It's no secret that the business world is slow to change.
Sure, it has made the evolution from typewriters to computers for word processing, and from snail mail to email for written communication. But in regard to the core of doing business—from the methods and measurements that are used to the way departments are siloed—many 21st-century companies might as well be stuck in the Stone Age. And now that the recession has set in, this unwillingness to replace old business models, strategies, and metrics with new ones is causing some companies hardship and leading many others to their deaths.
Given the gloomy circumstances many businesses find themselves in today, I ask CEOs and marketing executives to reconsider one popular metric: Return on Investment (ROI) as a resource-allocation tool and measure of performance (including marketing productivity).
It is time for CEOs, managers, and decision makers at different levels to take a closer look at this old-school way of doing business and to reassess whether the ROI approach is leading them to rags or to riches.
The idea behind ROI is commonplace in business regardless of whether you're a CEO or a finance, marketing, or sales executive. As you doubtless already know, the traditional formula goes like this:
ROI = Profit/Investment
So, if your profit equals $1 million and your investment equals $20 million, then your ROI is 5%.
Pretty elementary, right? Well, in my opinion, there are two glaring problems with the ROI metric. First, it measures financial performance without taking into account the level of risk, particularly when assessing marketing strategies. Second, except for simple strategies, ROI is likely to lead to poor decisions—for example, when the firm uses a multimedia plan, sells products to a common customer base, or sells products that share joint costs.
For many people, the idea of adjusting ROI for risk is quite novel and the idea of comparing risk-adjusted ROI across different strategies is equally so. But at a time when most businesses could use a boost, and some are in serious trouble, it's time for such "new school" strategies to become commonplace.
To get a clearer picture of what I mean, let's look at the following examples.
ROI: Customer retention vs. market growth
Wal-Mart is facing increasing competition in the United States from a major European retailer, Aldi. Let's say that Wal-Mart is considering two strategies to hold off Aldi's rise: (a) increasing the retention rate of its own customers or (b) obtaining new customers. Let's say that the advertising expenditures for both strategies are equal ($1 million).
Suppose Wal-Mart's management expects the retention strategy to lead to an average increase in net profits of $300,000 and the market growth strategy to lead to a higher average increase in net profits ($400,000). Clearly, by using the standard ROI criterion, Wal-Mart would conclude that the market-growth strategy is superior. After all, an ROI of 40% is better than an ROI of 30%, right? Sure, if other things were the same. But, they aren't.
When you recognize that Wal-Mart's choice of marketing strategies changes Wal-Mart's risk level, you find that market growth isn't necessarily the way for Wal-Mart to go. In general, it is more risky to obtain new customers than it is to retain existing ones. Indeed, after correcting for risk, it is quite possible that the customer-retention strategy is superior for Wal-Mart—even though, on average, it provides a lower ROI than the market-growth strategy.
As the Wal-Mart example illustrates, the standard ROI criterion is likely to lead to poor decision making, because it fails to consider the tradeoff between risk and return. It is essential to compare strategies using the risk-adjusted ROI, since different marketing policies involve different combinations of risk and return. Depending on the magnitude of the uncertainties involved, after comparing risk and return, many companies could well find that it may be better for them to focus on marketing strategies with lower, not higher, average profits.
So, regarding the "market growth" vs. "customer retention" question, how should a company decide which strategy is best? Two steps are necessary:
- The marketing department must provide quantitative estimates of the risk and return of the cash flows from both strategies.
- The finance department (or senior management or CEO) should determine which strategy provides a higher risk-adjusted ROI. In this analysis, the ownership structure of the firm is critical. A publicly owned firm should focus on market risk—i.e., the risk to stockholders after they have diversified their holdings across firms. A privately held firm should choose the optimal strategy based on the owner's tolerance for risk and return.
Starbucks is a prime example of a company that made the mistake of focusing on average ROI without adjusting for risk. In October 2006, Starbucks dramatically raised its long-term store-opening goal to 40,000 from its prior goal of 30,000. The stock market responded positively to this announcement, and the company's shares closed higher by 7.6% that day. But subsequently Starbucks paid a high price (i.e., lower profits) for choosing the wrong strategy.
ROI and media planning: when risk adjustment isn't enough
As with most rules, there is always a caveat. The same is true of the risk-adjusted ROI. Just as calculating ROI isn't sufficient, there are times when a company will have to look deeper than just its risk-adjusted ROI to determine which marketing strategy is best.
For example, suppose Dell is thinking of advertising a new laptop through two mediums: national TV and Internet advertising. Let's say that the budget is the same for both media plans. Should Dell choose the advertising medium with the higher ROI? As the Wal-Mart example shows, simply focusing on ROI fails to consider the tradeoff between risk and return; hence, it may not lead to the optimal decision for Dell's new media plan. However, there is an additional factor that Dell needs to think about: media overlap.
Examining your risk-adjusted ROI will not always be enough. Dell should also consider whether audience duplication would boost or reduce its media productivity. Let's say that Dell's only advertising goal is to create brand awareness. In this case, TV and Internet advertising are substitutes.
However, here's the more realistic scenario. Let's say Dell's goal is twofold: to create brand awareness (via national TV) among the target segment and to encourage this subgroup to go to the Internet to obtain more detailed information about the new product.
For that scenario, audience duplication will boost Dell's media productivity. Hence, Dell needs to measure the joint productivity of its national TV and Internet advertising. Measuring productivity for each medium separately (even after adjusting for risk, as in the Wal-Mart example) and allocating resources accordingly will lead to suboptimal results.
In general, Dell needs to measure the joint productivity of its marketing mix. Separately analyzing the ROI of each marketing decision will lead to poor resource allocations, even if one allows for the tradeoff between risk and return.
Though they might be hard to swallow, those examples highlight an overarching truth about business: The best marketing strategies, those that yield long-term value, are based not on trends, anecdotal evidence, or past "success stories" but on new scientific methods and metrics explicitly developed for analyzing often-imprecise data.
With that in mind, here are four key takeaways managers should glean from the above examples:
- When allocating marketing resources and assessing performance, it is necessary to adjust the ROI metric for risk.
- Since different marketing decisions involve different combinations of risk and return, financial and marketing decision-making must be coordinated. In particular, a top-down approach should not be used where the CEO, senior management, or Finance dictates the required rate of return of marketing activities.
- In general, firms must measure the joint effect of different marketing decisions on risk and return, and simultaneously correct ROI for risk.
- Publicly and privately held firms need to assess risk differently when measuring marketing productivity. The owners of public firms can reduce risk by diversifying their holdings across different firms; in contrast, the owners of privately held firms cannot. Hence, ownership structure has a crucial effect on how a firm should determine its risk-adjusted ROI when choosing and assessing marketing policies.
Clearly, those lessons have far-reaching implications: A fundamental transformation is necessary in the mindsets of managers at all levels in the organization and across functional areas.
As companies work to integrate these changes into their "new school" of operations, they'll have to find answers to the following questions:
- How should the risk and return from different marketing policies be measured?
- How should the standard ROI criterion be modified so that it leads to better decision making?
- How should performance metrics in the organization be revised so that Marketing and Finance can work together to maximize organizational performance?
To answer those questions, it is necessary to develop a new paradigm by fusing marketing and finance. That fusion may sound daunting; however, the hardest part is making the psychological leap.
There is great opportunity out there—even in a recession. When key players go beyond conventional metrics (e.g., ROI) and work together to apply new concepts and metrics to measure marketing productivity, your company can seize the hour.