The e hustle 34: Let me bust a paid media myth

Read time: 2 mins

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This week’s newsletter has been an easy topic to come up with, as I think I've counted 6 online businesses that have approached me this week with big profitability issues, all with similar symptoms. 

It’s become increasingly predictable each time I take these calls.

Most retailers approach me saying that something I’ve said has resonated with them, and my answer is always the same - I know, that’s why I said it. You see if it’s happening in your business, the chances are it’s a common issue that’s happening in a lot of businesses.

There’s a common problem out there, and this is it.

The common problem

Retailers are being told that spending more on Facebook is the key to growth, even when they aren’t profitable.

That’s wild.

Here’s the scenario.

You’ve worked out your gross profit margin, with your variable costs including marketing, then you’ve worked out your fixed costs, and you think you can spend the difference.

Except that is not how it works. 

Quick math:

Your COGS are 30% (that makes your margin on your product at 70%).

Other cost of sales (COS) are 15%

That leaves your gross profit margin at 55% (70% - 15% = 55%). 

Now, let’s switch to your fixed costs (less marketing), which sit at 30%.

You have a 25% gap - 55% minus 30% = 25%.

You spend that 25% on ads, leaving you at breakeven, but thinking that it will scale your revenue so hard that your fixed cost rations will somehow come down to 20%, leaving you with a 10% profit.

Except that doesn’t happen, because to scale your sales you go on sale, which hits your gross profit margin. Then you run out of money, so you borrow money to scale, and the interest hits your cash flow - because you know, interest doesn’t sit on the OPEX line of the P&L, so we don’t worry about that right? Wrong.

You’re in a self-fulling death spiral

• You can’t stop spending because you’re too dependent on Facebook ads
• You can’t stop spending because your fixed costs are too high for your size, and when you drop your spend your sales come down, even though it’s not profitable you need to pay your bills
• You are the opposite of recession proof - the moment sales go soft, your business and cashflow is under intense pressure

Here are a few reasons why this strategy falls apart

• You don’t know your fixed cost ratios or can’t achieve the ones you incorrectly entered into your model - model breaks
• You don’t know with 100% accuracy your cogs or margins - model breaks

Here are some warning signs that you might be in this cycle

• Your sales have grown but not your bank account

• You're constantly borrowing money 

• Your sales are good when your discounting but the rest of the year is stressful

• You’re spending over 25% on ads and your gross profit margin is under 55%

• You feel the stress of needing to go on sale or spend more on Facebook to cover your fixed costs

• You aren’t paying yourself what a multi million dollar business should be
• It just doesn’t feel right

That is a broken model that needs to be fixed.

Let me let you in on a little secret. The quickest way to improve profitability is to cut costs, not increase spend. If you’re spending 25-35% on Facebook ads, I have simply never seen a business be taking home a healthy net profit of greater than 20%.

The brand I work with that has the highest NET profit margin currently is 35% and they’re making $4m per month. They spend 11% on ads.

The next highest NET profit is 30% and they spend 10% on ads.

At the end of the day, it doesn’t matter what I think

If you’re spending over 25% on ads, and you aren’t living the life you thought you would be, then that’s probably a better indication than reading this email, that something isn’t right with your business model.

Finally, if we all have the same strategy, which is to spend our way to the top, then we're all just flogging products with the same strategy, and competing against ourselves to drive paid media costs up. There's usually one winner there, and it's not the brand.

Remember, it's unlikely that Branson, Musk, Arnault and co go home and talk about scaling their Facebook spend.

If only it were that easy, we'd all be rich, and no businesses would fail.

Until next week,

Paul

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