Question

Topic: Research/Metrics

Calculating The Marketing Roi

Posted by mgoodman on 12/10/2009 at 8:03 PM ET 500 Points
I recently noticed that a few of my clients were calculating the Marketing ROI differently from each other, and that got me to thinking about what the right way really is. Of course, the clients are not comparing one to the other, so as long as they are each consistent internally it probably doesn’t much matter. But now I’m curious, and I’d like to know how YOU do it.

Here’s an over-simplified example:

Companies A, B and C each spend $5,000 on a marketing campaign and generate $50,000 in incremental sales as a direct result. The average fully-loaded profit on those sales is 25%, or $12,500. The variable profit is 30%, or $15,000. What is the ROI?

Company A says it’s 250%, calculated as $12,500 / $5,000.

Company B says it’s 150%, calculated as ($12,500-5000, the investment) / $5,000.

Company C says it’s 300%, calculated as $15,000 / $5,000.

There are probably a few other possibilities too.

How would YOU compute the Marketing ROI in this example?
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RESPONSES

  • Posted by koen.h.pauwels on 12/10/2009 at 11:33 PM Accepted
    Hi Michael,

    Great question, to which I'd love to see others respond as well. My short answer: ROI is calculated as
    [net incremental profit - investment]/investment.

    Therefore, the typical calculation would be
    $15,000 - $5000 / $5000

    However, if the additional fixed costs of $ 2500 are necessary to make the additional sales (eg hire another customer service agent), then company B is correct.

    The long answer: is ROI the right measure to compare across projects? Jim Lenskold would say 'yes', Tim Ambler would say 'no'. Key concern: why divide by the investment? The numerator yields the added economic value of the project, and is thus more informative. As an example, if you only had below two options to invest in, and needed to choose one, which would you engage in:

    Option A: Invest $ 1M, net incremental profit = $ 3M
    Option B: Invest $ 5M, net incremental profit = $ 10M
    Option A has higher ROI (200%), option B has higher economic value to the company ($5M versus $ 2M)

    My opinion: firms with limited budgets often care mostly about efficiency (i.e. the biggest bang for their buck), and will go with the highest ROI project, while firms with ambitious growth goals will choose option B.

    Of course, in real life, options may not be mutually exclusive, and they may be scalable (e.g. could you invest the first $2M of suggested option B and get half of the result, i.e. $ 5M). These questions (and others) represent the true challenges of marketing, not the definition of what ROI is. We discuss 10 such challenges in my recent article with Dave Reibstein:

    Challenges in Measuring Return on Marketing nvestment: Combining Research and Practice
    Perspectives,” Sixth ANNUAL REVIEW OF MARKETING RESEARCH, edited by Ed Naresh Malhotra, ME Sharpe, Inc., Irvine, CA, 2009.
  • Posted by Peter (henna gaijin) on 12/11/2009 at 1:00 AM Accepted
    Not sure what you mean by average profit and variable profit.

    I am with Koen in the calculations he did up front his long answer, though good and useful, went a bit outside of what your question actually asked).

    But percentages can be confusing in how the terms are phrased - 100% increase has the same as 200% of profit.

    That said - it is rare to get that much details or any accuracy. In many cases, I've had to settle for just sales growth. Be nice to have the data to compare clients like this and worry about the terminology...
  • Posted by Dawson on 12/11/2009 at 5:53 AM Accepted
    Ratios are comparative so need to be calculated in the same way to be useful. The problem is "definition of terms". Since there's no way to police this issue, it's a question of preference.

    I think Hakim has a valuable point about "value at risk" and makes the correct point that this ROI has to be measured against the opportunity cost of other investments such as capital projects or other OPEX.

    One other factor I'll chuck in here is that Average ROI is highly misleading if you're looking to decide how to change investment decisions. What organisations need to review is Marginal ROI - the incremental profit for the next unit invested.

