Analyzing the ROI Formula - Part 1

This is the third in a series of articles about measuring the performance of marketing, including the use of marketing return on investment (ROI).  In my last post, I described the basic concept of ROI and discussed how ROI has been used to measure many types of business performance.  Beginning with this post, I'll discuss each component of the basic ROI formula and explore some the the issues that each component presents when ROI is used to measure marketing.

The basic ROI formula is:

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

So, the ROI formula contains three components:

• Gain from Investment
• Cost of Investment
• Time - Although the formula doesn't expressly contain a "time" value, ROI is always measured for a defined period of time.

This post will focus on the Gain from Investment component of the formula, and this component presents two basic issues.  First, how should Gain from Investment be defined?  And second, how should ROI be calculated when the Gain from Investment is produced by more than one marketing campaign or program?

For ROI purposes, the best definition of Gain from Investment is the incremental contribution margin produced by the marketing function or by a marketing campaign or program.  One of the biggest mistakes that I still see some marketers make is to use incremental sales (revenues) to calculate marketing ROI.

To understand why this mistake distorts ROI, remember that most marketing programs are designed to increase sales volume either by acquiring new customers or by increasing sales to existing customers.  But increases in sales volume are not free - there is always an associated cost of producing and delivering the additional products or services.  Therefore, if incremental sales are used to measure ROI, the ROI will be overstated.

Using contribution margin solves this problem by taking costs into account.  Contribution margin is defined as sales minus variable costs.  Variable costs are costs that the company will not incur if the additional sales are not made.  Therefore, incremental contribution margin is a measure of the "net new revenues" produced by a marketing program.

The second major issue presented by the Gain from Investment component of the ROI formula is how to address situations where the Gain may have been produced by more than one marketing campaign or program.  This situation is not at all uncommon in B2B companies where each prospect may be "touched" by several marketing programs over the course of his/her buying cycle. 

Some companies deal with issue by assigning all of the incremental contribution margin earned from a prospect to the marketing program that generated the first "inquiry" from that prospect.  Others assign all of the incremental margin to the program that "touched" the prospect last (just before the purchase).  It should be obvious that this first touch/last touch approach will often produce a distorted picture of marketing ROI if a prospect has had several interactions with your company.

Some companies attempt to eliminate this distortion by allocating the Gain to all of the marketing programs that "touched" the prospect.  But what percentage of the Gain do you assign to each program?  Allocating the Gain equally to all of the marketing programs may not reflect which of the programs were truly influential in the purchase decision and which ones weren't.  Unless you have some way of knowing how much influence each program actually had in driving the purchase decision, the allocations are arbitrary, and the resulting ROI measurement is likely to be inaccurate.

This allocation issue presents one of the most serious challenges in measuring marketing ROI accurately, especially when we attempt to measure marketing ROI at a very grandular level.  The difficulty of using ROI in this way suggests that there may be a better approach, and I'll have more to say about that in a later post.

The Basic Idea of Return on Investment

As I wrote earlier, return on investment has become the "gold standard" for measuring the performance of marketing.  Return on investment is now used to measure both the performance of the overall marketing function and the performance of individual marketing activities and programs.

In addition to measuring past performance, marketers are using ROI estimates and forecasts to make decisions about future marketing programs and to allocate marketing budgets.  Therefore, ROI is playing a significant role in determining how marketing wll be done.

The basic idea of ROI is easy to understand.  Investopedia.com defines return on investment as:  "A performance measure used to evaluate the efficiency of an investment or to compare the efficiency of a number of investments.  To calculate ROI, the benefit (return) of an investment is divided by the cost of the investment; the return is expressed as a percentage or a ratio."

The basic ROI formula is:

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

For example, suppose that you purchase 100 shares of stock for $10 per share.  One year later, you sell the stock for $11 per share.  Your annual ROI for this investment would be 10%, calculated as follows:

ROI = ($1,100 - $1,000) / $1,000
           $100 / $1,000
           10%

ROI has been used to measure the performance of companies and business units for over eighty years.  ROI estimates have also been used to evaluate major capital investments for decades.  More recently, ROI has been used to measure the benefits provided by everything from process improvement projects to employee training programs.  All things considered, ROI (or one of the variations of ROI) has become the most prevalent measure of financial performance used in business today.

