November 30, 2006

Return on Investment Formulas In Multichannel Retailing

Let's talk about some of the equations that individuals use to measure advertising return on investment in the multichannel retailing industry.

Ad to Sales Ratio: This is one of the most frequently used equations. Assume you spent $10,000 on an online marketing campaign, and generated $50,000 net sales. The ad to sales ratio is calculated as ($10,000 / $50,000) = 20%. Obviously, the lower this percentage is, the better your advertising performed. Multichannel retailers compare advertising efforts against each other with this metric.

Sales per Ad Dollar: Some industry publications like to use this metric. In the above example, we simply calculate the inverse of the ad to sales ratio. ($50,000 / $10,000) = 5.00. In this case, you get five dollars of sales for every dollar of advertising spent. The higher the metric, the better your advertising performed. E-Mail pundits like to use this measure, since e-mail has virtually no cost, thereby insuring that it has a good "return on investment".

Cost per Order: Online marketers enjoy using this metric, one that is maybe the least effective metric of all. Assume that the $10,000 spent in our previous examples generated 400 orders. Cost per Order (sometimes labeled "CPA" for cost per acquisition) is ($10,000 / 400) = $25.00. Each advertising strategy is compared, with lower metrics preferred. This metric is highly skewed, because the metric doesn't account for how much was spent, per order.

Profit per Order: A more effective, but less-used metric, is profit per order. Let's assume that, in the example above, twenty-five percent of the sales generated are converted to profit. In this case, ($50,000 * 0.25 - $10,000) = $2,500 of profit is generated. Next, divide the $2,500 profit by 400 orders. This yields $6.25 profit per order. This is one of the better ROI measures, because all aspects of the profit equation, sales, margin, and marketing cost, are included. Better yet, this measure can be stacked-up against long-term value metrics. For instance, if a marketer loses $10.00 profit per order, but expects to get $50.00 lifetime value back, the marketer should invest in the marketing activity.

Internal Rate of Return: This metric is not frequently used, but reflects what happens if marketing dollars are continuously invested over the course of a year. In the Profit per Order equation, we netted $2,500 profit on an investment of $10,000. Let's assume that this marketing effort took place over a twenty-six week period of time. The internal rate of return is calculated as ($12,500 / $10,000) ^ (52 / 26) = (1.25 ^ 2) = 1.56. In other words, on an annual basis, this investment has a fifty-six percent interest rate. The interest rate can be compared against all other marketing activities (many of which have a different time window --- e-mail may have just seven days, for example).

Your turn! What return on investment metrics do you like to use to evaluate marketing activities at your company?