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.

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