Today on Stack & Growth, Matt, Chanella, and Dale Harrison are back to dig into marketing ROI. In this first part of the live event, they focus on how marketing ROI is typically calculated and why that's the wrong approach. They also go into detail on the R part of ROI, how to properly calculate the return. Hope you enjoy.
Let's go ahead and kick this off. So I'm really excited to walk through this sort of measurement methodology with Dale Harrison. We've been going back and forth on it now for several weeks. It's going, it really factors itself well with how businesses run.
It takes more of a wider aperture outside of just marketing source and also accounts for a lot of the cost thing that goes into actually creating revenue for the business. And I think all those things will hopefully come to light here as we go through this discussion. If you have been here for any of the previous discussions, you will probably know that we have normally run over an hour going through these. So I would expect to do the same today just based on how Dale and I have worked on this and even our dry run.
Basically, we went an hour, secondly imagine what the actual live conversation will be. So I do want to hand it over to Dale to kind of walk through some aspects here of this, of the deck. We'll talk through it. Please bring your questions.
I have a couple of my own questions overall. But this should, what this really is about what bringing this kind of brain measurement or wide calculation is about is about giving you guys a repeatable and defensible way to measure against your brand investments in the absence of having an MM or even being able to use things like multi touch attribution. Things that most businesses don't have the can't make the business case for or don't or have too much technical debt to actually bring something like that on. So this will give you a repeatable methodology that should be very easily to defend to your finance team because it's going to account for a lot of aspects that they think about as they think about the financial health of the business and it's going to give you a chance to look at really how brain is supposed to work which is something that should affect all aspects of the business not just marketing source.
And so that is exactly what this or like calculation is going to bring into the fold. So Dale, go ahead and go ahead and get started and I'll jump in as things transpire. Yeah. And if anyone has questions, throw them out and I'm not going to be looking at the chat or anything.
So I'll rely on Matt or Stephanie to stop me and we can dive into any questions. So marketing ROI, everyone does it. So let's start with ROI is typically calculated. These come from the Facebook HubSpot and Salesforce websites and they should be fairly fairly recognizable to most people.
So Facebook says that it's your revenue minus your marketing cost divided by your marketing cost. And then ROAS is sales revenue divided by ad spin. HubSpot was essentially the same revenue minus marketing cost. Salesforce because they're a sales oriented company and they acknowledge that there's actually such things as sales teams, they have a little bit broader definition where they simply call it marketing value, although they never actually defined what marketing value is, but they assure you that's the number you should be using.
And so there are some fundamental problems with these. So why is this wrong? So first and foremost, revenue is the wrong metric because businesses run on gross margins. They don't run on revenue.
And as a result, it's misaligning marketing spend with the revenue recognition events in the sense that, and there's two misalignments here. One misalignment is with the fact that only a small portion of that revenue actually gets recognized as value to the business because the revenue doesn't come for free. You actually have to have made and sold something in order to get that revenue and there's some cost in delivering the product and there's definitely cost in acquiring the customer. The other thing is that it fails to capture the long duration impact of brand marketing.
And we've seen this over the last 20 years, especially in B2B digital marketing, where you've seen this almost complete abandonment of brand marketing in favor of the more easy to measure short term performance marketing. Maybe the bigger, more subtle issue is the fact that it can't be used to determine if our marketing is effective. That it really is a measure of how efficiently you're spending the budget, but it's not a measure of whether or not that budget spend is actually producing effective results for the business. So marketing RIs essentially an efficiency metric, which means that it's got a much narrower scope than how people tend to try to use it.
And again, the distinction here is efficiency is doing things right. So how well were the resources used relative to the outputs versus effectiveness is doing the right things. So the degree to which the things you're doing are achieving business objectives. So I want to start with a little bit of discussion on how even when you can calculate an ROI number, it can be misleading.
This is the other problem with ROI is that it's often used to try to represent the value that marketing is bringing to the business, which is an effectiveness measure. And it's really at best an efficiency metric and often not even a very good metric for that. So one of the examples I always use is this idea of what's the ROI of a factory building. Nobody calculates the ROI of a factory building.
So why are factories housed in buildings to start with? The buildings cost money up front to build and they keep costing you forever through maintenance costs. So why aren't all factories just built out in the open and the middle of a field? Because their ROI is negative.
No matter how you calculate it, it's a negative value. And the answer is that the factory building is bringing value to the business through mechanisms other than generating revenue or directly generating revenue. That factory building is has value to the business and is worth investing in because it takes the contents of the building, the machine tools and the workers that are running the factory. And it makes them both more efficient and more effective.
So the machine tools last longer because they're not on the weather. They're not down as often for maintenance. So these reduce both reduce cost and increase output. The workforce is more productive.
