Wednesday, June 23, 2010

For More Accurate Marketing ROI, Think Incrementally

Return on investment (ROI) is a financial measure that managers use to guide major investment decisions.  For example, suppose that you are considering a business expansion opportunity that will require the purchase of new machinery and certain other investments.  To evaluate this potential expansion, you would discount all of the future profits and expenses related to the expansion and calculate a net present value for the expansion opportunity.  Then, you would use those net present values to compare the gain from the expansion investment with the cost of the expansion investment and calculate the projected ROI of the expansion project.

When we use ROI to evaluate prospective marketing investments, we need to adapt the traditional ROI analysis process a little, primarily because unlike most major capital investments, marketing investments can often be made in relatively small increments.  In other words, marketing investments are often not simple "go-no go" decisions.  In many cases, the more difficult questions relate to the size and scope of a potential marketing campaign or program.  How long should the campaign run?  How many prospects should be targeted, and how many times should they be contacted?

For example, suppose that you are considering a direct mail campaign to generate new sales leads for your B2B company.  You have identified three mailing lists that you could use in this campaign.  Each of these lists contains 1,500 names.  The first list (List 1) is a "house" list that includes prospects that your company has had some previous contact with.  Therefore, you believe that List 1 contains the best prospects and will probably produce the most new customers.  List 2 and List 3 are both outside lists that you can purchase, and based on past experience, you believe that List 2 will be more productive than List 3.  The question is:  Should your campaign target only the prospects in List 1, or those in List 1 and List 2, or those in all three lists.

The table below shows the estimated costs and the projected results of all three alternative versions of the campaign.  The top portion of the table shows the overall ROI calculations.  The lower portion of the table shows the incremental results as you move from the first option to the second and from the second to the third.

For this example, let's assume that your company requires that all proposed marketing investments show a projected ROI of at least 15 percent.

If you look at the overall ROI calculations shown above, you would probably recommend including all three mailing lists in the direct mail campaign.  Even though the projected ROI of 57.5 percent is lower than the other two options, it still far exceeds your company's ROI threshold of 15 percent.  The three-list option also generates the highest projected total return ($15,750) and the highest projected net return ($5,750).

However, if you look at the incremental analysis, you see a different story.  Here, you see that if you include List 3 in the campaign (as opposed to only List 1 and List 2), your company will incur $2,500 of additional costs, and you will increase your net return by $250.  This means that the incremental ROI generated by including List 3 in the campaign is only 10 percent.  Since this falls below your company's ROI threshold, you would probably recommend against including List 3 in the campaign.

This example illustrates how the incremental approach to analyzing marketing ROI can lead to more profitable marketing decisions by measuring the incremental value of each incremental investment.

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