Will using this traditional metric lead you to riches or to rags? Maybe it’s time for a new look at the old return on investment.

by Sharan Jagpal

It’s no secret that the business world is slow to change. Sure, it has made the evolution from typewriters to computers for word processing and from snail mail to e-mail for written communication. But when it comes to the core of doing business, such as the methods and measurements used and the way departments are siloed, many 21st-century companies might as well be stuck in the Stone Age.

And now, even as the recession wanes, this unwillingness to replace old business models, strategies and metrics with new ones will lead many companies to their demise and cause others significant hardship.

Given the gloomy circumstances many businesses find themselves in today, CEOs and marketing executives need to take a fresh look at standard financial metrics. A good example is Return on Investment, a popular resource-allocation tool and measure of performance, including marketing productivity.

The question is, is your reliance on the ROI approach leading you to riches, or keeping you in rags?

As you doubtless know, the traditional formula goes like this: ROI equals profit/investment. So, if your profit equals $1 million and your investment equals $20 million, your ROI is 5 percent.

Fairly straightforward, right? Not so quick.

While the ROI concept may seem pretty elementary, there are two glaring problems with this popular metric. First, it measures financial performance without taking into account the level of risk associated with the investment, particularly when used to assess marketing strategies. Second, except for simple strategies, ROI is likely to lead to poor decisions — for example, when the firm uses a multimedia advertising strategy, sells products to a common customer base or sells products that share joint costs.

For many people, the idea of adjusting ROI for risk is quite novel, and the idea of comparing risk-adjusted ROIs across different strategies is equally so. Yet, at a time when most businesses could use a boost, and some are in serious trouble, it’s time for such “new school” metrics to become the standard. To get a clearer picture of what I mean, consider the following two scenarios.

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ROI Scenario No. 1: Customer Retention vs. Market Growth.

Walmart is currently facing increasing competition in the United States from a major European retailer, ALDI. Let’s say that Walmart is considering two strategies to hold off ALDI’s rise: (1) increasing its rate of retaining its own customers or (2) obtaining new customers. Let’s say that the advertising expenditures for the two strategies are equal, $1 million.

Suppose Walmart’s management expects the retention strategy to lead to an average increase in net profits of $300,000 and the market growth strategy to lead to a higher average increase in net profits, $400,000. By using the standard ROI criterion, Walmart would conclude that the market growth strategy is superior. After all, an ROI of 40 percent is better than an ROI of 30 percent, right? Sure, if other things were the same. They aren’t.

When you recognize that Walmart’s choice of marketing strategies changes the company’s risk level, you find that market growth isn’t necessarily the way to go. In general, it is riskier to obtain new customers than to retain existing ones. In fact, after correcting for risk, it’s quite possible that the customer retention strategy is superior for Walmart — even though, on average, it provides a lower ROI than the market growth strategy.

As the Walmart example shows, the standard ROI criterion is likely to lead to poor decision making because it fails to consider the trade-off between risk and return.

It is essential to compare strategies using the risk-adjusted ROI since different marketing policies involve different combinations of risk and return. Depending on the magnitude of the uncertainties involved, many companies could well find, after comparing risk and return, that it may be better for them to focus on marketing strategies with lower, not higher, average profits.

Starbucks is a prime example of a company that made the mistake of focusing on average ROI without adjusting for risk. In October 2006, the company dramatically raised its long-term store-opening goal to 40,000 from its prior goal of 30,000. The stock market responded positively to this announcement, and the company’s shares closed higher by 7.6 percent that day. Subsequently, however, Starbucks paid the price for choosing the wrong strategy. It paid a high price (i.e., lower profits) for focusing on ROI without correcting for risk.

So, regarding the “market growth” versus “customer retention” question, how should a company decide which is better? The answer requires two steps. First, the marketing department must provide quantitative estimates of the risk and return of the cash flows from these two strategies. Second, the finance department (or senior management or CEO) should use this information to determine which strategy provides a higher risk-adjusted ROI.

