Will the Real ROI Please Stand Up?

marketingFor a long time now, I’ve noticed a disturbing trend in the use of the term “Return on Investment” (ROI). 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 forewarned here, kids, we’re going to be talking about mathematical equations here today. But don’t panic, it’s nothing close to John Nash level equations, just simple division and multiplication.

In my almost ten years of working in the interactive advertising field, I’ve noticed a disturbing trend in the use of the term “Return on Investment” or ROI. The problem isn’t a flat out inaccurate use of the term, because its true definition has softened over the years, but more along the lines of a complete 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 guess 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 past 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.

The real ROI equation is one of those rare mathematical formulas that are pure poetry in their simplicity yet produce 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, it 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:

ROI Marketing

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%, the closer you are to simply breaking even. The farther the number is away from 0%, 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%, 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%, that is, you got 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 so often, 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, using 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.

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.

ROI Marketing

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 they’re into sharing the 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:

ROI Marketing

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 the 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.

I know what you’re thinking, “Hey, this is cool and all, but this is a search engine optimization site! How do I use this in my search engine marketing?” Thank you for your patience, the time is now, the place is here.

So, in all its glory, below is the expanded ROI equation that takes into account the Cost per Click metric used in Pay For Performance search engine advertising.

ROI Article

(Where C = Clicks, CR = Conversion Rate, AS = Average Sale, PM= Profit Margin, and CPC = Cost per Click).

Before we get too deep into this equation, a few important notes about the ROI equation in this form are in order. For starters, remember that this equation refers to the Average Sale value based on all the Sales made during the campaign and the average Cost per Click value used in the campaign. Also, it needs to be said that the bottom half of this equation is missing a lot of pieces of the total Invested Capital that was used in the campaign. However, as long as this form is only used in comparing similar advertising campaigns, the results are going to be closer to reality than using nothing at all. Finally, going back to our friend Mr. Algebra, note that it is safe to remove the “Clicks” variable from the top and bottom of the equation as long as you continue to use the Average Sale and Cost per Click values properly.

Before I wrap things up, I did want to point out one odd variation and one flat out inaccurate abuse of the term Return on Investment. I’m pretty sure I’m going to get a few e-mails from people who have been doing both of these, but I can take it.

The first, the odd variation, is the use of the term Return on Investment or ROI as an esoteric term that has no reference back to the actual equation that bears its name. I hear consultants and traditional advertising agencies throwing this one around a lot in meetings and I find an unhealthy joy from providing an actual percentage when these types ask, “What kind of ROI are you lookin’ for in this campaign?”

The second, the flat out inaccurate abuse, is the substitution of the equation for Return on Advertising Spend (ROAS) for ROI. I recently had someone at a traditional agency try and tell me that the two were interchangeable and I almost passed out. The ROAS equation, which is used to determine how much Revenue (or Sales) is needed to cover the cost of the advertising, usually looks something like this:

ROI Marketing

The reason this substitution is an abuse of ROI lies in the top half of the equation, Revenue. You can usually pull off just using your Advertising Spend on the bottom half of the ROI equation in place of Invested Capital, but Revenue is never the same as Profit – ever. Using ROAS in place of ROI will result in percentages often well over 1000% and gives the user a false sense of accomplishment. It’s easy to fix, all one has to do is multiply the top by the Profit Margin (or at the very least, subtract the advertising expense from Revenue), but in so many cases, the damage is already done and usually in front of a client.

I Know it’s Only ROI, But I Like It…

See? That wasn’t so hard now, was it? A little division, a little multiplication, and now you’ve got a better grasp of if your advertising activity is making you money or just draining your coffers. Sure, it isn’t a perfect equation and far more people use its powers for evil than good, but just the fact that you’ve made it this far in the article means you now have a leg up over the many other businesspeople who don’t even bring this powerful equation into play.

This time, we just did a pass over how the basic ROI equation works. Look for future articles from me that will show you how to use some slight variations on this equation to help optimize your pay-for-placement and other advertising programs.

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