Return on Investment is Only Part of the Solution

I was reading a paper on measuring return on investment for marketers this weekend and thought that the author had misclassified a set of expenses in one of the examples. The specific issue was whether a gift certificate given to respondents is part of the marketing investment or the cost of sales. It matters because including the gift in the marketing investment increases the denominator in the return on investment ratio (profit / investment), thereby lowering the ROI. Profit is not affected because marketing investment and cost of sales are both expenses.

You could argue this case either way. If the real definition of marketing investment is the amount that will be spent regardless of whether anyone responds, as James Lenskold argues in Marketing ROI, then the gift would not be part of the marketing investment. But in many companies, the gift would be charged to the marketing budget. This would reduce the funds available for other marketing efforts and really should be considered a marketing cost.

I don’t have a strong feeling about the answer. To me what this highlights is the difficulty of working with any return on investment calculation. Not only must you estimate cash flows correctly, as with any business analysis, but you face the added challenge of classifying those flows properly. As Lenskold’s thoughtful book illustrates, this gets quite complicated when you start looking at the details.

The question is whether it’s worth the trouble. The fundamental benefit of ROI is it gives a single number that can rank investment opportunities in terms of how productively they use capital. The problem is the ROI value doesn’t indicate the total amount of return. A small investment with high ROI might make less sense than a larger investment with slightly lower ROI. (The answer depends on what you would do with the capital remaining after the smaller investment.) Things get especially complicated when you start looking at customer investments, where many options interact, conflict, or are mutually exclusive.

This is why I keep coming back to the notion of a customer value model that incorporates all the interactions a customer has with the company and calculates the resulting cash flows. Return on investment can be one output from such a model, but it isn’t the main focus. Rather, such a model attempts to estimate the net value of different combinations of customer treatments, and find the one which gives the best results. In other words, the focus is on return per customer, which in most businesses today is arguably a more constrained resource than capital.

In some ways, this is simply a difference in focus. You still have to consider return on investment, but in combination with customer value. Similarly, you still have to model specific business projects (marketing campaigns, customer service policies, new products), but also customer behaviors. If anything, the customer-based models will be even more complicated than the models that estimate project ROI. But you’ll build one customer-based model rather than many project models, and you’ll explicitly include interactions among projects rather than trying to integrate them after the fact. I believe this gives a more meaningful and ultimately more relevant view of your business, one which is likely to focus attention in the proper direction (customer experience) and result in better long-term decisions.