In my decade working in interactive advertising I’ve noticed a disturbing trend in the use of the term “Return on Investment” or ROI. The problem isn’t really an inaccurate use of the term -- the definition has softened over the years -- but more of a disregard of the equation’s potential due to sheer laziness. For instance, in the past week alone, I’ve read two different electronic books that promised an “increase in your ROI” by using their methods. However, once I got past the promising title, I found out that the author doesn’t even bring up the equation for determining this important measure of profitability.
I can’t get too upset about this abuse; math has always been a point of contention for a wide range of people, including myself. In fact, I even switched majors during my undergrad days from computer science to advertising because I couldn’t get through Discreet Mathematics. But since the ROI equation is really just about division, I’m going to take a minute or two to go over the details of what the real ROI is about and how you can use it in the optimization of your SEM and other interactive advertising activities.
Be warned here, kids, we’re going to be talking about mathematical equations today. But don’t panic, it’s nothing close to John Nash level equations, just simple division and multiplication.
The Power is in the Purity
The real ROI equation is one of those rare mathematical formulas that is pure poetry in its simplicity yet still produces powerful results. In fact, according to the “Dictionary of Modern Economics” from the MIT Press, the definition of ROI is "A general concept referring to Earnings from the Investment of Capital, where the earnings are expressed as a proportion of the outlay."
Basically, this means that ROI is a measurement of profitability that takes into account the profit from an activity in reference to the capital invested in the activity itself. Or, in an equation style format:
Isn’t that beautiful? I know, I know, it’s nothing you would want to take to the prom, but you really can’t ask for a more simple way to measure your profitability. The results are easy to interpret as well: Just like when looking at a result for profit, the closer your ROI is to 0 percent, the closer you are simply to breaking even. The farther the number is away from 0 percent, the better the return. Think of ROI in the same way you would a regular bank savings account’s interest rate.
Alternatively, if your ROI is less than 0 percent, then you’re losing money, as you probably already knew from the negative profit number. So, for example, if you partake of an activity of some sort that results in $100 in Profit that only cost you $100 in Invested Capital, then your ROI would be 100 percent, that is, you get an additional $100 back from your investment of $100, thus doubling your money.
Now, since a lack of knowledge with these terms is usually one of the reasons the ROI equation is abused, I would be remiss if I didn’t fully explain the two major parts of the equation in detail. Profit, in its simplest form, is the gain from a business activity after subtracting all of the expenses used in the activity. Invested Capital refers to all capital (that is, cash or goods), used to generate the profit in the aforementioned activity, such as advertising costs, physical plant, and so on.
It is important at this point to bring up the value of accuracy and consistency. In both halves of the equation, to get as accurate an ROI result as possible, you need to make sure you are really taking into account all of the expenses and capital used in the activity. Otherwise, your results will be a lot better than reality, and you stand the chance of possibly continuing an activity that does not warrant continuing while your company slowly bleeds cash. Additionally, you should make every effort to be as consistent as possible when calculating your ROI value; that is, you need to use the same methods to determine profit and invested capital each time. This little precaution will ensure that a comparison from one activity to another is not biased because in one instance you counted one aspect of the activity -- say a set-up fee or other expense -- and the other you did not.
By the way, while we’re discussing things like profit and invested capital, I should bring up that the financial world is a tad wishy-washy when it comes to what to call the variables used in this equation. So, if you see terms like “Net Income,” “Net Profit,” or “Net Earnings,” in this instance it is the same as “Profit.” On the other side of the equation, if you see terms like “Assets” or “Total Assets,” in this instance it is the same as “Invested Capital.” There are instances where these terms do have alternative meanings, but when calculating ROI for something like advertising, just stick to these definitions and you’re golden.
One more point that should be made: the ROI metric is specifically designed for comparison to other ROI measurements and not to be used as a stand alone measurement. Remember the "Click-Through Rate (CTR)" metric? Remember what a bad rap it got for a while? Well, that bad rap came from people misusing it. The problem arose when people started comparing their CTR for a campaign against things like "industry averages." Often, they neglected to take into account variables like sales or ad placement. In the end, these folks would cut perfectly effective campaigns that were making them money because they misunderstood the metric.
Variations on a theme
While the power of the ROI equation may lie in its simplicity, that same simplicity can cause some issues when it comes to collecting all the necessary data to provide the most accurate results. For instance, finding the true profit of an activity can prove difficult in some instances due to a lack of data on other aspects of the business. Omissions in this data can, as previously mentioned, provide inaccurate and costly results. With this in mind, I will present a collection of variations on the ROI equation that may prove useful.
To begin with, the equation itself can be broken into two separate parts that incorporate sales (a.k.a. revenue) into the equation without undermining the quality of the results.
If you remember back to your algebra days, this equation is made possible by the fact that since the sales variable is both above and below, it cancels itself out and therefore simplifies the equation down to the previously discussed form. However, for now, let’s concentrate on the expanded version above.
As you might have noticed, the right half of the equation (profit over sales) is the same equation that provides you with the Net Profit Margin (or just Profit Margin) percentage. This rate can often be found in all public companies’ annual reports and on the balance sheets of most private companies, if the company shares information with the rest of their employees. (It should be noted that the left side of the expanded equation, sales over invested capital, is another metric known as Turnover. This metric is also often found in most annual reports; however, its use would only complicate things here, so we won’t present any versions of the ROI equation with it in place.)
Once you convert the right side of the equation to just profit margin, the above equation can be simplified further to:
In this form, it is much easier to use the company’s overall profit margin in your ROI calculations, rather than just what you can dig up as expenses used in a particular instance, such as just the cost of goods or advertising. Some may argue that this variation places an undue burden on sales revenue by multiplying the profit margin for the entire company against the sales from this one activity. Conversely, not using this number in place of a more lenient profit estimate may produce an ROI result that keeps a money-losing activity alive. When this decision is up to me, I tend to lean towards a more conservative answer that could save the company money. However, if you feel you can stand the risk, feel free to use a broader profit variable in the equation, such as Sales less the Cost of Goods, etc.
Tomorrow: So what does all this math have to do with interactive marketing?
Jeff Ferguson is an internet marketing consultant and president of TheGag.com.
