A very common acronym that gets tossed around in DTC circles is ROAS, or “return on ad spend”. As we like to say here at Triple Whale, “You’re Not Your ROAS”, but maybe you should get to know it a little better.
In the simplest of explanations, Return on Ad Spend is defined as Ad revenue divided by ad spend (click here for a primer on ROAS). However, for something that seems relatively straightforward, the term has many derivatives and has become somewhat obscure in recent years - especially in the post iOS14.5 world. Perhaps you’ve heard of “in-platform ROAS,” “Blended ROAS,” “Target ROAS,” “Breakeven ROAS,” and some other metrics yet to be uncovered or defined.
Today, I want to explore what I believe is the most critical derivative of the return on ad spend metric for hyper-growth businesses: Breakeven ROAS.
If ROAS is calculated as ad revenue divided by ad spend, breakeven ROAS is the ROAS where you breakeven on acquiring a customer. This metric depends on three components: AOV (Average Order Value), Gross Margin, and CAC (Customer Acquisition Cost) - also known as your unit economics.
We can think about unit economics as essentially a profit-and-loss (P&L) statement, but reduced down to the single order level, and specifically for a new customer’s first order. You start with AOV, multiply it by your gross margin, and then subtract your CAC. When the result you get is zero, your AOV divided by your CAC equals your breakeven ROAS. I also call breakeven ROAS ‘critical MER’ (for critical marketing efficiency ratio), but let's stick with breakeven ROAS for simplicity.
Visualized below, if you have an AOV of $50, and a gross margin of 50%, you have gross profit of $25. If you have a CAC of $25, your net income is exactly zero dollars and your breakeven ROAS is AOV / CAC ($50 / $25), or exactly 2.0x.
In high growth companies, breakeven ROAS allows us to identify the variable profit breakeven point for new customers. You may be thinking to yourself, don’t I want to make money on acquiring a new customer? It’s a valid point! But when it comes to higher growth businesses, the objective may be to acquire as many customers as it can, as quickly as possible (within reason). When this happens, the business may take a loss up front in order to acquire those new customers that will hopefully become return customers. If the company can break even on the first purchase, every purchase thereafter will be generating a positive contribution margin on a customer-level basis.
This strategy allows a company to keep its foot on the gas to acquire new customers quickly without dipping into the upside-down economics (in the situation where customers don’t return). If a product is more of a ‘one and done’ type purchase, this strategy won’t be as fruitful as a product that creates a return customer.
Once a company acquires a critical mass of customers, the profit on returning customer cohorts is entirely gross profit. Since they’ve already paid the customer acquisition cost, these returning customers will hopefully spend enough money to cover all of the ‘below the line’ expenses like salaries, rent, travel, and the like, so that the business will then generate a net income profit.
In this situation, the contribution margin per customer over time will look similar to this:
Breakeven ROAS can be a North Star for many high growth consumer businesses with recurring revenue. Where a lot of brands of the early 2010s got themselves into trouble was by being willing to dip so far into the red on contribution margin on the first purchase. Even with strong customer lifetime values, they never were able to generate enough recurring revenue to cover the cost of acquisition, and thus were stuck in permanently upside-down unit economics. This is sure to kill any business once its unable to raise capital in an effort to outrun the operational inefficiencies. In the more modern DTC landscape, brands are generally looking to generate positive cash flow sooner than later, and starting at zero means that even $1 of subsequent cash flow can get you unit economics into the black.
It misses everything below the line, meaning everything beneath the contribution margin line in the profit-and-loss statement. This means any cost of running the business outside of product costs, shipping costs, payment processing fees, advertising, and any other variable expenses that are incurred to generate an order.
So what’s usually left over after those expenses? Well it depends on the business, but to name a few, generally businesses will have salaries, legal fees, banking fees, taxes, interest, and more. We call these expenses ‘general and administrative expenses’ (G&A). Breakeven ROAS, as I have described it, does not contemplate these expenses. There is certainly a version of breakeven ROAS you can calculate to take into account all of your G&A or fixed overhead, but generally speaking, breakeven ROAS in hyper-growth consumer startups is best considered within the context of your unit economics.
Breakeven ROAS does not take into account how your business is staffed, how many legal fees you rack up, how much interest you are paying, or really anything that goes beyond your ad spend within your P&L.
Therefore, it’s important to be mindful of how much fixed overhead your business requires. I’m not declaring that as long as you are breaking even on a first purchase that your business is going to make it. There are many other factors that go into generating net income profitability. Additionally, it’s worth noting that a brand pursuing the strategy I’ve outlined in this article would have to generate some sort of EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) burn for some period of time, and would need to have adequate capital to do so.
So there you have it: breakeven ROAS. I want to reiterate that this version of a breakeven ROAS is just one of the many derivatives of ROAS that exist. In order to be successful, you need to understand many different aspects surrounding the way your advertising is generating return, and it would be foolish to only consider one metric. That said, I do hold the strong opinion that breakeven ROAS is a very powerful North Star in corporate budgeting. It can help set you up for healthy unit economics, balance your growth with your runway, and much more when harnessed correctly.
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