The factory doesn't have to shut down every time it rains. So these are always that the building that houses the factory is bringing value to the business and why businesses are more than happy to pay money to build a building even though it has negative ROI. And so ROI is not always an ideal measurement for certain types of activities and assets. And I think marketing is one of these.
So in many ways marketing is a lot more like the factory building. Sales is more like the factory. So marketing delivers value by being this nonlinear amplifier of other linear functions of the business. So if marketing didn't exist several things would happen.
Once the sales team would have to spend a significant fraction of their time basically doing coal prospecting to find leads rather than spending all of their time focused on being able to take leads that are likely to buy and focus on trying to close those to revenue. So because of what marketing does, sales is going to close deals faster at a higher close rate and at a lower cost, sales cost, then what would be happening if marketing didn't exist. And I've seen this often in companies where you'll have an early stage startup and they will basically not do any marketing for the first two, maybe three years and they focus entirely on being sales driven. So they'll hire that sales team.
And what you see that sales team doing is often spending at least half of their time just trying to prospect looking for someone who's likely to buy, then they have to basically explain a company that no one's ever heard about before. And the entire sales process tends to be very, very inefficient and very costly without marketing being there to lay the groundwork ahead of time in terms of awareness about the product and the company, the ability to build trust in the product and the brand, and the ability to be able to identify and capture those leads so that sales can do the thing that really brings value from a sales standpoint, which is closing deals. So where are best and worst cases for marketing ROI? And if you go back to the early prehistory, the earliest use of marketing ROI tended to come out of what used to be called direct response marketing.
So these were companies, this was pre-internet, so 30, 40, 50 years ago. There were companies that sold products by putting ads in the back of magazines and you would either mail something in or you would call an 800 number and be able to then buy the product either through mailing something in or through calling a phone number. And in those cases, there's no sales team, there's sort of no brand marketing typically. Everything that you're doing with marketing is directly immediately resulting in a sale.
And so a lot of that kind of old school direct response marketing looks a lot like digital marketing that is focused exclusively on performance marketing, exclusively on things like paid search would be an example of something that would be equivalent to that. So this still works quite well if you're doing something very narrow like peer online direct to consumer marketing, that kind of that traditional, whatever we spent this month on marketing applies to the revenue that came in because the lag time between when we made the marketing expenditure and when the revenue hit tends to be a very, very short time window where it does not work well is for most of B2B. And part of the problem here is we tend to have very long time lags and long purchase cycles. So certainly something like enterprise B2B, enterprise SaaS, the average purchase cycle is five plus years between coming back in market to buy again.
For many, especially for larger companies, it can often be a decade or more. So once you've got that CRM system installed, you're going to go years before you're going to ever come back into the market to look at potentially replacing it. And the other problem here is that a lot of these B2B products have a very long sales cycle. So not only is it a very long period between purchases, but once they are ready to purchase, the sales cycle happens over a very extended period of time.
And then the other part is the very heavy involvement in cost of the sales team and closing the deal. It's not a typical for the budget for the sales organization to be significantly larger than the budget for the marketing organization and B2B companies, because a lot of resources have to be poured into closing those deals. And we need to be able to somehow account for all of this if you want to do an ROI measurement. So the first step here is, if you think about ROI, it's two parts, return and investment.
So return on investment. So the first step here is we need a better version of return. So the first thing to know is that the return in ROI is not revenue. Revenue does not come for free.
Every dollar of revenue costs that business is something to collect. And the business only gets to keep just the portion of that revenue that's left over after paying the cost associated with making, selling and delivering the product. And even for something like a SaaS product, that cost of just delivering and provisioning one more unit of that product is far from zero. I mean, typically that number is in the 20 to 25% range, because you've got all of the onboarding, the provisioning, it's usually relatively labor intensive.
There's the initial support to get the customer up and going. That's all the part of delivering the product that you would not have paid those dollars out if you had not sold that one extra unit to one extra customer. And then there's all the cost associated with running the business in general beyond just delivering and selling the product. So let's give an example of why revenue ROI is a really, really bad idea.
So let's say we've got two campaigns and you're reporting your campaign ROI is out and this is using kind of the traditional meta hub spot kind of definition. So all we know is that one campaign generated 250,000 revenue, one 400,000 each campaign cost 100,000. So we have 150% ROI and a 400% ROI. So which campaign was best for the business?
So if this is all you know, then you would say campaign being generated 150,000 more in revenue and has almost three times higher marketing ROI. It looks like a no brainer. But reality is you have no idea. This information tells you nothing about which of these campaigns was best for the business.
And the reason why is let's look at what the campaigns are doing. So campaign A is, so the campaign is for the widget store. Campaign A is we have better widgets. Campaign B is 50% off sale.
