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How to Calculate Marketing ROI

September 24th, 2009 Leave a comment Go to comments

money_in_clampI’d like to take a moment to backup and share a basic understanding of what “marketing ROI” means, in order to build upon it in the future.  For those who already know this stuff, please bear with me, but for small business owners/marketers who never learned this or have gotten fuzzy on it since college, it should help.  If you find this too technical, jump to the SUMMARY at end.

I read an interview today with Merry Elrick, author of the book “What’s the Truth about B2B Marketing ROI?” who says the following:

“Marketing ROI is NOT an increase in market share, click-throughs to your web site or even revenue generated from your marketing communications. Marketers must understand the literal definition as the rest of the world does, including everyone in the C-suite. ROI is the profits generated over and above the initial investment and expressed as a percent of the investment. There’s a formula, but you really need to understand the nuances of how ROI is calculated in your company because there are multiple ways to interpret concepts like gross margin, net present value or discount rate, just for starters. You need to know your own company’s standards.”

GROSS PROFIT MARGIN

From About: The Gross Profit Margin is a measurement of a company’s manufacturing and distribution efficiency during the production process. The gross profit tells an investor the percentage of revenue/sales left after subtracting the cost of goods sold. A company that boasts a higher gross profit margin than its competitors and industry is more efficient.

From InvestorWords: Gross Profit Margins reveal how much a company earns taking into consideration the costs that it incurs for producing its products and/or services.

It can be expressed in absolute terms:

Gross Profit = Revenue − Cost of Sales

$89,250.00 = $109,250.00 – $20,000

Gross margin is expressed in the form of a percentage:

Gross Margin % = Gross Profit / Revenue

81.69% = $89,250.00 / $109,250.00

Note: Gross Margins of 82% rarely exist.  The example does not take into consideration costs that are continually increasing to pay for overhead and marketing, thus lowering Gross Profit Margin.

As example, a company makes 100 widgets in their first year and sells them for $1,000 each.  With tax of 9.25% the Revenue or Net Sales is $109,250.00, which is the amount generated after the deduction of returns, allowances for damaged or missing goods, any discounts allowed, freight, and any other expenses (in this case, $0).

The Cost of Sales or Cost of Goods Sold (COGS) is $200 each or $20,000.  COGS is the beginning inventory, in this case $0, plus the Cost of Goods Purchased during some period, $20,000, minus the ending inventory, $0, in this case. Gross Profit or Gross Income then is $89,250.00.

RETURN ON INVESTMENT

Now that we have the Gross Margin, we can generate the ROI in the first year (it typically is done on an annual basis).

ROI = ((Revenue – Expenses*) / Investment)

*namely, business, depreciation, interest, and taxes

To get the figure in percentage format, multiply ROI by 100%.

To further the example, when the company went into the widget-making business, they spent $5,000 as their initial investment in setup costs, plus $200 for every widget produced ($20,000), plus $9,250 in taxes.  On a sale of 1,000 widgets their ROI is 300%

300% = ($109,250.00 – $34,250) / $25,000

It would be wise to calculate how many widgets they had to sell at pre-tax $1,000 to break even.  According to my calculations, when they sold widget #22 they broke even on their current plus future investments.

Furthermore, the investment of $25,000 is likely a loan.  If the company borrowed this amount on a 3 year plan at a rate of 20%, by my calculations it would cost them $33,447.24 if compounded annually.  Monthly payments, therefore, would be $929.09. As we are just talking about the first year of operations, the first year amount due would be $11,149.08 with the remaining $32,050.92 due in years 2 and 3.  Total first year expenses also increase by $2,815.75, which is one third the total interest: $33,447.24 – $25,000 = $8,447.24

Realized Gross Profit (first year): $78,100.92 = $89,250.00 – $11,149.08

Realized Gross Margin (first year): 71.48% = $78,100.92 / $109,250.00

Realized ROI (first year):  289% = ($109,250.00 – $37,065.75) / $25,000

From these results, we can conclude that it would not be a bad investment.  However, as more and more details of the reality of costs are added into the equation, profit, margin and ROI will all decrease.

NET PRESENT VALUE

The good business person will then decide if making widgets has the best ROI for the outlay of $25,000 or if some other opportunity – including an investment in financial markets – may yield a higher return.  To evaluate this, calculate the Net Present Value, which takes a look at the current value and timing of cash flows, comparing it to the discount rate – the rate of return that could be earned in the financial markets – currently 0.75% as of September 20, 2009.  Another name for discount rate is the IRR rate (Internal Rate of Return).

SUMMARY

When we talk about marketing ROI we’re often looking at things like the results of a campaign (purchases, new subscribers, click-throughs), but we have to keep in mind that those results roll up into the real ROI, which calculates return on an overall investment.  To do this, we have to calculate three things: Gross Profit, Gross Profit Margin, and ROI.

Gross Profit = Total Revenue minus Cost of Sales or Cost of Goods Sold, which is inventory plus the Cost of Goods Purchased during some period minus the ending inventory.

Gross Profit Margin % = Gross Profit divided by Revenue or Net Sales, which is the amount generated after the deduction of returns, allowances for damaged or missing goods, any discounts allowed, freight, and any other expenses.

ROI = Total Revenue minus Total Expenses, divided by the Total Investment.  The result can be calculated across different scenarios and it can then be decided where the investment can be best spent, taking into consideration the Net Present Value of the differing cash flows that are created.

