Thursday, December 08, 2005

Revenue Metrics - Bad for Credibility

Marketers show a tendency to use dashboard metrics that relate to revenue (topline sales) as opposed to profits (bottom line). This is a critical error that not only risks misleading decision makers about the effectiveness of marketing investments, but also perpetuates the cynicism with which other departments view marketing.

The potential to be misleading is relevant in that marketing costs must be allocated to the sales they generate before we determine the net incremental profits derived from the marketing investment. If we spend $5 million in marketing to generate $10 million in sales, fine. If the cost of goods sold (COGS, fully loaded with fixed cost allocations) is less than $4 million, we probably made money. But if the COGS is more than $4 million, we’ve delivered slightly better than breakeven on the investment and more likely lost money when taking into account the real or opportunity cost of capital.

Presenting marketing effectiveness metrics in revenue terms is seen as naive by the CFO and other members of the executive committee for very much the same reason as outlined above. Continuing to do so undermines the credibility of the marketing department, particularly when profits, contribution margins, or even gross margins can be approximated.

In my experience, there are several common rationalizations for using revenue metrics, including:
  • limited data availability;
  • an inability to accurately allocate costs to get from revenue to profit; and/or
  • a belief that since others in the organization ultimately determine pricing and fixed and variable costs, marketing is primarily a topline-driving function that does not influence the bottom line.

To the first of these, I empathize. Many companies suffer from legacy sales reporting infrastructures where only the topline numbers are available or updated with a minimum of monthly frequency. If you’re in one of those, we encourage you to use either the last month’s or a 12-month rolling average net or gross margin percentage to apply to revenue. Finance can help you develop reasonable approximations to translate revenues to profits in your predictive metrics. You can always calibrate your approximations later when the actual numbers become available.

If you suffer from the second of these, an inability to allocate costs precisely, consider using “gross margins after marketing” (revenue less COGS less marketing expenses). Most companies know what their gross margins are by product line, and most CFOs are willing to acknowledge that incremental gross margins after marketing that exceed the overhead cost rate of the company are likely generating incremental profits. This is particularly true in companies in which the incremental sales derived from marketing activities are not necessitating capital investments in expanding production or distribution capacity. In short, engage finance in the conversation and collectively work to arrive at a best guess.

If you find yourself in the third group, you need to get your head out of the sand. The reality is that the mission of marketing is to generate incremental profits, not just revenue. If that means working with sales to find out how you need to change customer attitudes, needs, or perceptions to reduce the price elasticity for your products and services, do it. Without effective marketing to create value-added propositions for customers, sales may feel forced to continue to discount to make their goals, leading the entire organization into a slow death spiral — which, ironically, will start with cuts in the marketing budget.

If you identified with this third group, this should be a wake-up call that your real intentions for considering a dashboard are to justify your marketing expenditures, not really measure them for the purpose of improving. If that’s the case, you’re wasting your time. Your CEO and CFO will soon see your true motivation and won’t buy into your thinking anyway.

Having said all that, there are some times when using revenue metrics is highly appropriate. Usually those relate to measurements of share-of-customer spending or share-of-market metrics that relate to the total pie being pursued, not those attempting to measure the financial efficiency or effectiveness of the marketing investment.

In addition, be especially careful with metrics featuring ROI. If ROI is a function of the net change in profit divided by the investment required to achieve it, it can be manipulated by either reducing the investment or overstating the net profit change beyond that directly attributable to the marketing stimulus. Remember that the goal is to increase the net profit by as much as we can, as fast as we can, not just to improve the ROI. That’s just a relative measure of efficiency in our approach, not overall effectiveness.

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