I was recently chatting to a good friend of mine, who runs a successful plumbing business. He was about to start work with a digital marketing agency, which shall remain nameless.
I asked him, “Why did you choose that agency?”
He replied, “They promised me 400% Return on Investment (ROI).”
I said, “And do you think that is a good outcome?”
He replied, “Yes, of course, don’t you?”
The Math’s on Marketing ROI
To answer my friend’s question, we need to look at the math’s of an actual – not fictitious – return.
So, let’s say you spend $1,000 to make $4,000, correct? This gives you a gain of $3,000 because with any investment you’re supposed to get the original amount back plus the return, yes? This immediately brings us down to a 300% ROI.
My friend’s business runs at a 50% gross profit, or in other words, it costs him 50% of his revenue to deliver on his promise. 50% of $4,000 = $2,000, bringing us down to 200% ROI.
Then we’ve got staff wages, which run at 20% of revenue, so we’re another $800 down.
He’s also got other fixed costs. To open his doors costs 25% of his revenue. So, for $4,000 in revenue, he has $1,000 in costs. I know what you’re going to say – these are fixed costs, so there are no extra costs associated with delivering his products or services.
But tell that to anyone who has grown a business before. With growth comes the growth of fixed costs, so you need to factor them in at all times; otherwise, your revenue goes up, and your profit comes down!
So, now, we are negative $800 ROI. Not only have I not made money, but I’ve also lost money on what I thought was a good deal. That is not a good ROI. What started as a 400% ROI is actually -80% ROI.
This is just one example of how using the term “ROI” in a marketing sense is very misleading.
Revenue Vs Profit
Now let’s take a step back and look at the definition of ROI on Investopedia:
“ROI is a performance measure used to evaluate the efficiency or profitability of an investment or compare the efficiency of a number of different investments. ROI tries to directly measure the amount of return on a particular investment, relative to the investment’s cost.”
Notice the key term throughout is ‘investment’ and when we look at that definition:
“Investment is the action or process of investing money for profit.”
Profit is the operative word. Revenue is not profit. When marketers use the word ROI, they measure revenue and not profit, which is very misleading. The adage “Revenue is vanity, profit is sanity, and cash is reality” applies. Revenue is irrelevant; profit is what really matters.
This all started with a very smart (and perhaps a little shifty) marketer who wanted to look good. So, they started using accounting terms in a marketing sense and turn marketing into a ‘revenue’ focused proposition without the ramifications of what real costs there are in the business. What once looked impressive now makes no business sense.
Marketing campaigns aren’t an investment
When you spend $1000 on google ads to make $5000 in revenue, this isn’t an investment, this is an expense. That’s why it appears in the expense column of a profit and loss, not in the balance sheet).
Also, revenue isn’t a return on investment. It’s actually a terrible measurement because It hides the underlying outcome to the business. It’s not accurate and it doesn’t tell us anything of real value. What can look like a great ROI can actually mean the business is losing money.
The better and more honest metrics to measure are:
- Cost per LTV (for example, it costs us $100 to make $4,000 in revenue over the life of that customer)
- Cost per acquisition (work out from above)
- Cost per lead (depending on how well your sales team are converting)
So, what are acceptable “cost per” numbers?
That depends on the business, and every business is different. To work this out, you need to spend time going through your finances and financial statements to work it out. Once you’ve set your target profit (and %), you can work backwards to an acceptable cost per acquisition.
The exceptions to the rule
There are two notable exceptions in marketing that can be considered an investment – but as you will soon see, it is near impossible to put any accurate ROI figures on them:
- Your website – It will produce a significant return when done right for the rest of your business’s life. The taxman is also happy for you to treat it as a capital expense (CAPEX) that is incurred to create a benefit in the future instead of an operating expense (OPEX) required for the day-to-day functioning of your business. But the ROI is hard to quantify or measure.
- A marketing system – If it continually generates new customers within an acceptable cost per acquisition, that is profitable.
Despite this, it’s time to remove ROI from our marketing vocabulary and get smart with reporting on things that really matter.
So, the next time you hear a marketing person spruik 700% ROI or a marketing company telling you they’ll return 5 x your investment, run for the hills.