Driving sustainable profit is at the core of every successful business. Profit allows companies to invest in R&D, hire new employees, market their products, and much more.
But when it comes to digital marketing, most companies rely on metrics that don’t accurately measure profit. Instead, they use metrics like return on investment (ROI), return on ad spend (ROAS), cost per conversion, or reach. Although these are good indicators of profit, they don’t tell the full story.
Before getting much further, let’s take a moment to define profit. In a nutshell, profit is a financial gain. If we look at it through the lens of a business, profit can be expressed as the difference between the amount earned and the amount spent to produce and sell a product.
When it comes to advertising, we generally look at gross profit, which is expressed in the following formula:
Gross Profit = Revenue - Cost of Goods Sold
We can also express gross profit as a percentage, otherwise known as a profit margin. Here’s the formula for the gross profit margin:
Gross Profit Margin = (Revenue - Cost of Goods Sold) ÷ Revenue
So this begs the question, why should marketing be looked at through the profit lens rather than metrics like ROI? The simple answer is metrics like ROI, although valuable, can be misleading indicators if a business wants to maximize profit.
Let’s geek out: assume you’re running a business. You have the choice to sell 10 products at $100 each, or 1,000 products at $10 each. One situation sells fewer products at a higher margin, and the other sells more products at a lower margin.
Pretty simple! Company 1 is a winner if we’re looking to maximize product margin, and Company 2 is the clear winner if we’re looking to maximize Revenue.
Now let’s assume you start to advertise on Google. Let’s add in the cost of advertising and ROI.
Imagine if you were Company 1 - this would be great, right? You command a great ROI and start to think of ways to optimize the ad spend to make it even better. This might include things like weeding out underperforming keywords or testing new ads.
If you were Company 2, things might look a little different. With a lower ROI, you may think about ways to cut the advertising cost to increase the ROI, or even look at a cost / benefit analysis of raising the product's price to increase revenue.
In either case, companies that use ROI as a primary metric tend to analyze the performance of their advertising budget in ways that improve ROI.
Let’s take the final step and add in profit margins.
Oh, how the tables have shifted!
Company 2 sells products at a lower margin, spends more on advertising, and has a lower ROI. If looked at individually, all these metrics would indicate Company 1 is more successful than Company 2. But the reality is just the opposite - Company make 5 times more profit than Company 1!
So what’s the main lesson from this example? Metrics like ROI, ROAS, cost per conversion, and reach can be misleading indicators of how successful a company is. For that reason, profit is the best metric to use when optimizing an advertising portfolio.
As an example, Company 2 may start to optimize their Google Ads account by testing new ad copy, weeding out underperforming keywords, and transitioning to a new attribution model. When the testing takes place, Company 2 will monitor how the optimizations affect profit. It could be that switching attribution models decreases ROI, but increases over all profit - this is still a win for the business!
To apply this to your business, make sure you have a good understanding of the business's Gross Margin, and then apply this to your advertising in whatever measurement system that works best. Over time, monitor how different advertising techniques affect profit, and make adjustments as necessary.
Stay tuned: in our next blog, we’ll explore ways to optimize towards profit in more depth.
Contact Makalu Marketing with questions or comments!