In this analysis, the ownership structure of the firm is critical. A publicly owned firm should focus on market risk — that is, the risk to stockholders after they have diversified their holdings across firms. A privately held firm should choose the optimal strategy based on the owner’s tolerance for risk and return.

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ROI Scenario No. 2: Media Planning

As with most rules, there is always a caveat. The same is true of the risk-adjusted ROI. Just as calculating simple ROI isn’t sufficient, there are times when a company will have to look deeper than just its risk-adjusted ROI to determine which marketing strategy is better for it.

For example, suppose that Dell is considering two media in which to advertise a new laptop: national TV and the Internet. Let’s say that the budgets for the two media plans are the same. Should Dell choose the advertising medium with the higher ROI?

As the Walmart example shows, simply considering ROI fails to consider the trade-off between risk and return. Hence, it may not lead to the optimal decision for Dell’s new media plan. However, there is an additional factor that Dell needs to consider: media overlap.

Dell should consider whether audience duplication will boost or reduce its media productivity. Pretend that Dell’s only advertising goal is to create brand awareness. In this case, TV and Internet advertising are substitutes. However, consider the more realistic scenario that Dell’s goal is twofold: to create brand awareness among the target segment (via national TV) and to encourage this subgroup to go to the Internet to find more detailed information about the new product.

For this scenario, audience duplication will boost Dell’s media productivity. And it is for this reason that Dell needs to measure the joint productivity of its national TV and Internet advertising.

Measuring productivity for each medium separately, even after adjusting for risk as in the Walmart example, and allocating resources accordingly will lead to suboptimal results.

In general, the firm needs to measure the joint productivity of its marketing mix. Separately analyzing the ROI of each marketing decision will lead to poor resource allocations, even if one allows for the trade-off between risk and return.

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In Summary

Here are four key takeaways that managers should glean from the cited examples:

1. When allocating marketing resources and assessing performance, it is necessary to adjust the ROI metric for risk.
2. Since different marketing decisions involve different combinations of risk and return, financial and marketing decision making must be coordinated. In particular, a top-down approach should not be used, where the CEO, senior management or finance officer dictate the required rate of return of marketing activities.
3. In general, firms must measure the joint effect that different marketing decisions have on risk and return and must simultaneously correct ROI for risk.
4. Publicly and privately held firms need to assess risk differently when measuring marketing productivity. The owners of public firms can reduce risk by diversifying their holdings across different firms. By contrast, the owners of privately held firms cannot. Hence, a firm’s ownership structure has a crucial effect on the way it should determine its risk-adjusted ROI when choosing and assessing marketing policies.

Although such new-school ideas might be hard to swallow, these examples highlight an overarching truth about business. The best marketing strategies — those that yield long-term value — are based not on trends, anecdotal evidence or past “success stories,” but on new scientific methods and metrics explicitly developed for analyzing data, which are often imprecise.

Clearly, these lessons have far-reaching implications. A fundamental transformation is necessary in the mindsets of managers at all levels of the organization and across functional areas. As companies work to implement this new thinking, they’ll have to find answers to the following questions:

• How should the risk and return from different marketing policies be measured?
• How should the standard ROI criterion be modified so that it leads to better decision making?
• How should performance metrics and reward structures in the organization be revised to enable the marketing and finance managers to work together to maximize organizational performance?

To answer these questions, it is necessary to develop a new paradigm by fusing marketing and finance. Fusing marketing and finance might sound daunting, but the hardest part is making the psychological leap.

Great opportunity is out there, even in a tough economy. When key players go beyond conventional metrics and work together to apply new concepts and metrics to measure marketing productivity and to allocate resources, your company can seize the hour.

Editor’s note: Sharan Jagpal, PhD, is an internationally recognized specialist in marketing, economics and strategy. He regularly publishes articles in journals on marketing and on other disciplines, including economics and statistics. His first book, “Marketing Strategy and Uncertainty,” laid the foundation for the fusion of marketing and finance, an area he has pioneered. His most recent book is “Fusion for Profit: How Marketing and Finance Can Work Together to Create Value” (Oxford University Press, 2008).