Two numbers from a profit and loss statement would suggest that marketing budgets are too small. The first, gross profit, measures the profit on product revenue after related outlays. The second is marketing expense. If these two numbers are combined in a ratio as gross profit/marketing expense, the result measures how much profit is generated by every marketing dollar.
For instance, a gross profit of $10,000 divided by $1,000 marketing expense would result in $10 generated by each $1 of marketing. By extension, an extra dollar of marketing expense will be expected to generate $10 additional gross profit. Hence, the marketing budget is too small.
Of course, this is a fallacy. Such a conclusion contains many assumptions: It attributes every dollar of profit to marketing activities; it assumes that each incremental dollar of marketing would generate the same return; it posits that there are additional avenues or channels for incremental marketing activity; and it assumes that additional channels or actions will return the same or higher value. It also assumes there is no better path for an incremental dollar of business expense – investment – within the company, and that there is no change in risk of return.
As a result, trying to increase the marketing budget is difficult. Apart from the risk and validation of incremental returns, there are many competing demands for incremental investment within a business, all with measurable outcomes: investments in product design, packaging, operations, plant and equipment, as well as salaries and benefits.
This does not mitigate the significance of the gross profit/marketing expense ratio. In fact, these arguments reinforce its importance in evaluating the relationship between marketing expense and gross profit. Such a metric can be used to focus effort on measurably improving marketing efficiency—by reducing cost, for example, while maintaining gross profit.
If marketing costs could be reduced by 10%, the ratio could be used to highlight that achievement, demonstrating an improvement from $5 gross profit for every $1 invested in marketing to $5 earned for every $0.90 spent.
However, the value in improving efficiency is not in cost savings, it is in reinvestment. The ratio of $5 to $0.90 may be literally correct, but it is also equivalent to the ratio $5.56 to $1. In other words, instead of representing a marketing cost savings of $0.10, the savings has much more potential if reinvested for a higher return. If reinvested, the savings of $0.10 represents a potential gross profit of $0.10 times $5.56, or $0.56 gross profit.
Furthermore, a new and higher level of efficiency may create additional marketing opportunities. Previous customer segments that might have barely broken even when earning $5 (on average) for every marketing dollar may now be profitable enough to pursue with the better-performing programs earning $5.56 for every $1 of marketing.
How can marketers improve efficiency? By focusing on groups of low responders and establishing more refined selection filters, thereby eliminating the least responsive customers. Another approach could be based on refining customer segments to improve targeting and raise response rates. A third possibility is provided by testing new promotions to boost the accuracy of marketing’s perception of the customer.
The ratio of gross profit to marketing expense may be simplistic, but such a measure will highlight high-return marketing activities as well as low-return ones. This should allow marketers to fund activities that earn a better return and improve or reduce efforts that earn a lower return. In this way it may be easier to allocate the existing budget more effectively in order to generate additional marketing dollars.
These calculations, which highlight the relationship between marketing activities and gross profit, increased level of marketing efficiency, and incremental marketing opportunities generating additional profit can then combine to demonstrate marketing’s responsibility and capability for influencing business results.
Jeff LeSueur is the author of Marketing Automation, Practical Steps to More Effective Direct Marketing, published by John Wiley – Volume 10 in the Wiley and SAS Business Series. Copyright (c) 2008 SAS Institute Inc., Cary, NC, USA. All Rights Reserved.