It's only natural, therefore, to use ROI to evaluate the performance of marketing activities and programs.  CEO's and CFO's are rightfully demanding proof that their "investments" in marketing are producing real financial benefits, and they view ROI as a proven method for measuring those benefits.

So, if you're a marketer today, you need to be ready to measure and/or estimate the ROI of your activities and programs, or you need to be prepared to show why a different metric should be used in lieu of ROI.

In my next post, I'll take a closer look at the "return" component of the ROI formula and explore some of the issues that arise when ROI is used to measure marketing.

Measuring Marketing Takes More Than ROI

Over the next several days, I'll be posting articles here about measuring the performance of marketing, including the use of marketing return on investment, or MROI.

This may not be one of the sexiest marketing topics out there, but it has become an extremely important one.  For the past several years, CEO's and CFO's have been demanding greater financial accountability from the marketing function, and they are now pressing marketers to prove the value of marketing activities and programs.  Many years ago, John Wanamaker is reported to have said, "Half the money I spend on advertising is wasted; the problem is, I don't know which half."  CEO's and CFO's expect better from marketers today.

I'm also writing about this topic because, even though there is a large volume of literature about how to measure the performance of marketing, there are many misconceptions floating around, even about some of the most basic principles.  For example, you can find many marketing campaign "ROI calculators" in use today that calculate ROI based on revenues or sales instead of profits (in one of its various forms).  If a marketer presents one of these kinds of "ROI calculations" to a CFO, his/her credibility can be undermined.

Another issue is that in recent years, MROI has become the "gold standard" for measuring not only the overall performance of the marketing function, but also the performance of individual marketing activities.  Some experts argue that this approach is both possible and essential.  But, like any metric, MROI has limitations, and we need to understand those limitations in order to use the metric in the right ways, for the right purposes.

In my next few posts, I'll start by explaining the basic idea of ROI, and I'll describe how ROI has been used to measure business performance.  Then, I'll look at the components of the ROI formula and describe how each of the components should be defined and calculated and what issues that may present.

And finally, I'll argue that, while MROI is an important metric, we need a more holistic approach to get a comprehensive view of marketing performance, especially in B2B companies with complex marketing/sales processes and longer revenue cycles.

Four Ways to Jumpstart Content Development

Successful B2B marketing depends largely on the quality of marketing content.  To break through the marketing clutter that fills the environment and create real engagement with potential buyers, you need relevant and compelling content that helps buyers address important business challenges.

Although this "new" approach to marketing is quickly becoming a competitive necessity, it's not an easy transition for many companies to make.  The volume of content needed can seem to be overwhelming.

For example, suppose that you sell to only one type of company.  Your buying group typically contains three individuals so you have three buyer personas to address.  Your buyers usually move through a four-stage buying process, and you believe you will need to interact with each buyer at least three times during each stage of the buying process.  This means you'll need at least 36 "pieces" of marketing content to fuel your marketing effort (3 personas X 4 buying stages X 3 interactions per buying stage).

The good news is that getting started with content marketing is usually the most difficult step.  Once your initial base of content is created, the job becomes more manageable.  So, is there any way to make getting started easier?  These four tactics will enable you to jumpstart your content development.

Narrow Your Focus

If you sell to more than one type of business, pick your largest, most profitable, or most attractive customer segment and start by developing a full set of content materials for that segment.  You can add content for other types of customers later.  When it comes to content marketing, you are better off having the content you need to take some of your prospects all the way through the buying cycle than having content that will take all of your prospects only part of the way through the buying cycle.

Use Existing Marketing Materials

OK, I'll admit that most of your existing marketing materials probably aren't suitable for the kind of customer-focused marketing you need to be doing today.  I include this tactic for two reasons.  First, at the right time in the buying cycle, your potential buyers will want and need to learn about your company and your products, and your existing marketing materials should be able to perform this function.  Second, even if your existing materials aren't suitable in their current form, you may be able to make some of them suitable by making relatively minor changes.  At least you won't be starting from scratch.

