The Great DTC Reset: From Growth Addiction to Profitable Operations

Key takeaways for ecommerce brands:

1. Rising customer acquisition costs are making traditional ad-based growth strategies unsustainable, with brands spending up to 50% of their marketing budgets on increasingly expensive paid ads.
2. Common metrics like ROAS and CAC can be misleading as they don't account for crucial costs, leading to false assumptions about profitability.
3. Success in today's DTC landscape requires mastering financial fundamentals, lifetime value (LTV) per SKU, profit on ad spend (POAS), and new customer acquisition cost (nCAC).

In 1962, the American philosopher of science Thomas Kuhn coined the term "paradigm shift." What has become one of the most used phrases in the English language was conceived to explain why and how scientific revolutions happen, though it's really relevant for any type of intellectual change. And in the context of DTC ecommerce, it seems like a paradigm shift is needed to deal with the collapse of its classic playbook – growth through ads.

DTC operators know this all too well: ad platforms have become increasingly more expensive. “We saw the cost to advertise double between 2019 and 2023,” said Carla Penn-Kahn, an ecommerce veteran with four successful ventures under her belt. “It used to cost us anywhere between $20 and $25 to acquire a customer. We were pushing $40 to $50 to acquire a customer by the time we sold out.”

Penn-Kahn sold her latest ecom business – Kitchenware Australia – when she “realized the unit economics didn't work.” Other DTC brands, who continued to spend on ads, kept seeing their margin profile shrink. Temple & Webster, Australia's largest pure-play ecommerce retailer in the furniture and homewares market, is a good cautionary tale; in the last fiscal year, it increased its advertising and marketing costs by 62%, while revenues only grew by 26%.

Temple & Webster is not alone. Netcore Cloud, a global MarTech company, surveyed over 300 businesses worldwide in Q4 of 2023. The results were published in its State of Ecommerce and Retail Marketing 2024 report. Key findings include:

• On average, brands are allocating 35% of their budget to paid ads for customer acquisition.

• 1 in 4 brands will allocate over 50% of their marketing budgets towards paid ads this year.

• 80% of brands anticipate that rising customer acquisition costs will significantly impact business operations going forward.

‍Caught in the Ad Spend Spiral

The negative impacts of rising customer acquisition costs are only expected to get worse. “Brands feel they have little or no choice but to continue spending because they have few alternatives to reach out to new digital customers,” explained Rajesh Jain, Netcore Cloud’s Founder and Managing Director. “The result: brand profits are taking a hit, and big AdTech amasses even more power.”

Ironically, one of the biggest reasons brand profits are taking a hit is that they don't prioritize business profitability. Much of this has to do with DTC marketing agencies. The two main metrics DTC agencies use to track the effectiveness of marketing and ad spending are:

• Customer acquisition cost (CAC) – i.e., the amount a brand spends, on average, to acquire a new customer.
  
• Return on ad spend (ROAS) – the revenue generated by an advertising campaign relative to the amount spent on that campaign.

Many marketing agencies are still hyper-focused on improving ROAS, promoting it as the most important metric in ecommerce. There's only one problem: it does not equal profitability. You can have a sky-high ROAS but still make very little profit or even lose money on an ad campaign, because ROAS doesn't account for cost of goods sold (COGS), overhead expenses, and other operational costs. 

Without including all these costs, your break-even ROAS – the ratio at which revenue generated by the campaign equals the cost of advertising – will not be accurate. Unfortunately, this often happens when marketing agencies help clients calculate their gross margin. Here's a typical chain of events:

1. The agency will ask the client to share their COGS (while they should be asking for landed costs per SKU)

2. Based on the client's COGS, the agency will roughly calculate the gross margin and determine their break-even ROAS.

The True Cost of Incomplete Cost Analysis

Of course, the buck does not stop with marketing agencies. Ultimately, DTC operators are responsible for their profitability. That requires, first and foremost, in-depth knowledge of financial principles and ecommerce accounting. For example, most ecommerce brands don’t know their lifetime value (LTV) per SKU. This is problematic, as it can lead to overspending on acquiring customers who purchase the least valuable SKUs.

While brands are getting wise to their bottom line, there's still some catching up to do. “We're hearing a lot of people say ‘I want my agency or my performance marketer to optimize advertising for profitability,’” said Penn-Kahn, an industry leader in Australia. “But then, when we actually speak to them on how they're measuring profitability on advertising spend, they look at us pretty stumped.” 

To measure the profitability of their advertising expenditure, brands need to focus on POAS (profit on ad spend) instead of ROAS. In other words, how much money do you get back on your net bottom line per $1 you spend on advertising.

In addition, brands need to look at the right form of CAC to address the matter of scale in business. There are two main forms of CAC:

• Blended CAC (also known as normal CAC) – i.e., the costs of acquiring new customers and retaining existing ones.
  
• nCAC (new customer acquisition cost) – which measures the cost involved in acquiring new customers.

Since it's difficult to achieve scale in business by acquiring existing customers, brands should monitor their nCAC to evaluate the efficiency of their marketing spend.

The evidence is clear: as acquisition costs continue to climb, brands can no longer rely on surface-level metrics like CAC and ROAS to guide their decisions. Success in today's market demands a laser focus on business profitability, underpinned by ecommerce accounting knowledge and careful optimization of advertising spend. The survival of DTC brands depends on recognizing and embracing what this moment demands: a paradigm shift.

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