If you want to advertise on any marketing platform for free with an unlimited marketing budget then you need to focus on optimizing just one metric.

This metric is called Profitable ROAS (Return on Ad Spend).

You can never scale your ad spend and marketing efforts if you do not know your profitable ROAS. So calculating it is very important.

What is Profitable ROAS (Return on Ad Spend)?

Profitable ROAS is the minimum ROAS you need to stay within your maximum CPA target.

Following is the formula to calculate profitable ROAS

Profitable ROAS = Average order value / Maximum CPA

• Average Order Value (AOV) is the average value of an e-commerce transaction. Google Analytics report on AOV.
• Maximum CPA is the maximum amount you are willing to spend to acquire one customer without sacrificing your operating profit margin.

Let us suppose, your Average order value is $100 and your maximum CPA is $35

Then your profitable ROAS would be:

Profitable ROAS = $100 / $35 = 2.86 = 3

So you would need a ROAS of 3 or more to stay within your Max. CPA target.

Introduction to Maximum CPA

Maximum CPA (Cost Per Acquisition) is the maximum amount you are willing to spend to acquire one customer without sacrificing your operating profit margin.

Following is the formula to calculate maximum CPA

Max. CPA = operating profit per customer – operating profit per customer you want to keep

The operating profit per customer is the gross income you earned from a customer in a given time period. This ratio metric is used to separate profitable customers from unprofitable customers.

In order to calculate the maximum CPA, you need to decide what sort of operating profit per customer you want to keep.

Technically speaking, you can spend all of your operating profit per customer in acquiring one customer but then you wouldn’t be making any profit. You would be breaking even on every customer.

So in order to make a profit, you would need to decide what percentage of operating profit per customer you want to keep.

However, in order to acquire a new customer, you would need to sacrifice a certain portion of your operating profit. This portion of your operating profit would cover your customer’s acquisition cost.

So you can’t keep 100% of your operating profit as you also need to cover your customer’s acquisition cost.

Consequently, the more operating profit per customer you want to keep, lower would be your Maximum CPA.

Operating Profit Per Customer

Operating profit per customer is the gross income you earned from a customer during his lifetime.

Following is the formula to calculate operating profit per customer:

Operating profit per customer = Customer Lifetime Value – (average refund per customer + average direct cost per customer + average operating cost per customer)

• Customer lifetime value (also known as LTV) is the projected revenue your customer will generate during his lifetime.
• Direct costs include the cost of manufacturing/procuring goods + cost of delivering the goods (shipping cost). In the case of services, direct costs include the cost of delivering the services
• Operating costs are the ongoing costs of running a business. The operating costs can include employee salaries, administrative expenses, office rent, water, gas, and electricity, etc.

Let us suppose:

Your customer lifetime value is $300

Your Average refund per customer is $80

Your Average direct cost per customer is $70

Your Average operating cost per customer = $25

So your operating profit per customer 

= $300 – ($80  + $70 + $25) = $125

This is the gross income you earned from a customer during his lifetime.

Customer Lifetime Value

Customer lifetime value (also known as LTV) is the projected revenue a customer will generate during his lifetime.

Different types of customers (like high-value customers, low-value customers) tend to have a different lifetime value. So it makes sense to calculate LTV for each unique segment of customers (i.e Cohort).

Note: LTV calculations make sense only when you are getting repeat business and when you expect repeat business from the same customers.

Following is the formula to calculate LTV:

Customer Lifetime Value = Average Order Value * Average Purchase Frequency * Average Customer Lifespan   

• Average Order Value (AOV) is the average value of a transaction. Google Analytics report on AOV.
• Average Purchase Frequency is how often on average, the customers make a purchase on your website. For example, your customers may purchase once every 6 months.
• Average customer life span is the average duration (number of weeks, months or years) people remain customers of your business.

Let us suppose,

Average Order Value = $100

Average Purchase Frequency = once every 52 weeks (i.e. once every year)

Average customer lifespan = 156 weeks (i.e. 3 years)

So Customer Lifetime Value = $100 * 1 purchase per 52 weeks * 156 weeks = $100 * 1/52 * 156 = $300

Operating profit per customer you want to keep

The operating profit per customer you want to keep depends upon your operating profit margin and customer lifetime value.

The following is the formula to calculate operating profit per customer you want to keep

Operating profit per customer you want to keep = (operating profit margin * customer lifetime value)

• Operating profit margin (also known as operating margin) is the percentage of total sales that remains, after all direct and operating costs have been deducted from the total sales.

Higher your desired operating profit, lower is going to be your Max CPA

In other words,

Higher your desired operating profit margin, lower is going to be your Max CPA

The more operating profit you keep, the higher would be your operating profit margin. As a result less amount of money would be left to acquire a new customer.

Conversely, the less operating profit you keep, the lower would be your operating profit margin. As a result more amount of money would be left to acquire a new customer.

In other words,

Higher your desired operating profit margin, the less amount of money would be left to acquire a new customer.

Conversely,

Lower your desired operating profit margin, the more amount of money would be left to acquire a new customer.

If you are operating in a very competitive/saturated market then your average cost per acquisition is going to be pretty high. In that case, you can not afford to operate with a high operating profit margin. You would then most likely be operating on a very low-profit margin.

For example, if you choose an operating profit margin of 40% then you would keep 40% of Customer Lifetime Value i.e.

40% * $300 = $120 per customer.

So operating profit per customer you keep = $120

That would leave you with just $125 – $120 = $5 to acquire a new customer. So your Max CPA would be $5. You can spend up to $5 to acquire one new customer.

On the other hand, if you choose an operating profit margin of say 30% then you would keep 30% of Customer Lifetime Value i.e.

30% * $300 = $90 per customer.

So operating profit per customer you keep = $90

That would leave you with $125 – $90 = $35 to acquire a new customer. So your Max CPA would be $35. So you can spend up to $35 to acquire one new customer.

Your Maximum CPA depends upon your desired level of profitability and your industry.

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How to Calculate the Operating Profit Margin

Operating profit margin (also known as operating margin) is the percentage of total sales that remains after all direct and operating costs have been deducted from the total sales.

The following is the formula to calculate the operating profit margin:

Operating profit margin = (operating profit / customer lifetime value) * 100

Here, 

Operating profit is the company’s operating profit.

The general formula to calculate the company’s Operating Profit Margin is:

Operating Profit Margin = (Operating Profit / Revenue) * 100

Here instead of using total sales, we are using total customer lifetime value.

Note: The operating profit margin is measured and reported as a percentage.

Other Articles on Cost Per Acquisition (CPA)

• CPA Analysis in Google Analytics Multi-Channel Funnel Reports
• CPA optimization – How to reduce cost per acquisition
• Do ROI Analytics, Calculate ROAS in Google Analytics
• How to advertise on Facebook for FREE with unlimited budget

Frequently Asked Questions About How to calculate maximum CPA and profitable ROAS