Follow the "Rule of Five"

The rule of five says that whenever you develop a significant content asset, you should try to create at least four "smaller" content pieces from the original asset.  For example, say you write a white paper.  You then use the content in the white paper to create one or two short articles and two or three blog posts.

Outsource the First Wave

Even if you follow the first three suggestions, you may still find that you don't have the time or internal resources to create the content you need as fast as you need it.  If that's the case, you should consider outsourcing some or all of the content development work.  Once the initial wave of content is developed, you may find that you can build on that foundation to create the additional content you need.

The "Other" Jobs of B2B Marketers

A lively discussion is underway in the Marketing Communications group at LinkedIn.  The question that started the discussion was: "In one sentence, what is marketing?"  In less than a month, this question has produced 145 comments.  As you might expect, the comments have included a wide range of definitions, but I think it's fair to say that most have focused, in one way or another, on the "persuasion" aspect of marketing.

Because of my work, I read almost everything I can find about B2B marketing.  For example, I regularly follow over three dozen B2B marketing blogs, and the list keeps growing.  There are some wonderful B2B bloggers sharing insights and ideas - Seth Godin, Ardath Albee, Steve Woods, and Jon Miller, just to name a few.

The hot topics today in the B2B marketing blogosphere include the use of social networks, inbound marketing, content marketing, lead management (lead scoring, lead nurturing, etc.), and marketing automation.  All of these topics also relate to how we communicate with and persuade potential buyers.

It's understandable why we devote so much attention to marketing communications.  Most B2B marketers spend most of their time developing and executing marketing communications programs of various kinds.  Marketing communications are extremely important, but they are only part of the "promotion" component of marketing.  And promotion is only one of the "four P's" of marketing.

Peter Drucker once said, "Because the purpose of business is to create a customer, the business enterprise has two - and only two - basic functions:  marketing and innovation."  I might not go quite that far, but I do believe that B2B marketers can and should play a broader role that just managing marketing communications.

Let's consider just two examples.  First, marketers should have a strong voice in the development of new products and services.  Marketers (in collaboration with salespeople) are best suited to be the "eyes and ears" of the company in the marketplace.  Gathering information about the changing needs and challenges of customers and prospects should be an ongoing priority for marketers, and you should create a systematic process for collecting and evaluating this information.  This kind of market intelligence can be vital for developing new products or services that will win in the marketplace.

Marketers should also play a significant role in making decisions about pricing.  I realize that pricing is a sensitive subject in many companies and is often the source of contention among marketers, salespeople, and financial/accounting professionals.  Research has shown that pricing is the single most powerful profit lever that managers can use on a daily basis.  It's up to marketers to understand the real economics of pricing decisions so that they can bridge the gap between those who view pricing as a tool for closing a sale and those who believe that your company's costs should dictate its prices.

Managing the marketing communications effort is important, but B2B marketers also have other critical jobs to perform. 

B2B Value Propositions That Resonate With Buyers

One of my favorite definitions of value proposition comes from Jill Konrath, author of Selling to Big Companies.  She says that a value proposition is, "a clear statement of the tangible results a customer gets from using your products or services."

Value propositions are a core element of your marketing strategy.  They describe how you create value for customers and, therefore, they are the ultimate source for your marketing content.  In fact, you can't create compelling marketing content until you really understand how you create value for customers.

Despite their undeniable importance, most companies don't do a good job of formulating and communicating compelling value propositions.  A recent survey of decision makers in B2B companies conducted by the Marketing Leadership Council of the Corporate Executive Board found that 86 percent of the "unique benefits" touted by sellers were not seen by potential buyers as having enough impact to create a preference for a particular seller.

In their 2007 book, Value Merchants, James C. Anderson, Nirmalya Kumar, and James A. Narus identified three basic types of B2B value propositions.

