December 03, 2007

Diminishing Returns On Annual Customer Behavior

Diminishing returns, and its impact on annual customer behavior, became more difficult to understand with the advent of the internet.

These days, the internet causes a level of "organic demand" to occur. If no advertising occurs, a fraction of customers will repurchase next year.

As customers are exposed to advertising, behavior changes.

First, more customers repurchase, but at a rapidly decreasing rate.

Second, customers who have already repurchased spend more than they would have otherwise.

Let's take a look at what this relationship looks like, when there is $25.00 of annual organic demand, and a 30% cannibalization rate across advertising activities.

Ad Expense Rebuy Rate Spend/Rep. Demand Profit

$0.00 28.6% $87.43 $25.00 $8.29
$1.50 34.5% $109.18 $37.67 $10.97
$3.00 37.5% $120.60 $45.23 $11.98
$4.50 39.8% $129.57 $51.57 $12.59
$6.00 41.8% $137.18 $57.34 $12.99
$7.50 43.5% $143.89 $62.59 $13.23
$9.00 45.0% $149.94 $67.47 $13.36
$10.50 46.4% $155.49 $72.15 $13.41
$12.00 47.7% $160.64 $76.63 $13.39
$13.50 48.9% $165.46 $80.91 $13.31
$15.00 50.0% $170.00 $85.00 $13.18
$16.50 51.1% $174.30 $89.07 $13.00
$18.75 52.5% $180.36 $94.69 $12.67
$22.50 54.8% $189.64 $103.92 $11.96
$30.00 58.7% $205.88 $120.85 $10.08

In this table, the multichannel retailer spends an average of $15.00 per existing customer on annual advertising (catalog, e-mail, online, search, etc).

Notice two things in this table. First, "peak profit" occurs at an annual spend of $10.50. Second, there isn't a huge different in profit between $7.50 and $16.50 of spend per year per customer.

This is the seductive part of diminishing returns.

In this example, if the brand spends $7.50 per customer, the brand experiences an annual repurchase rate of 43.5%, spend per purchaser of $143.89, yielding demand per customer of $62.59.

If the brand spends $16.50 per customer, the brand experiences an annual repurchase rate of 51.1%, spend per purchaser of $174.30, yielding demand per customer of $89.07.

As a multichannel brand evolves, advertising spend per customer increases significantly. This yields a modest increase in repurchase rate, and a modest increase in spend per purchaser.

But overall profit does not significantly change, meaning that the incremental profit associated with each individual advertising activity actually decreases. People ask "what's wrong" with traditional advertising activities? People get excited about "new marketing techniques", like paid search and e-mail, because they "seem" to be doing better.

Yet, the customer generates the same amount of profit.

In multichannel cataloging, we continue to experience this phenomenon. Eventually, the advertising techniques that appear to yield lower profit levels are cut back, the techniques that appear to yield good profit levels are increased.

But in reality, across many multichannel catalogers, half of the marketing activities truly yield little incremental profit. A bump in repurchase rate, and a bump in spend per purchaser occurs. No additional cash is in the cash register, at the end of the day.

Some folks will argue that the additional advertising yields a stronger customer file, one that pays dividends long-term. These situations can be simulated, especially in catalogers, and to a large extent across online retailers.

At the end of the day, diminishing returns yield less and less incremental benefit, but require more and more resources to produce the advertising necessary to obtain the incremental benefit.

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