In a previous article (DM News, Jan. 21), I presented a formula for calculating return on investment for marketing technology purchases. This article will provide a formula for calculating ROI on the two most common applications for that technology.
Most direct marketing and database marketing programs are designed to accomplish one or more of only three basic business objectives: acquiring new customers, retaining existing customers or cross-selling. Measuring return on investment for customer acquisition is fairly straightforward. Most businesses have a reasonably good idea what kind of revenue a new customer will generate in a year, and they know how much profit that revenue will create. Comparing that margin to the cost of promotion yields a customer acquisition cost. If the margin is greater than the cost, the effort was profitable. Quite often it is not profitable, because the cost of acquiring the customer is a lot higher than the expected first-year revenue, which makes retention and cross-selling critically important. Life insurance companies, for example, usually do not expect a customer relationship to return a profit until the customer has been on the books for five to 10 years.
Measuring ROI on existing-customer programs is somewhat more complex, for two reasons:
· Retention and cross-selling efforts are complementary, especially in multicontact or continuity programs. In order to determine the effect of one, the calculation really needs to include both. Cross-selling programs that increase the number of purchases or relationships that a customer has will always have a positive effect on retention. Conversely, retention efforts will always create opportunities to increase the depth of the relationship through cross-selling.
· The retention calculation should recognize that lost customers have to be replaced. For some reason, no one ever seems to include the cost of replacing lost customers in the ROI calculation for retention and cross-selling programs, but unless your objective is to have fewer customers at the end of this year than you had at the end of last year, you should include it. It is a real cost, and it is usually significant.
In order to calculate ROI that incorporates both retention and cross-selling, you will need to start with some basic metrics:
· Number of Customers (nc). This is the total number of customers you plan to communicate with in your marketing program.
· Annualized Revenue per Customer (rc). This is the average number of dollars in purchases you get from each customer each year.
· New Customer Acquisition Cost (ac). The amount of money it costs you — fully weighted — to find and sell a new customer.
· Number of Contacts per Year (cy). If you are segmenting properly, you will talk to some customers very often, some less frequently, and others not at all. How many times, on average, will you contact your customers during the year?
· Cost per Contact (cc). This is the total cost of your yearly database marketing or direct response customer communications program, divided by the total number of contacts per year for all customers.
· Projected Cross-Sell % from Contacts (cs). When you communicate with your customers, you expect some of them to make additional purchases. This is the percentage of contacts that you expect to generate those additional sales.
· Projected Annual Revenue Improvement Per Customer (ai). When those customers do buy additional products and services, how much revenue, on average, will be generated per customer?
· Improvement in Retention Rate (ir). This is the expected retention percentage improvement that will result from your efforts. For example, if you expect retention to improve from 85 percent to 87 percent annually, then the improvement would be 2 percent.
Here's the formula for calculating ROI:
ROI = ((nc X ir X rc) + (nc X cy X cs X ai) + (nc X ir X ac)) / (nc X cy X cc)
This calculation will yield the return in one year per $1 invested. With a little effort, the formula can be set up in a spreadsheet program, which will allow you to play “what if” scenarios.
If you want to amortize your cost to acquire the technologies necessary to facilitate your marketing program, simply adjust the total marketing cost appropriately. For example, if you have $300,000 in technology purchases in your costs and you want to amortize those over three years, reduce the marketing cost for purposes of this calculation by $200,000.
To make the formula understandable, here's how it works step-by-step. Use the numbers above to calculate these measures.
· Total Retained Revenue = Number of Customers X Improvement in Retention Rate X Annualized Revenue Per Customer.
· Total New Revenue from Cross-Selling = Number of Customers X Number of Contacts per Year X Projected Cross-Sell % from Contacts X Projected Annual Revenue Improvement Per Customer.
· Replacement Customer Acquisition Cost Saved = Number of Customers X Improvement in Retention Rate X New Customer Acquisition Cost.
· Total Marketing Cost = Number of Customers X Number of Contacts per Year X Cost per Contact.
· Now, add three of those measures together to aggregate them:
· Total Retained, New and Saved Revenues = Total Retained Revenue + Total New Revenue from Cross-Selling + Replacement Customer Acquisition Cost Saved.
And finally, the ROI calculation:
· Return on Investment = Total Retained, New and Saved Revenues / Total Marketing Cost.