    Great discussion btw!
  • Posted by Gary Bloomer on 12/11/2009 at 12:58 PM Member
    Dear Michael,

    I'm not a numbers person, so percentages have never really
    been anything I've found easy to grasp.

    But in terms of ROI I'd say one of the best rules of thumb is
    to ask the following question:

    "Did every dollar (pound, yen, euro etc.) spent on marketing
    bring in MORE than a dollar in sales?"

    If it did, positive ROI shows the marketing had an upward effect
    on the sales curve. And regardless of projections, any rise in sales compared with its previous annual period or compared to projected
    sales could be said to be a worthwhile end result.

    But if the spend per dollar resulted in lower sales, then the ROI
    becomes negative. Which means there's something flawed about
    the message, or the way in which it's being delivered, with the offer,
    or with the willingness to buy on the part of the audience the message and offer are being presented to.

    Just my humble two cents' worth.

    Gary Bloomer
    Wilmington, DE, USA
  • Posted by mgoodman on 12/11/2009 at 1:24 PM Author
    Gary, I think you mean PROFIT not SALES, right? If I spend $1 on marketing and it generates $2 in incremental sales, but my gross profit is only 25%, then I lose money on the marketing effort. That's not a good thing.

    So I would re-phrase what you wrote to read:

    "Did every dollar (pound, yen, euro etc.) spent on marketing bring in MORE than a dollar in PROFIT on INCREMENTAL sales?"

    (You also need to allow for cannibalization if the marketing program brought in sales that would have occurred anyway ... i.e., without the marketing effort.)
  • Posted by mgoodman on 12/11/2009 at 1:53 PM Author
    Peter, the AVERAGE fully-loaded profit simply recognizes that each item in the line has a slightly different profit margin, and the mix can vary somewhat. Thus we use an average gross margin in calculating the ROI.

    The difference between FULLY-LOADED and VARIABLE reflects things like corporate overhead, rent, utilities, etc. that are covered by the basic budget and don't change when volume or gross margins increase. So the issue is whether we should expect incremental sales to cover a share of the fixed costs or not. If yes, then fully-loaded margin would apply. If no, then variable margin would apply.
  • Posted by mgoodman on 12/11/2009 at 1:58 PM Author
    I suppose that the answer to my question could be different depending on how it would be used.

    If the purpose of computing an ROI is to compare different marketing programs to each other (and pick the most efficient/effective), then it probably doesn't matter which approach we select.

    If the purpose, however, is to compare an incremental investment in marketing to some other [non-marketing] use of those same funds (e.g., plant modernization, new machinery, etc.), then it becomes highly relevant.

    And if the purpose is to determine whether to borrow money to put into the marketing effort, there might be yet a different answer. (We'd need to consider the cost of capital and the inherent risk: "What if it doesn't work so well next time?")
  • Posted by Gary Bloomer on 12/11/2009 at 2:40 PM Member
    Dear Michael,

    Yes, I mean profit, not sales. Apologies for the confusion.

    Gary Bloomer
    Wilmington, DE, USA
  • Posted by telemoxie on 12/11/2009 at 2:44 PM Accepted
    I agree that different people with different perspectives and different usages for the information might calculate things in different ways.

    I have never specialized in maximizing return on investment, but if I were approaching a business owner regarding an Internet marketing venture, I would personally calculate the ROI differently.

    The client would have to write checks for $37,500 for the cost of goods sold, plus $5,000 for the marketing campaign. That is an outlay of cash of $42,500 to earn $7,500. clearly this is a much lower number than you have calculated above, but a much higher rate of return than you can get at the bank, and calculating the internal rate of return would require more information about timing of payments...

    Generally speaking, the clients that I've worked with are smaller clients who are strapped for cash and have small budgets, who are much more interested in calculating breakeven than ROI.

    I'm not saying that small cash-strapped businesses have a better or more proper way of looking at things, I'm merely suggesting some look at things differently.
  • Posted by mgoodman on 12/13/2009 at 3:30 PM Author
    Thanks to all. I appreciate the input.
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