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  1. September 25th, 2009 at 12:14 | #1

    Hi Rebekah,
    Thanks for your presentation on LinkedIn. Although I am familiar with ROI and balance sheet calculations (P&L), it still is great information to have documented.
    Can you send me your presentation? It won’t print out from LinkedIn.

    Many thanks!

    Amy

  2. Martin Jennings
    September 26th, 2009 at 04:29 | #2

    Rebekah,

    You’re absolutely right! Many people, experienced and inexperienced alike, ignore some of the factors you eloquently explained. I’d like to throw one more thing in the mix. It’s the intangible of awareness, brand, favoribility etc. All these are intangible assets resulting from marketing and need to be included in ROI. The difficulties are in assigning appropriate values to each intangible.

    Martin

  3. Rob Pickering
    September 26th, 2009 at 08:21 | #3

    Renekah,

    I agree completely with your explanation, and wish I’d had it as a tool for training staff over the years. Wonder why I never thought to collate it together? I’m sure my time spent on that would have represented a good ROI 😉

    One thing has often frustrated me over the years when someone brings me a marketing activity to sign-off. Even when they show me the ROI, they present the idea as “here it is, ROI is 2.5 times the investment of $50K – please will you authorise me to go ahead?”. How do I know this is a good activity to action?

    What I struggle to get across is that it’s impossible, or maybe just poor, to look at a single activity and go ahead. Sometimes 2.5 represents a good ROI. But the point is – it’s relative. I look at marketing as an investment. If you had $50K of your own money to invest, you would compare options and strike a balance of ROI vs risk and take into account timescale and perhaps other factors. The same should apply to a marketing investment.

    So even when you understand the expected ROI of an activity… I recommend always looking into at least three alternatives and then picking the best one. I think about ROI far more BEFORE investing than after. You should always review afterwards and learn what was good and what was bad, but ensure that most of the thought goes into the choice of investment, not just the measurement afterwards.

    Rob.

  4. Ravinder
    September 27th, 2009 at 12:07 | #4

    Rebekah,

    Great writeup, very insightful.

    I am wondering if there is a generally accepted formula or terms for calculating intangible ROI as Martin mentioned. A great example would be market share growth, which can me measured year over year.

    -Ravinder

  5. September 28th, 2009 at 13:08 | #5

    @Ravinder

    Martin: It’s the intangible of awareness, brand, favorability etc. All these are intangible assets resulting from marketing and need to be included in ROI. The difficulties are in assigning appropriate values to each intangible.

    Ravinder: I am wondering if there is a generally accepted formula or terms for calculating intangible ROI as Martin mentioned.

    Hi, Ravinder.

    Calculating intangibles are best suited for traditional market research studies, which is what the company I work with does. You can test your target market(s) for pre- and post-awareness surrounding a marketing campaign, unaided awareness, brand perceptions, brand associations, brand loyalty/recommendation/switching likelihood, willingness to consider/pay a price premium for your brand vs. competitive brands, how well your brand’s products fit into their lives, etc.

    As for assigning appropriate values, that would have to be done on a case-by-case basis. To some brands, awareness may be the primary goal in a campaign and therefore a lift in that area may be a “10” in importance, while to another their goal is to get across a message of “trustworthiness,” so to them that may be their “10.”

  6. September 30th, 2009 at 01:16 | #6

    Very interesting, but I take this opportunity to ask if someone has to submit a case study related to Web Marketing ROI.

  7. Teresa Nurmi
    October 1st, 2009 at 11:39 | #7

    Rebekah,
    Thank you for this post, it has reminded me what was taught in the beginning of my business classes. I also would like a copy of your presentation as it is informative and to the point. A question I have is: when changes are made how can the marketing ROI be calculated to know if the new changes are working or if it a build up from the old?

  8. Chuck Bishof
    October 2nd, 2009 at 10:30 | #8

    Great summary. People ARE getting more rirorous about resolving the old saw “I know that half my marketing investment doesn’t work. I just don’t know which half!”. Looking at ROI in agrigate helps us understand how we drive earnings for the total business. It’s also to look at it at the MARGIN to help decide which programs are most beneficial. It’s also important to make a good decision on your measurement horizon. A trade program can spike volume while it’s running but will decay fast and even cause a trough the period after which needs to be accounted for. Advertising and consumer promotions will lift base volume while running, but have a much slower volume decay rate over 2-3 subsequent periods. If these benefits arent considered, the Advertising and Consumer investment can look significantly lower than the trade investment. Great article.

  9. October 2nd, 2009 at 13:03 | #9

    @Claudio Montesion

    Hi, Claudio.

    I will keep in mind that you would like to see case studies, if I come across any I can share.

    Best,
    Rebekah

  10. Ravindra
    October 4th, 2009 at 22:05 | #10

    Rebekah,

    wonderful post.. Its just tickled my senses to understand more in detail about the ROI.

    Thanks for the post ..will keep visiting your blog

    Ravindra

  11. October 5th, 2009 at 00:24 | #11

    I think that a lot of the comments which talk about ‘Marketing ROI’ or ‘Intangible ROI’ need to look into the difference between financial returns and other Metrics.

    Marketing results should always be measured, but not always in Dollars or Pounds. ROI is always a financial calculation, but other objectives can and should be measured by choosing different Metrics (increase in website users, newsletter subscribers etc). Improving the correct Metrics will improve financial results, but don’t get the two confused.

  1. September 30th, 2009 at 05:09 | #1

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