Tuesday, August 3, 2010

Increased Profits, Not Higher Sales, Determine Marketing ROI

Return on marketing investment has become a hot topic as marketers seek to prove the value of their activities and programs and strive to bolster their credibility in the C-suite.  Today, marketers are using ROI for everything from justifying marketing budgets to measuring the performance of individual campaigns.

Given its increased use and popularity, you would think that the process for calculating marketing ROI is now well understood.  Unfortunately, I still see far too many examples of marketing ROI that has been calculated incorrectly - in many cases by people who should know better.

One of the most common errors is the use of increased revenues (sales) rather than increased profits when calculating marketing ROI.  To illustrate this error, take a look at the following table.  I based this table on an example ROI calculation that appears on the Website of a well-known national provider of direct mail services.  I won't name the company because they are only one of many companies that use this methodology.

In this example, Return On Investment (ROI) was calculated by dividing Total revenue ($1,250) by Total cost of the mailing ($550), resulting in an ROI for the mailing of 227%.

That ROI number looks fantastic, but the problem is, it's flat out wrong.  Way wrong.

The basic formula for calculating ROI is:

ROI = (Gain from Investment-Cost of Investment) / Cost of Investment

For ROI purposes, Gain from Investment is the incremental gross profit (gross sales/revenues less cost of goods sold) produced by a marketing campaign or program.  Using incremental sales or revenues in the ROI calculation distorts ROI because most marketing campaigns are designed to increase sales volume.  And increases in sales volume are not free - there are always costs associated with producing and delivering the additional products or services.  Therefore, incremental gross profit is the real meaure of the "gain" produced by most marketing investments.

So, the first problem with the methodology used in the example is that it bases ROI on incremental revenues rather than on incremental gross profits.  If the cost of goods sold of the products covered by the example is 50% of the products' selling price, the incremental gross profit produced by the direct mail program would be $625 (total revenue of $1,250 X 50%).  Using incremental gross profit causes the ROI to drop from 227% to just under 114% ($625 / $550).  That's a more accurate ROI calculation than the one used in the original example, and it's still an impressive number, but it's also still wrong.

To calculate marketing ROI correctly, you must subtract the cost of the marketing investment from the incremental gross profit produced by the investment and then divide by the cost of the investment.

So, the real ROI produced by the example direct mail project would be calculated as follows:

ROI = (Incremental Gross Profit-Total Cost of the Mailing) / Total Cost of the Mailing
ROI = ($625 - $550) / $550
ROI = $75 / $550
ROI = 14%

It should be clear from this discussion that inaccurate calculations of marketing ROI can lead to unprofitable marketing decisions and can also undermine marketers' credibility with senior company leaders.  Would you want to tell your CEO that a marketing campaign has an ROI of 227% when the real ROI is 14%?  The moral of the story:  If you're going to calculate ROI, it's wise to calculate it correctly.

Have you seen instances where inaccurate calculations of marketing ROI have led to flawed marketing decisions?

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