How to run and read an ROI analysis

Return on investment (ROI). It's one of the most commonly used phrases in the direct marketing lexicon and one of the paramount benchmarks on which success or failure of a campaign is measured.

But as common a concept as ROI is, many direct marketers still don't perform the analysis or, perhaps worse, perform it incorrectly. As a financial analysis, ROI is a measure of a company's net income related to its total asset investment. For direct marketers, that "asset investment" generally is the advertising cost associated with generating the sales that contribute the net income. Depending on the business, it also could include the investment in inventory to sell.

For the purpose of this column, the focus is on advertising dollars as the investment to illustrate the technique.

ROI then is the net profits (the return) related to the advertising dollars spent (the investment). For example, if, after all costs are accounted for, net profits for a campaign are $10,000 and the advertising costs for producing and mailing the piece are $50,000, ROI would be equal to $10,000 divided by $50,000 or 20 percent.

What ROI is not is sales divided by ad spend. This is a common mistake. By focusing on sales as the numerator, none of the pertinent costs are addressed, and the calculation is virtually meaningless from a decision-making standpoint. If, using the numbers above, a company generated $95,000 in sales with its $50,000 investment, this miscalculation would render a 190 percent "ROI." But if costs rise in any key areas such as cost of goods, advertising expenses, fulfillment or overhead, the profits will shrink and a big sales generator may become an investment loser.

Using ROI Analysis
For most mailers, ROI analysis is applicable as a strategy-level analysis as well as a post-mortem analysis.

As a strategic analysis, a pro forma ROI should be evaluated prior to any effort or campaign. Each campaign, when built, typically is forecasted for sales and net profits at the segment level, as well as overall. That campaign P&L becomes the foundation for the ROI analysis, and the results of the analysis should provide insights during the decision-making process for whether a campaign should be executed and to what extent.

If the company's ROI requirement is 25 percent and the pro forma analysis suggests an expected ROI of 50 percent, this may indicate the mailing can go deeper into the housefile or can be mailed to more prospects. It's also important to perform the ROI analysis to establish campaign expectations against which the final results of a campaign can be measured.

As a post-mortem tool, ROI analysis answers the question, "What did we get for our money?" and starts the process of establishing the next effort's strategy. After a campaign is complete, ROI analysis should be performed on as many aspects of a mailing as possible, including version tests, offer tests, individual drops and individual segments. Armed with this information, planning for the next effort starts with an understanding of the effects of various offers and versions on various customer and prospect groups and exactly what those variables generate for every marketing dollar spent.

As a decision-making tool, ROI obviously is valuable. If a company can get more for its money by letting it generate interest in a bank account than it can get by investing in a marketing effort, the money should stay put until either a program that will perform better is found or a way to make the existing program perform better by improving costs, increasing average order values or cutting the advertising expense is discovered.

Calculating ROI
Calculating ROI isn't difficult. It starts with a P&L, which most companies would run as a pro forma prior to a campaign and as a final complete after a campaign is executed. A typical cataloger's P&L groups together the merchandise, fulfillment, advertising and overhead components, so key benchmarks can be used to manage costs.

The P&L provides the necessary information for calculating ROI: earnings before interest and taxes divided by advertising costs. In this example, ROI is $100,489 divided by $533,672 or 19 percent. If this cataloger can get better than 19 percent return on its money by leaving it in the bank, it should. Otherwise, this program is successful, and the ROI baseline should be used to compare other potential programs against it in the future.

A pro forma ROI, run prior to the final go/no go decision for a campaign, can be less detailed but should follow the same general guidelines as the P&L version. The chart above is an example of a pro forma that uses projected data, based on historical mailing performance and established corporate benchmarks for costs, to establish the figures for the ROI calculation. Going into the mailing, the company knows that if, for example, the required return on capital is 30 percent, the campaign in question will dramatically exceed that. From here, adjustments can be made in the plan to perhaps mail deeper or more frequently to "water down" the ROI to a point where sales are maximized and profits are minimized down to the required level of return.

As you can see, ROI analysis isn't difficult to do, it just takes a little time to set up the process to run the calculations. Once set, the findings can be powerful. ROI analysis, run correctly, is as likely to find money left on the table as it is to find pet projects that will never be worth the money.