Marketing Metrics Made Simple, September 9, 2015
By: Germar E. Reed
Return on Investment (ROI)
Return on Investment (ROI) or Return on Marketing Investment (ROMI) equals the gain from a program minus the cost of the program, divided by the cost of the program.
ROI = (gain – cost) / cost
For example: Let’s assume that you started a new (incremental) advertising program, that it cost $50,000 in its first year, that it promoted $600,000 in incremental sales during the same year, and that the gross profit from these sales was $200,000.
If you subtract your incremental advertising dollars ($50,000) from the incremental gross profit generated ($200,000), you see that you have generated $150,000 of net operating profit.
Stated differently: the effect of your advertising added $200,000 to operating profit, and the cost of your advertising subtracted $50,000 from operating profit, for a net increase of $150,000.
Your ROI is ($200,000 – $50,000) / $50,000 = 3 = 300 percent
In other words, on average, each dollar you spent on the new (incremental) program brought in three dollars of profit.
For clarity of presentation, we usually express ROI as a percentage. So, in this case, we say “300 percent” rather than “3.”
Keep in mind that a “300 percent” return on investment means the company received revenues of 300 percent of its investment, plus the return of the investment itself. Therefore “300 percent” means it quadrupled its money.
Similarly, “200 percent” means it tripled its money, and “100 percent” means it doubled its money.
WHY WE USE GROSS PROFIT IN THE CALCULATION
Some marketers use sales revenue to measure ROI. But it is much preferable to use gross profit (also called gross margin).
Why? Because if you use gross profit, you will be speaking the conservative language of your CEO and CFO.
Here is a detailed example:
Let’s say you have invested $100,000 in a campaign and you have identified $500,000 in incremental sales that resulted from that campaign. You can prove it from the leads you have tracked. That’s good.
But if you calculate ($500,000 – $100,000) / $100,000 = 4 (an ROI of 400%), you will be overstating your ROI.
You are ignoring the cost of goods sold (COGS), also called “cost of sales.” As the accounting world sees it, your company’s incremental gain from those sales is this:
Revenue – COGS = Gross Profit
So, to talk the language of your CEO and CFO, you need to know the gross margins on the kinds of items sold (which you can probably get from Sales or Accounting). Then, you can make a calculation like this:
Sales revenue ($500,000) minus COGS ($200,000) equals gross profit ($300,000).
Gross Profit minus the Cost of Your Campaign, all divided by the Cost of Your Campaign, equals ROI.
($300,000 – $100,000) / $100,000 = 2
The ROI is 200 percent.
So, whenever you measure ROI, inquire into the COGS. In exceptional cases, such as the sales of services that have no direct costs, you won’t have to figure in any cost. Be guided by what Accounting says.
Germar Reed is a Partner at Growth Strats, LLC, managing the Advanced Analytics Group.