So if we come back and recalculate this, but based on gross margin, and we'll talk about exactly what gross margin is in a minute, but as a rough estimate, gross margin is the amount of money that the company keeps out of the revenue for the next incremental sale. So if the underlying product has a 50% gross margin, then that 250,000 allows the company to book 125,000 profits, the 400,000 if we sell it at half price, we're going to cut our margin in half. And so now that 400,000, the business only keeps 100,000. So you're actually selling a lot more stuff and putting less money in the bank.
And when we recalculate based on a margin based ROI, instead of a revenue based ROI, suddenly campaign A has a 25% ROI and campaign B is a complete wash, zero return on investment. So not only is this massively wrong, but the final answer of which of the two campaigns is better, completely reverses once you start looking at how many dollars a business actually gets to keep from the sale versus just looking at the revenue. So this is why you cannot use revenue as the baseline for an ROI calculation. So this takes us into how do we do a margin based ROI?
And the problem is what type of margin? It turns out that there are 10 or 12 different types of margins that will be familiar to people in finance. The two most commonly used and talked about is net margin and gross margin. But there are many, many other kinds of margins that finance is going to be aware of.
So net margin is at a very, very high level, how much income do the business make after they paid all their bills versus how much revenue they generated. So in most businesses that net margin is down and around 15%, 12, 15%, is relatively small, which means that they're spending 80, 85, 90% of the revenue they bring in is spent on running the business, making the product, selling the product, delivering the product, and then all the overhead of running the business. But a more important number is what's called gross margin. And so this is essentially revenue minus cogs divided by revenue.
So cogs is an acronym. It stands for cost of goods sold. And so this really encompasses everything that a business has to spend to be able to deliver one more unit of product to a customer. So if you're manufacturing Toyotas, it's the cost of all of the parts that you had to buy and bring into the factory to assemble into a Toyota, although labor it took to assemble those parts.
And then all the expenses that you incur in getting that car from the factory to the showroom and into the hands of a buyer. So it's all the things associated with making and delivering the product to a paying customer. So there's another type of margin. And this is one we're going to focus on is contribution margin.
So contribution margin is gross margin minus the cost of selling the product. So we have essentially two costs here. It costs something to produce one more unit of the product and get it delivered. But then it also costs something to get that customer to be able to close that customer that we're going to deliver the product to.
And so these are both real costs that come off of revenue. So in that cost of acquiring a customer is essentially the cost of the marketing plus the cost of the sales. And so what's left over after this? So this is a contribution margin essentially what's left over after making the product and getting the product sold.
And these are real costs that businesses have to write checks for and send out the door and they only get to keep what's left over. So the important thing about contribution margin is that it's what's called the marginal cost of delivering the next unit of sale. Meaning we're not looking at what did it cost to build a factory. We're not looking at what did it cost to how much do we spend on the development team to produce the SaaS product.
So these are sort of historical sunk cost that we're trying. Ultimately we need to recover those costs as a business. But the first step in recovering those costs is to make sure that we sell it for more than the direct cost of making it and selling it. So if we're going to sell it for $100 we need to make sure that it costs something less than $100 to both make it and to sell it and deliver it to the customer.
And so even businesses that are say early stage fast growing businesses that are losing money where they're relying on outside venture capital investment to be able to cover their expenses, there's still the expectation that contribution margin will be positive. And you see this for instance with Amazon in their history. So Amazon did not start booking profits for almost 20 years. And they spent that time basically making a lot of money off of every individual unit they sold.
So their contribution margin was very positive on each individual item sold through Amazon. But they were taking those those profits and pouring it back into building more warehouses, buying more inventory and buying more trucks and airplanes to deliver it. And so they were basically financing their capital expansion over their first 20 years because they had really strong contribution margin for each individual item sold. And so that's typically what you see in businesses is that you focus on not revenue, not net margin, which can both be, you know, net margin can be way negative, you know, what you focus on is contribution margin.
So now if we go a little bit deeper, contribution margin is still not marketing's return. It's not what marketing is delivering to the business. Marketing is only delivering a part of that. So some fraction of that revenue would still have come in even if marketing did nothing, even if marketing didn't exist.
And again, you often see early stage startups that will invest in a sales team well ahead of bringing in a marketing team. And in those companies, they were still making money, maybe not very efficiently, but they were still bringing in revenue long before the first sales person was ever hired. And, you know, so sales is directly producing some fraction of that revenue. But then there's some additional fraction of revenue that exists solely because marketing is in place in doing their job.
The other thing that's important here is this is not about marketing sourced revenue. Marketing sourced revenue is a very bad idea. And the reason the reason why is that that, you know, just because marketing solely sourced that lead doesn't mean that lead instantly materialized into a pile of cash. That lead still has to go through a lengthy and expensive sales process.
