The basic calculation
If your paper describes a campaign for a commercial business, then at some point you should try to demonstrate that the campaign in question was financially worthwhile. Ideally, you should try to prove that the campaign paid for itself and generated a net profit.
For a campaign that aims to generate sales, the steps involved in the calculation should be as follows:
1) Calculate the value of incremental sales
First, estimate the total value of the incremental sales generated by the campaign. To do this, you will need to estimate the “base level” of sales – the sales that would have been made even if the campaign hadn’t run. Incremental sales is then simply:
Incremental sales value = Actual sales value – Base sales value
Common methods for calculating base sales include econometrics, regional analysis, and extrapolation from trends. However, as an IPA author, one of your main aims should be to find new and better ways of measuring the incremental effect.
2) Calculate incremental sales revenue
Next, you need to calculate the incremental revenue to the client. This is usually less than the incremental sales value, because retailers and other intermediaries take a cut:
Incremental revenue = Incremental sales value – Intermediary margins
3) Calculate marginal contribution to profit
Extra sales lead to extra revenue, but they also lead to extra costs. As sales go up, clients need to buy more raw materials and pay more wages. These costs need to be deducted in order to work out the payback.
The best way to do this is to work out the variable costs associated with each extra item sold, and then subtract them off. The resulting number is called the marginal contribution:
Incremental costs = Variable cost per unit x Incremental units
Marginal contribution = Incremental revenue – Incremental costs
Alternatively, if you don’t have detailed P&L data, you may be able to estimate the marginal contribution by knowing the client’s average profit margin:
Marginal contribution = Contribution margin x Incremental revenue
[Note that this method may underestimate payback, since the margin on an extra sale is often higher than the average contribution margin.]
4) Calculate net profit
The net profit generated by the campaign is then simply the marginal contribution minus the cost of the campaign:
Net profit = Marginal contribution – Cost of Campaign
This is the ultimate measure of effectiveness, the measure of how much money the campaign made for the client.
5) Calculate return on investment
Net profit is the ultimate measure of effectiveness. However, you may wish to include a measure of financial efficiency as well, in which case you should calculate the Return on Marketing Investment (ROMI). This simply expresses net profit as a percentage of campaign cost:
ROMI = (Net Profit) / (Cost of Campaign) x 100%
ROMI is a useful measure, because it allows you to compare the efficiency of different campaigns with different budgets. It also allows you to compare the return from your campaign with the returns from other alternative investments.
Common mistakes
A recent review of IPA entries revealed that a high proportion miscalculated payback in one way or another. Here are some of the most common mistakes:
1) Assuming all sales growth is incremental
Your campaign may not be the only reason why sales increased. If it was, then you should make sure you prove it beyond doubt by ruling out other possible causes. If other factors did play a role, then you should try to disentangle their effects somehow. Econometric modelling is one way of doing this. Another is to use some kind of regional analysis, comparing regions or countries where the campaign ran with those where it didn’t. Conversely, just because sales didn’t grow very much, it doesn’t mean that the campaign didn’t work. Perhaps sales would have declined without it. Once again, econometrics and regional analysis can help. Or you may simply be able to extrapolate from historic trends.
2) Assuming all direct sales or promotional sales are incremental
It is common practise to measure the sales effect of a piece of direct response activity (whether online and offline) by counting the number of people who responded to it, and then counting how many of them went on to buy the product. However, this calculation assumes that all of those sales were incremental sales generated by the direct response activity. In fact, some of those people would probably have bought the product anyway, even if they hadn’t been exposed to the activity.
Rigorous evaluation of direct response should take account of this. You should try to estimate the base level of sales that you would have achieved without the activity, and calculate incremental sales as in step 1 in the calculation above.
Similar problems exist when evaluating promotions. The number of packs sold on offer is not the same as the number of incremental packs sold, because many of those packs would have been sold anyway.
3) Treating revenue as profit
Many IPA authors seem to be confused about the difference between revenue and profit. If a campaign costs £1m, and generates £10m worth of sales, then it is not true that it pays for itself 10 times over. Once the retailer has taken his cut, and the extra manufacturing costs are taken into account, it is quite possible that the campaign made a loss.
Authors should wherever possible try to give an indication of the profitability of the campaign. This may be difficult, since clients are often reluctant to share data on profitability. The IPA has published a separate note on the issue of confidentiality which may help you here. There are various ways in which profit figures can be disguised so as to avoid breaches of confidentiality. You are advised to study previous papers to see how other authors have tackled this issue.
4) Miscalculating net profit
When calculating net profit, you should subtract off incremental variable costs (the cost of extra raw materials, wages, etc.) and you should subtract off the cost of the campaign itself. You should not subtract off any other fixed costs, otherwise you will underestimate the payback from your campaign. Similarly, if you calculate net profit by applying an average percentage profit margin to the incremental sales revenue, make sure you use the right margin. The figure you want is the contribution margin, which is the profit margin before fixed costs are deducted. Don’t use the overall profit margin, otherwise you will underestimate payback.
Further refinements
The basic calculation outlined above is fine for the simple marketing effects, but there are various “longer and broader” effects that you may wish to consider:
1) Supporting higher prices
Rather than increasing volume, your campaign may be allowing the campaign to sell the same volume at a higher price. Measuring such effects is tricky, and may well require econometrics. However, the payback calculation is basically the same as before, except that the increase in sales value comes from higher prices.
2) Reducing costs
In principle, marketing might be used to reduce costs rather than increase revenue. For example, trade marketing, internal communications and recruitment advertising are all likely to have an effect on the cost side of a business. Measuring such effects is hard, but the payback calculations do not change significantly, except that the incremental costs now become incremental cost savings.
3) Longer-term payback
If your campaign has longer-term effects, then the payback calculations do become more complex. Firstly, you may need to project the incremental sales, revenue and costs into the future. This will typically require some kind of forecasting model.
Secondly, you need to take account of the time value of money. A campaign that generates £1m over the next five years is not as valuable as a campaign that generates £1m this year.
Get a financial expert to help you here. Accountants have a technique called discounted cash-flow analysis (DCF) for dealing with this. You should always use DCF when dealing with longer term effects.
DCF allows you to calculate the “net present value” (NPV) of any flow of money over time. Use DCF to calculate NPVs for incremental sales, incremental costs and campaign costs. Then repeat the basic profit calculation outlined above using NPVs for all values.
4) Creating options as well as increasing profits from existing products and markets, marketing may create options to launch new products or enter new markets. Little has been written on this aspect of marketing, although (insert reference to Sam Dias article) outlines one possible approach.
5) Changing market expectations
Marketing affects investors as well as consumers. By improving market expectations of a product or company’s future performance, marketing may increase its financial value. Increases in the financial value of brands or in a company’s share price can generate real financial returns for the owners. Linking these effects to marketing presents an interesting challenge to IPA authors.
6) Reducing the cost of capital
If your campaign causes the City to reassess your client’s company, then one effect may be to reduce the cost of capital. Again, little research has been done on this effect, although the potential benefits for highly geared firms may be large.