Should you scale your ad spend (go hard), or keep budgets as-is (go home)? Here is how I answer that question.
This content originally appeared in the No Best Practices newsletter on 01.15.2023.
I posed the following question on Twitter a few weeks ago:
Let’s say that, in 2022, you drove $5M in new customer revenue and you brought in $900K contribution margin from those orders.
You find out that you LOST money on a third of those orders.
What are your next steps?
Almost half of the folks who answered the poll would try to fix the unprofitable customers, while slightly more than a fourth would scale harder (i.e. increase ad budgets).
So what’s the right answer? There isn’t one. It depends on what you’re trying to accomplish. But I want to take a minute to talk through the nuances of this question, because they hold the key to developing the KPIs you need to manage your business.
How Could This Even Happen?
Most of us are used to looking at average metrics, because that is what most tools provide. But averages sometimes conceal opportunities for growth or improvement.
The situation I outlined above is based on a real scenario that I’ve identified across multiple brands, and it’s driven by assortment and pricing strategy:
- The brand has a broad range of AURs at full price. One example: a knitwear brand that sells $700 Cashmere sweaters and $98 Cashmere socks. So the average order is 1.5 units with a $850 AOV, but the mode (most common) order is 1 unit at $98.
- The brand has a seasonal clearance cadence OR a really aggressive promotional strategy. So the average order is for 1.5 units at full price, but the mode (most common) order is for one unit at 25% off.
If you set your paid advertising KPIs based on the average order, you’re not going to break even on the most common order in either of these scenarios…unless your product margin is much, much higher for the low AUR item.
We typically “take the temperature” of the business based on daily, weekly or monthly averages. In fact, it’s nearly impossible to perfectly attribute ad spend on the individual order level. So we must use averages to make decisions. The question is simply how aggressive we want to get in the pursuit of profit.
“The Rub”
One of my favorite cliches: “there are three sides to every story: yours, mine and the truth”.
When it comes to scaling, one side (honest media buyers) make the very prescient point that CPMs will probably never be cheaper in the future than they are today. What if you could go back in time and run Facebook ads in 2014?
In general, digital marketing costs only go up. Covid proved that there can be macro exceptions, but trends often regress back to the mean. So if you view customer acquisition as an investment, you’d want to “buy low” i.e. invest as much as possible today.
On the other hand, dishonest or ego-driven media buyers might push you to scale your ad spend because they’re putting their own best interests before yours. Everyone wants to say “I managed $XXX million in Facebook spend” or “I spend $10K+ per day on Facebook”.
There are only two ways for a media buyer to accomplish this–start working for a business that is already “doing numbers” (hard), or push all of your clients to spend as much as possible, damn the long term consequences.
Given those two narratives, here is what cuts closest to the truth: if you are a young, bootstrapped brand with relatively low returning customer revenues, you will run out of money if you’re not contribution margin-positive on new customer acquisition.
You can see what costs I factor into contribution margin in the screenshot below. I’ll explain this calculator in more detail in just a minute.
Why Use Contribution Margin To Scale Your Ad Spend?
Contribution margin is the measure of all of the variable costs involved in closing a sale–truly, the “costs of doing business”. You use your contribution margin to pay your employees, your rent and yourself (among other things).
If none of your customer acquisition is contribution margin positive, the average mono-brand eCommerce business will run out of money. That’s because the vast majority of your new customers will not come back and buy again.
I use this worksheet to help clients estimate their contribution margin before ad spend for three different scenarios:
- The most common new customer order (this is the “mode” we talked about at the top of the newsletter).
- The average order–the AOV you get out of Shopify or Google Analytics.
- AOV from Facebook’s in-platform reporting (if FB is their top acquisition channel). Sometimes a brand’s Facebook ads bring in higher or lower AOV customers than average.
To do this yourself, plug in your own average cost inputs in column G and the order values for the three scenarios I outlined in row 5 (all these cells are highlighted in yellow). Quick note–you’ll have to save your own copy of the worksheet.
The bottom portion of the calculator helps you estimate target CAC for different contribution margin goals, including simply breaking even. If all your orders break even, you won’t lose money on each order, but you’ll have nothing left over to pay yourself–or anyone else.
Note that this is all-in CAC: total acquisition spend for a period divided by total customers acquired during that period. So if you run Facebook ads and Google Ads and an affiliate program, the individual platform targets for each of those need to be even more aggressive.
So, Should You Scale Your Ad Spend?
There are scenarios where you’ll want to be more or less aggressive with your contribution margin targets.
Venture-backed DTC brands are the classic example where profitability did not matter…until it did. A media buyer for a brand like this might accept a marketing ROAS of one…or less. This means they’re willing to spend a dollar on ads to win a dollar of revenue.
You’ll lose SO MUCH money doing this. Plug this scenario into the calculator and see for yourself.
At the very opposite end of the spectrum are self-funded brands starting from scratch. These folks put up an initial investment in product development, inventory, a website, etc. They’re already “in the hole” from the start. So ads need to start making money ASAP.
It’s almost impossible to be contribution margin positive on Facebook Ads with a net-new brand from day one. But these folks will have a ruthless process for identifying the most relevant ad creative strategy. Once some winners are identified, they will only scale spend if they can maintain a strict contribution margin target.
By the time your brand is three to five years old, you should have a meaningful returning customer base. This will allow you to get more aggressive with acquisition spend. But don’t get too aggressive, because a number of factors can impact your returning customer revenue forecasts. Especially macro events like Covid, which are becoming more common and harder to predict.
How agro you want to get is entirely up to you…if you are the business owner and/or head of finance. If you’re a marketer, agency or media buyer, you typically don’t have a say in these decisions.
That said, I encourage you to introduce this perspective into the conversation if it’s absent. Sometimes finance literally sets targets by saying “ok we spent 10% of revenue on digital marketing this year and we ended the year with a 9% EBITDA margin, let’s just keep doing this”.
But that conversation happened in 2014, and this is 2023. If you don’t give management a fact-based reality check, you’re in for a bad time.
TL;DR: Average contribution margin on new customer orders is what I consider the “North Star Metric” to scale your ad spend.
What that means: you should be tracking it daily, and any other reporting you do should help diagnose/understand changes in new customer contribution margin.
My next newsletter will outline my “reporting stack” in more detail.