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.

Tuesday, June 15, 2010

Analyzing the ROI Formula - Part 3

This post concludes my discussion of the individual components of the formula used to calculate the return on investment (ROI) of marketing activities and programs.

The basic ROI formula is:

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

In earlier posts, I've discussed the Gain from Investment and the Cost of Investment components of the ROI formula.  Although it's not explicitly included in the formula, time is the third component of the calculation.

ROI is always measured over a specified period of time.  The goal is to select a time period that will enable you to capture an accurate view of the stream of profits and expenses that are attributable to a marketing investment.  A time period that is too short will cause the ROI to be understated, and this may cause you to not go forward with proposed marketing programs (or eliminate existing programs) that produce significant value over the long term.  If the time period used is too long, the accuracy of the ROI calculation may be diminished because of the uncertainty that is inevitably involved in forecasting profits and expenses for distant time periods.

When specifying the time period to be used in an ROI calculation, marketers need to focus on several issues.
  • Over what period of time will the marketing campaign or program have an impact?  The time period used does not need to extend past the point where most (85%-90%) of the value and costs are captured.
  • How much uncertainty exists regarding future value and expenses?  If the degree of uncertainty increases substantially over time, marketers should use a time period that permits reasonably accurate forecasts.
  • What are the company's profit priorities?  Some companies rely on short-term cash flows to remain viable.  Such companies are naturally more interested in marketing programs that produce short-term results and, therefore, are more interested in short-term ROI.
To illustrate some of the issues that surround the selection of the correct time period for measuring ROI, let's look at two different situations.

Suppose that you are a retailer and you decide to send your existing customers a direct mail piece that includes a discount coupon.  Customers must present the coupon in order to receive the discount.  From past experience, you know that 95% of the coupons that are redeemed will be used within 90 days of the date of the mailing.  Therefore, it would be appropriate to measure the ROI of this marketing program over a period of 90 days.

Now suppose that you are a software company that provides warehouse management software to business customers.  You decide to market the latest version of your software to prospective customers using an integrated direct mail and e-mail campaign.  Because warehouse management software has a long sales cycle, your marketing campaign will involve several direct mail pieces and several e-mails sent over a period of several months.  Companies that buy your software pay an initial licensing fee and monthly support fees.  From experience, you know that once a company buys your software, they will remain a customer for an average of seven years.  Therefore, in order to get an accurate measure of the ROI of your marketing campaign, you would need to measure ROI over a seven-year period.

One final point about the role of time in measuring marketing ROI is that both future profits and future expenses must be converted into present values.  This is accomplished by "discounting" both future profits and future expenses.  The discount rate is typically set at the company's cost of capital, which marketers usually obtain from the company's chief financial officer.

Tuesday, June 8, 2010

Analyzing the ROI Formula - Part 2

This post continues our discussion about measuring the performance of marketing, including the use of marketing return on investment (ROI).

As I have already noted, the basic ROI formula is:

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

Therefore, marketing ROI is calculated using two factors - the gain or incremental "profit" produced by a marketing campaign or program and the cost of that campaign or program.  My last post discussed the Gain from Investment component of the ROI formula.  This post will focus on the Cost of Investment component of the formula and discuss some of the issues this component presents when ROI is used to measure marketing.

Cost of Investment is the total cost of the marketing campaign or program whose ROI is being measured.  At first glance, this can appear to be an easy determination to make, and in some cases it will be.  For example, if you outsource all of the work required to develop and execute a particular marketing campaign, the investment in that campaign will be easy to identify.

In other cases, however, the issue becomes more complex.  For example, if creative elements are developed that will be used in multiple marketing campaigns or programs, how should these creative development expenses be assigned to the multiple marketing efforts?  What if you don't know how many times a creative element will be used?  Should the labor costs of marketing department staff personnel be treated as marketing overhead or assigned to specific marketing campaigns or programs?

The most important principle to use when assigning expenses to specific marketing campaigns or programs is that cost assignments should always be based on real-world cause-and-effect relationships.  In other words, the marketing campaign or function whose ROI is being measured must be the "cause" of the cost or expense.

As noted earlier, this principle can be fairly easy to apply in some cases, such as when expenses are incurred to pay outside contractors (agencies, designers, printers, etc.) for specific work on a specific project.  Internal marketing department expenses can be more difficult to address.  For example, if you employ graphic designers, it is appropriate to assign their labor-related costs to the projects they work on.  On the other hand, it may not be possible to assign the labor costs of higher-level marketing managers who perform more general marketing activities.  Often, these costs cannot be logically assigned to specific marketing campaigns and should be treated as overhead expenses.

Assigning costs to marketing campaigns and programs can become relatively complex, and marketers may need to obtain help from financial professionals in performing these assignments.  Assigning costs accurately is essential to producing accurate ROI calculations.