In my recent post, “The Return on Investment (ROI) Craze Won’t Last,” I stated that the demand for ROI would not last because most organizations, agencies and marketers will struggle to gather all three necessary points of data: Net Profit, Sales and Investment. Without this information, marketers cannot provide ROI—it is that simple.
To be clear, I did not say that I was not a proponent of delivering ROI for social media or any marketing expenditures. Providing ROI is very important, especially if marketers want to prove their worth to an organization.
If you agree, this post is for you.
Understanding the ROI Equation
Chief Financial Officers (CFOs) use ROI to determine the ratio of net profit to the assets used to make the net profit. Since we are in marketing, what our CFOs will be asking for is Return on Marketing Investment, which is measuring profit gain from marketing expenditures.
Sure enough, the ROI equation was the same in both books:
ROI = Net Profit/Sales * Sales/Investment
Breaking Down the ROI Equation
When calculated, ROI is a percentage not a dollar figure. If marketers say that their marketing budget produced $50,000 in ROI, they have not calculated ROI.
There is often confusion when looking at the ROI equation because our first instinct is to assume that the sales portions of the equations cancel each other out. That is an incorrect assumption.
According to Etzel, Walker and Stanton, authors of Marketing, the first portion of the equation calculates the rate of profit on sales, which is influenced by marketing considerations such as sales volume, price, product mix, and advertising. (I think we can safely substitute advertising with other marketing expenditures, as the notion of pure advertising is a bit antiquated).
Therefore, marketers will definitely need to work with their accounting team to determine net profit. It is important to provide the accounting team with the amount of marketing investment so that they can accurately determine net profit. As well, let the accounting team know if multiple products or services (B2B or B2C) were part of the marketing campaign. That way they can determine the gross profit margin of each. [For example, Widget X sells at $100 with a fixed cost (i.e.overhead) of 40% ($40) and a profit margin of 60% ($60). If Widget X depends on raw materials the accounting department would use a variable cost instead, which means the ROI would fluctuate based on external conditions. Widget Y’s margins will most likely be different.]
The second portion of the equation focuses on capital turnover, which does not involve costs or profits only sales volume and assets managed. Your accounting team can provide investment, which is located on the balance sheet.
Working Out the ROI Equation
Assume the following:
- Net Profit: $500,000
- Sales: $1,000,000
- Investment: $600,000
X% = $500,000/$1,000,000 * $1,000,000/$600,000
ROI = 83.5% [.50 * 1.67]
Obviously, this example provides a high ROI percentage. In reality, this may not prove to be the case. Here are three ways marketers can increase ROI:
- Increase the profit margin (which means reducing overhead or finding tax breaks)
- Increase the amount of sales
- Reduce the amount of marketing investment
ROI & Investors
Are you a marketer that works in a VC-backed startup or a public company? If so, your ROI calculation will change if investors are only interested in the ROI for the specific investment they made. For example:
- Net Profit: $500,000
- Sales: $1,000,000
- Investment: $300,000
X% = $500,000/$1,000,000 * $1,000,000/$300,000
ROI = 166.50% [.50 * 3.33]
ROI & Non-Profits
Just to be clear, non-profit does not equal non-ROI. If anything, non-profits need to do more with less and every dollar counts. If any marketing is outsourced, that means it is even more important for agencies, vendors and consultants to provide the required financial information. This is especially true as cause marketing (versus public relations) becomes more widely used. I know non-profits can be sensitive about the term “sales,” so instead use a term like donations or support.
ROI = Net Profit/Donations * Donations/Investment
ROI & Marketing Agencies, Vendors, Consultants, etc.
If you are outsourcing your marketing, it is very important that marketers have financial data on all of the expenditures made. Marketers tasked with ROI should strive to avoid off-the-cuff marketing, for obvious reasons. From this perspective, planning becomes even more essential to getting a head start on gathering the data required for ROI calculation.
ROI and Planning
I won’t dive into details of planning, but will cover the basics so you can see why it is essential to calculating marketing investment. Here is a basic plan outline:
You will find your costs under tactics. Metrics will not help you with your ROI calculations, but they are important for determining cost per lead. When it comes to budget ALL costs must be included.
ROI and Public Relations and Branding
Should PR and branding require ROI? The argument is often no because they are meant to deal with long-term relationships and perceptions. That said relationships and brand equity do affect sales (and donations). Would it make sense then to calculate ROI on these endeavors?
So will the ROI craze fade away? I hope not. However, given the complexity of ROI I still believe ROI might find its way to the backburner. If ROI is not being required of you, do your due diligence and figure it out anyway. When your annual review comes up, you might just thank me.
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