How to calculate maximum CPA and profitable ROAS?

Maximum CPA (Cost Per Acquisition) is the maximum amount you are willing to spend to acquire one customer. 

You will never be able to scale your marketing campaigns and efforts, if you don’t know your maximum CPA (Max. CPA).

In order to calculate Max. CPA you would first need to calculate customer lifetime value and Customer profitability score (i.e. Operating profit per customer).

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)

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

Following is the formula to calculate LTV:

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

Here,

Average Order Value (AOV) is the average value of a transaction. Google Analytics report on AOV.

Average Purchase Frequency is how often on an average 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 24 weeks (i.e. 6 months)

Average customer lifespan = 52 weeks (i.e. 1 year)

So Customer Lifetime Value = $100 * 1 purchase per 24 weeks * 52 weeks = $100 * 1/24 * 52 = $216.67

Operating profit per customer (Customer Profitability Score)

Customer profitability score 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.

Following is the formula to calculate customer profitability score:

Customer profitability score = Customer Lifetime Value – (avg. refund per customer + avg. direct cost per customer + avg. operating cost per customer)

In case of products,

Direct costs include the cost of manufacturing/procuring goods + cost of delivering the goods (shipping cost).

In 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,

Average refund per customer = $20

Average direct cost per customer = $80

Average operating cost per customer = $10

So Customer profitability score = $216.67 – ($20 + $80 + $10) = $106.67

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

The more operating profit you want to generate, the higher your operating profit margin needs to be.

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 operating profit margin:

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

Note: Operating profit margin is measured and reported as percentage.

Technically 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 you would need to decide what sort of operating profit per customer you want to earn and maintain.

However,

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

Consequently,

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

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

40% * $216.67 = $86.67 per customer.

So operating profit per customer you want to keep = $86.67

That would leave you with just $106.67 – $86.67 = $20 to acquire a new customer.

So your Max CPA would be $20

So you can spend up to $20/$100 = 20% of your ‘average order value’ to acquire one customer.

 

On the other hand, if you choose an operating profit margin of 20% then you would earn 20% of Customer Lifetime Value i.e.

20% * $216.67 = $43.33 per customer.

So operating profit per customer you want to keep = $43.33

That would leave you with $106.67 – $43.33 = $63.34 to acquire a new customer.

So your Max CPA would be $63.34

So you can spend up to $63.44/$100 = 63.44% of your ‘average order value’ to acquire one 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 high operating profit margin.

You would then most likely be operating on a very low profit margin.

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

Operating profit per customer = customer lifetime value – (avg. refund per customer + avg. direct cost per customer + avg. operating cost per customer)


Customer lifetime value = (average order value * average purchase frequency * average customer life span)

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

You decide your operating profit margin based on your desired level of profitability and your industry.

How to calculate profitable ROAS (Return on Ad Spend)

Profitable ROAS is the ROAS you need to stay within Max. CPA

Say you spent say $25 on Facebook ads to generate 1 sale of $100 then your ROAS = $100 / $25 = 4

But since your CPA from Facebook ads ($25) is higher than your max CPA of $20, you won’t be profitable.

So what should be your ROAS to be profitable?

Profitable ROAS = Average order value / Max. CPA

             = $100 / $20 = 5

You would need a ROAS of 5 or more to stay within your Max. CPA

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Certified web analyst and founder of OptimizeSmart.com

My name is Himanshu Sharma and I help businesses find and fix their Google Analytics and conversion issues. If you have any questions or comments please contact me.

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