Calculating your Marketing ROI – a practical guide

Calculating your Marketing ROI sounds super simple, right? You just take the income, divide it by the marketing expenses, and boom! – there’s your marketing ROI. Super simple – or is it?

Well, the truth is, when you google “marketing roi” you will find that there is a huge number of different definitions out there. So many, in fact, that Forbes Magazine has called this situation “ROI Anarchy”.

In this article, we’ll look at what a marketing ROI calculation should take into account in order to deliver meaningful insights to evaluate a campaign.

So the most common and most simple definition of the Marketing ROI (shortened to MROI going forward) is

(Return – Investment) / Investment

Typically, this is expressed as a percantage. So if your marketing investment is $100 and your return is $300, then your MROI is ($300-$100)/$100 = 200%.

A real-life example

Right. So far so good. Now let’s try to apply that to a real-life example.

Say you’re an small online retailer selling shoes online. Let’s assume you’ve been in business for a few years and have steadily built a customer base. Last year you have sold an average of 250 pairs of shoes per month at an average price of $100 – i.e., a total of $25.000 worth of shoes every month without doing any online advertising.

Now let’s assume in January you spend $5.000 on banner ads. You sell $40.000 worth of shoes. Question now is: Was that a good investment? In other words, what is my return for my marketing expenditures, or – my MROI.

Calculating the MROI

So to calculate the MROI, let’s start with the easy bit, the investment. In our example, let’s assume for now that’s simply those $5.000 ads spent.

Now for the return that would be $40.000 right? Well not exactly. What we need to look at is the Sales Growth, not the sales. After all, we have made some sales in the past as well, without any advertisement! So we need to compare the sales last month with the sales we would expect if we hadn’t done any advertisment. That might be the sales of the previous month. Or the average of the last 12 months. Or, if there’s seasonality, the same month in the previous year.

So let’s assume you’ve done oyur research and figured out that the business has been growing at a steady rate of 25% every year. What you might do then is take the sales of the previous year’s January (let’s say that’s $22.000) and assume a continued yearly growth of 25%. This gets you the expected sales for this year’s January of $22.000 x 1,25 = $27.500.

This is the sales you would expect for this January. The extra sales you make because of the advertisment is then the actual sales ($40.000) minus the sales you would have made anyways ($25.000), so $40.000 – $27.500 = $12.500.

Now let’s use this to calculate the MROI:

(Return – Marketing Spent) / Marketing Spent = ($12.500 – $5.000) / $5.000 = 150%

That looks pretty good, right? Well, it’s not that simple…

Taking product cost into account

What’s we clearly need to take into account is the cost of the shoes that we sell. This is typically referred to as Cost of Goods Sold, or COGS(1).

So let’s assume that the average price of shoes when we buy them from the producer is $50. As we’re selling them at an average of $100, that’s a margin of 100% or, put differently a COGS-percentage of 50%.

So what we really need to look at is the gross profit, i.e., the gross profit rate times the incremental sales:  50% x $12.500 = $7.500.

That difference between net sales and COGS is called gross profit.

The MROI calculation then goes

(Gross Profit – Marketing Spent) / Marketing Spent = ($7500 – $5000) / $5000 = 50%

That’s a lot less all of a sudden. But are we really there yet?

A little bit of accounting: The contribution margin

Well, still not yet. Consider this: In the previous step we said that we can’t just look at the sales, but we need to take into account what the product costs when we buy or produce it. Fair enough, but what about the other costs that we have? So we already took care of the cost for the advertisement, and the cost of the product, but isn’t there a way to do something similar for all the other costs?

What we’re going for here is typically referred to as the contribution margin. Without going into the nitty gritty of accounting, the contribution margin is your revenues minus your variable expenses.

So essentially what we’re aiming at is to look at all variable costs that can be attributed to the sale of a product. Put differently: Which costs would we not have to pay, if we sold one pair of shoes less?

Generally, we want to look at all costs that go up as sales go up. While that’s less directly the case for costs like IT payroll, rent, utility bills, or insurance, the COGS that we dealt with above are a good example of such costs.

Similarly, the costs for shipping and handling are going up with every shoe that we sell (since the same principles as for the COGS apply, we won’t do the maths here).

Other costs that we can attribute to our sales, albeit less directly, are costs for marketing salaries. Typically, it requires a few assumptions to attribute the costs of marketing people to sales, but we’ll use a simplified example that allows us to so so.

Marketing salaries

As mentioned above, the cost involved in advertisment are not only the cost you pay for the banner ad, but also the salary you pay for someone managing your ads. Let’s assume that to manage the ad campaign, we hired a part-time employee working 40h a month at $25 per hour (this example allows us to attribute 100% of those costs to our campaign).

For January then we need to take into account overhead costs of 40*25$ = $1.000. Your total marketing spent then becomes $5.000 + $1.000 = $6.000.

The MROI then becomes

(Gross Profit – Total Marketing Expenditures) / Total Marketing Expenditures = ($7500 – $6000) / $6000 = 25%.

So compared to the 150% calculated initially we now have a much more modest value of 25% for our MROI.

From Gross Profit to CLV

But what if the customer buys more than one pair of shoes? Great question, which brings us to something called the Customer Lifetime Value, or CLV for short. The CLV is the profit generated over the entire lifetime of a customer, as opposed to just one sale. Lifetime here means the expected time for which a customer remains our customer. 

So for our example, let’s assume that we have learned from our past data (and by asking a clever business intern, who knows about net present value of future profits) that a typical customer for us has a lifetime value of $180. Let’s further assume that our campaign has only attracted new customers. The $12.500 in extra sales then were made by 125 new customers ($12.500 in sales divided by an average basket of $100).  Since those 125 new customers have an expected CLV of $180, the total value would be 125 x $180 = $22.500.

If we use that to calculate our MROI, it becomes 

(CLV – Total Marketing Expenditures) / Total Marketing Expenditures = ($22.500 – $6000) / $6000 = 275%.

Summary

So we have seen that we can’t just take the total sales and the marketing costs and call that ratio your Marketing ROI.

Instead, you have to take into account your gross profit, i.e., your net sales or revenue minus your COGS.

If you want to be more precise, you’ll want to extend that and look at your contribution margin, i.e. you want to take into account the costs that are dependent on your sales. Without turning this into an accounting nightmare, the easiest and most relevant thing to take into account is your marketing salaries.

To really impress your boss, you should try to estimate your CLV, or customer lifetime value. Because if you acquire a new customer, the value of that customer over their entire relationship with your company is potentially much higher than today’s sales.

 

 

 

Annotations

(1) For retailers, COGS includes the purchase price as well as all other costs of acquisitions, such as freight paid to acquire the goods, customs duties, sales or use taxes not recoverable paid on materials used, and fees paid for acquisition 
For producers, COGS include all costs of production, i.e., Parts, raw materials and supplies used,
labor, including associated costs such as payroll taxes and benefits, and overhead of the business allocable to production (not: selling and administrative expenses)
(hat tip to wikipedia for refreshing my accounting knowledge)