All Benefits - Essentially, a list of all the benefits that managers believe their solutions might deliver to target customers.  This type of value proposition requires the least knowledge about specific customers or competitors, but it has one major drawback.  This approach can lead managers to claim advantages for solution features that actually provide little real benefits to target customers.

Favorable Points of Difference - When managers use this type of value proposition, they attempt to differentiate their solution by identifying favorable points of differrence between their solution and the customer's next-best alternative.  While better than an All Benefits vallue proposition, this type of value proposition still has a major drawback.  It can lead managers to assume that all favorable points of difference will be valuable to a prospect, while the reality may be that many points of difference contribute little value to a particular prospect.

Resonating Focus - The third type of value proposition is called Resonating Focus.  Anderson, et. al. say that in a world where potential buyers are extremely busy, sellers must use value propositions that are both compelling and simple.  The basic idea behind a Resonating Focus value proposition is to identify the one or two points of difference (between your solution and your competitor's) that deliver the greatest value to the target customers.

Resonating Focus value propositions dovetail nicely with content marketing.  To begin with, companies that use Resonating Focus value propositions develop customized value propositions for various customer segments.  This is necessary because the elements of value that matter most are likely to vary based on the type of customer involved.

It's also possible to extend the Resonating Focus value proposition concept from customers (organizations) to individual buyers or buyer personas.  And when you develop Resonating Focus value propositions for each of your buyer personas, you will have taken a large step toward identifying the marketing content you need.

The Limits of Marketing ROI

For the past several years, B2B marketers have faced growing pressure to prove the value of their activities and programs.  CEO's and CFO's are increasingly demanding that marketers monitor and measure the results of their activities and calculate the return on investment (ROI) produced by those activities.

ROI is now seen as the "gold standard" for measuring the performance of marketing programs.  ROI has been used for decades to evaluate all kinds of investments, and it's widely accepted by financial professionals.  Some marketers believe that calculating the ROI of marketing activities will enhance their credibility in the C-suite.

Marketing ROI is certainly an important metric, but like any tool, it must be used in the right way for the right job.  There is no single "magic metric" that can fully capture the effectiveness of marketing.  So, it's important for marketers (as well as CEO's and CFO's) to understand the limitations of ROI for measuring marketing performance. I'll talk about some of the limitations and complexities here, but there are many others.

The basic ROI formula is extremely simple:

ROI = Return / Investment

The basic formula for marketing ROI (MROI) is almost as simple:

MROI = (Return - Marketing Investment) / Marketing Investment

Unfortunately, however, this simple formula hides a number of complexities.  For example, what does the term "Return" mean?  Total gross revenues or incremental gross revenues?  Total gross margin or incremental gross margin?  Total contribution margin or incremental contribution margin?  The best answer is incremental contribution margin, although incremental gross margin is also widely used.

But now I've introduced a new term - incremental contribution margin - that requires a definition.  Contribution margin is easy to define.  It's total revenues less variable costs.  The incremental part of the term is more complex.  Marketing ROI experts tell us that, ideally, a marketing ROI calculation will measure the incremental (new) returns produced by incremental (new) marketing investments.  So, supposedly, we can use marketing ROI to calculate the return on investment of an expanded TV advertising program, or a new direct mail program, or a new social media program.

Or can we?  How can we really know which marketing program actually produced the incremental (new) contribution dollars, especially when we are running several marketing programs simultaneously.  This won't always be a huge issue.  For example, if we run a direct mail campaign that incorporates a discount coupon, we can count the number of coupons that are actually redeemed.  But even this may not provide a completely accurate answer.  What if a new customer had already been predisposed to buy because of an earlier marketing program?  Should the discount coupon campaign get all of the "credit" for the new contribution margin associated with this new customer?

I am not suggesting that calculating marketing ROI is the equivalent of putting on a blindfold and throwing darts at a target.  There are, in fact, well-accepted methods for dealing with the kinds of issues I've just described.  I am trying to make the point that most marketing ROI "models" are based on numerous assumptions and judgment calls about the definition and the "allocation" of both returns and costs.  This does not mean that marketing ROI has no value.  It does mean that MROI often appears to be more precise than it actually is.