV and can set a target CPA (Cost per Acquisition) of approximately $2,000, or about a fourth of our LTV.

Then, knowing we would be willing to pay up to $2,000 to acquire a new customer, we can go further to determine a target CPL by multiplying the target CPA ($2,000) by your lead conversion rate (15%) to get $300 per lead.

To dial our targets even further, we can assume an average website visitor to lead conversion rate of 3%, which would give us a $9 target for our CPC.

Now, let’s see how this plays out with a $2,000/month advertising budget with an estimated $9 CPC.

• Target CPC: $9
• Target CPL: $300
• Target CPA: $2,000
• LTV: $8,000
• ROI: 300% ($8,000-$2,000)/$2,000)

But, here’s where things get interesting, at least for your wallet.

Let’s say you are able to get the CPC under your target down to $4.

• Estimated CPC: $4
• Target CPL: $300
• Target CPA: $2,000
• LTV: $8,000
• ROI: 800% ($8,000-$888.9)/$888.9)

The ROI nearly triples and CPA drops way down.

That’s the power of knowing your data and optimization. You can play with these calculations in my free spreadsheet.

3 Ways to Lower Your Acquisition Costs

Decrease Your Cost per Click (CPC)

• One of the ways to do this is by decreasing your CPC. While ad platforms will have varied baselines based on industry and target audience, better targeting, copywriting, and design can be rewarded with lower traffic costs and more impressions.

Increase Your LTV

• Create new products and services to upsell customers to increase their value.
• Increase product prices.

Increase Your Lead Conversion Rate

• Nurture leads in order to convert at a higher number.
• Improve your sales and follow-up process.
• Ensure you have the right product-market fit and are hitting the bullseye of what the market really wants, not what’s just convenient for you.
• Take a look at your pricing strategy to determine if there is a better structure that would convert at a higher rate.
• Develop a better user experience on your website.
• Provide more value up front through engaging content.

Thanks for sticking with me until the end!

At the end of the day, regardless of what industry you are in, we are all in the math business—the business of making a profit.

Advertising ROI Calculator: How to Make Smarter Marketing Decisions

To help you visualize all of this into a simple tool, just click here to be automatically directed to a Google Sheet that summarizes everything for you like the example below. Just be sure to make a copy.

A Few Notes on Startups and New Businesses

It can be difficult when just starting out to come up with these numbers without any previous data. In this case, I would advise you to research industry averages.

I also don’t want to give the impression that marketing will and always should make a profit in the short term.

For a new business, it’s quite common and sometimes necessary to require significant upfront investment in order to get the pieces of your brand together.

You’re going to need a logo, you’re going to need a message, a website, and so on…

As stated earlier, marketing return is almost always made on the backend as you nurture relationships with your customers and establish your brand presence in the market.

So, take a deep breath, embrace the process, and remember that you're laying the groundwork for a thriving and profitable venture.

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