It’s interesting that sometimes bad maths sounds completely logical, even to highly experienced senior managers.
Some time ago I met with a general manager of a small division within a larger company. His division had a strong focus on sales but very little investment in marketing. They had a solid client base and very high margins, so were strongly profitable.
While sitting in his office, discussing a potential marketing campaign, he explained to me: “I have target annual revenue of $1 million and a marketing budget of $50,000. So, every dollar spent on marketing must directly bring in $20, otherwise it doesn’t make sense to do it”.
At first, it sounds logical. His revenue target of $1 million is 20 times the size of his marketing budget of $50,000. Therefore, every dollar spent on marketing needs to produce $20.
Extrapolating the logic, we can say that if he spent money on marketing that only produced $7 for every $1 of ad spend, with the $50,000 marketing budget he would only expect to earn $350,000 revenue for the year, which would be a disaster.
However, this is an example of bad marketing maths, which was severely restricting the business growth.
His logic failed because most of their sales each year came from repeat customers, not from advertising. They had excellent email engagement with existing clients that drove sales, as well as two highly dedicated sales reps on the road visiting their clients throughout the year.
The truth is that even if he spent nothing on marketing for the whole year, they could still expect to have substantial sales from their repeat customers.
So then, if business is so good, why advertise at all?
For this business, the purpose of advertising was to attract new customers, who would turn into repeat customers.
Better marketing maths would start by asking what percentage of their revenue was expected from new customers each year. For this division, because of their strong repeat sales, just 20 percent of their revenue was expected to come from new customers.
This changes the maths significantly. The $50,000 marketing budget is actually aiming to produce $200,000 of new revenue. This means every marketing dollar spent needs to bring in a more realistic $4 to be profitable. This makes finding profitable marketing opportunities far more likely.
With the previous unrealistic 20x return-on-investment requirement the general manager was turning down many good advertising opportunities that could have easily brought in new clients. The result was that the marketing budget was underspent (since very few campaigns could come close to meeting the performance requirement) and the targets for annual revenue from new clients weren’t met, which affected their revenues overall.
Had he used better marketing maths, advertising campaigns would have been placed more often giving the sales team fresh leads and the revenue target for new customers could easily have been achieved.
There’s another, even a better way, that the general manager could have approached the marketing maths. It starts by asking, “How much is a customer worth?”
For this business, the average customer was worth $1650 in revenue per year. They had high gross margins of around 85 percent, meaning a gross margin per year of around $1400 per customer. The average lifetime of a customer was more than 10 years, so each new customer was worth on average $14,000 gross profit over their lifetime.
With these figures, the general manager could have decided that he was willing to spend $350 to acquire a new client. (He could have chosen any other figure, but for this illustration we’ll use $350, which equates to three months of profit from the average client). If we spend the $50,000 marketing budget acquiring new customers for $350 each, we are targeting 142 new customers for the year.
With the same average revenue of $1650 per annum, these new customers will bring in just under $235,000 of revenue for the year.
But the real return on investment is seen in the lifetime value of these new customers – 142 new customers are expected to be worth $2m in gross profit over the next 10 years. This shows the real benefit that investing in marketing would bring. Investing in acquiring new customers now, would set up profit for many years to come.
If he wanted to be more aggressive with acquiring new customers, he could choose to increase the marketing budget and increase what he is willing to spend to acquire a new customer. Since a new customer is worth $14,000 over a lifetime, spending $700 or even $1400 to acquire a customer will still give strong return on investment. It all depends on the nature of the industry, the aggressiveness of the competition and whether business cashflow allows it.
Bad marketing maths caused this general manager to be so restrictive on marketing campaigns that he was decreasing profits for many years into the future. Instead, using good marketing maths, businesses with strong repeat business should look at the lifetime value of their clients and invest in customer acquisition that will grow their customer base and build business profits for many years to come.