Do you really know how to calculate ROI? How about Lifetime Value? Can you explain how to calculate “marketing contribution”? Here’s a simple presentation of the key marketing math formulas, along with practical ways to calculate things like Lifetime Value.
Marketing Math for Analyzing Programs
How do you compare marketing results from different media? The key metric is Cost Per Sale or Cost Per Order (CPO):
Total $ Cost of the Program / # of Sales or Orders = CPO
This tells you how cost-effectively each program or vehicle generated orders.
What about ROI or Return on Investment? Many are confused by this calculation, perhaps because of the difficulty of assigning a number for Overhead. ROI is NOT:
- $ Revenue divided by $ Marketing Cost. That’s called the Expense to Revenue Return. It tells you how much revenue you generated for every $1 of marketing expense.
- Gross Profit divided by $ Marketing Cost. That’s called Marketing Contribution –the amount the marketing program has contributed to profit and overhead.
ROI is correctly calculated as: Net Profit / $ Marketing Cost. To get there:
- $ Sales + Shipping and Handling Fees = Gross Revenue
- Gross Revenue MINUS Returns and Bad Debt = Net Revenue
- Net Revenue MINUS Cost of Goods Sold (COGS), shipping costs, 800 number costs, credit card costs = Gross Profit
- Gross Profit MINUS Marketing Costs = Marketing Contribution (to profit and overhead)
- Marketing Contribution MINUS Overhead Contribution (typically a % of sales) = Net Profit
Net Profit / $ Marketing Cost = ROI
Planning Your Marketing Budget
If you’ve been measuring Cost Per Order (CPO) on every program and every different marketing vehicle, you should never have to argue about the Marketing Budget with your boss or CFO.
- If you have a Dollar Sales Target (let’s say $100,000), divide that by your past Average Order Size (let’s say $200) = your Target Number of Orders (500)
- Multiply CPO (let’s say $80) X Target Number of Orders (500) = Marketing Budget of $40,000.
If your boss or CFO says, “we can only spend $30,000″, your answer is, “no problem, based on our past Cost Per Order, that means we will likely only generate:
$30,000 / $80 = 375 orders @ $200 Average Order Size = $75,000″
When the marketer can bring CPO to the table, budget negotiations can be based on actual results, rather than guess-work or dreams.
Cost Per Acquisition and Lifetime Value
If you’re like most marketers, you may struggle with the question, “How much can we spend to acquire a customer?” The answer to that question depends on your company’s particular business model:
- Are you willing to just breakeven on each new customer? If so, that likely means you can rely on customer Lifetime Value (the stream of future purchases over the customer’s lifetime with you) to make each new customer profitable over time. The maximum amount you’re willing to spend to acquire a new customer = Gross Profit Per Sale.
In this case, you may calculate breakeven “incrementally,” by just considering the costs of making one more sale:
- Average Order Size MINUS Direct Product Costs Per Sale = Gross Profit Per Sale
- Total $ Marketing Cost DIVIDED BY Gross Profit Per Sale = # of Orders to Breakeven (Breakeven Quantity)
- Breakeven Quantity DIVIDED BY # Reached = Breakeven Response Rate
You may not be willing to just breakeven on each new customer — maybe each new sale must also contribute to overhead and profit immediately. In this case, the amount you can spend to acquire a customer will be the Marketing Allowable Cost Per Sale:
Gross Profit Per Sale MINUS Overhead and Profit (typically a % of COGS) = Marketing Allowable Cost Per Sale
Even more marketers struggle with actually computing Lifetime Value (LTV) which is defined as:
Average $ Sales from Active Customers Per Year / Average # Years as Active Customer
See the slides for a step by step way that most companies can use to calculate Lifetime Value.
Are there any key marketing math formulas that I missed?