And so when marketing does their presentation to, to the, you know, the board or to finance, and they say, you know, we had X number of dollars of marketing source revenue. When they leave the room and the salespeople come in and do their presentation, the salespeople will say that's BS because every one of those deals we sold it. And, and that's a, that's a convincing argument that not only completely undermines the whole concept of marketing source revenue, but undermines the entire credibility of the marketing team. And because the reality is is that in a sales based organization, you know, again, if you're not a direct to consumer, you know, fast fashion e-commerce site, if you're in something like a typical B2B enterprise SaaS company, you know, every single dollar of revenue flowed through the hands of a sales person.
And that sales person typically put in weeks or months of expensive effort that the company is acutely aware of having paid for before that revenue materialized. And so there's really no concept of marketing source revenue other than as a mechanism to kind of destroy your credibility with, with finance and senior leadership in the company. So how do we actually get at this contribution margin? And there's a couple of ways of doing it.
And what I want to talk about is kind of the simpler of the two ways. So here, you really kind of just need four numbers. You need your total revenue, what your, your cogs are. So, you know, what were the direct costs to make and deliver the product for a SaaS company?
This is not going to be the cost of this development team, but it's going to be related to things like, like server and bandwidth cost, a lot of the costs are going to be related to provisioning and early stage onboarding and support. So these are all part of what it takes to deliver that net, that type of product. If you're a manufacturer, it will be what's the cost of the materials and labor to produce, you know, one more unit of product. And then what's it cost to put that on a truck and get it delivered to an actual customer.
But there will be some sort of a cogs figure for manufacturing that cogs can often be 40 to 60% of revenue for SaaS company. It's can often be as little as 10 or 15% of the revenue, but it's not zero. And then what do the company spend on sales and what do the company spend on marketing? And so basically, a contribution margin is going to be the gross margin minus the cost to get the customer.
So essentially, you know, what did it cost us to make and deliver the product and what did it cost us to get someone to deliver the product to? And so an example of this would be if we made 40 million in gross revenue for the quarter, we had 10 million in cogs, we spent 10 million for sales costs and 5 million for marketing costs. So at a very high level, that contribution margin is going to be the 40 million in revenue minus the 10 million minus the 10 million from sales cost minus the 5 million. So that 40 million in revenue is going to become 15 million.
And this is why the traditional way of calculating marketing ROI massively grossly overstates what the ROI is. Because you're reporting ROI against 40 million, but the company only gets to keep 15 of that. And the deal is that they know, you know, people in finance know this, they're not being fooled. They know that that, you know, these ROI numbers that marketing is reporting are completely fantasy numbers.
So let's say there was a question about, so where's the cost of the dev team? Where's dev team fault? That's what calls under cogs in a sentence, doesn't it? No, no.
So typically, here's an easier way to visualize how you account for the dev team. The dev team for software product is equivalent to the factory for a physical product. Because they're the ones that, you know, the dev team is the ones that are actually making the exact thing that gets delivered to a customer and used. And the same way that a factory is making the widgets that are, you know, they're taking parts in the door, they're adding labor to it, and then they're using their machine tools to then, you know, fabricate these parts into a final product that gets delivered to the customer.
So the factory is considered a capital expense. So whatever it costs you to build that factory is a long term fixed sunk investment. You know, so typically you've already spent the money on the factory before the first unit comes off the floor. In the same way that you've already spent huge amounts of money on that development team before the first usable version of the product is ever able to be logged into.
So typically what you do is you want to separate it from a county standpoint, you separate out these kind of long term sunk cost that that you had to make an investment in in order to have something to sell. Separate that out from your short term variable cost. So, you know, if you didn't make that investment to create the product, you would have nothing to sell. But once you've made that investment, then there's going to be some cost to actually deliver it to the customer and to actually acquire the customer through sales and marketing.
And so, you know, so that so basically that investment in software development or that investment in building the factory is a cap X that then gets either amaturized or depreciated over a period of time. So in other words, you know, at some level in the accounting, they are applying some cost, you know, some prior expense toward building the product to every individual product that goes out the door. But, you know, from our standpoint in terms of because because marketing and sales are purely operating expenses, they're not capital expenses. And so that's why we can focus just on contribution, what's that incremental cost of getting one more unit of the product delivered to a paying customer.
And so, anyway, so this is why it's treated a bit differently. The other thing is there's also a lot of additional overhead. So there are other operating expenses, op-exes, that the business incurs that are that are sort of spread out across everything. It's a less you know, there would not be part of contribution margin.
So for instance, the finance team, the accounting team, HR, you know, the facilities, you know, the office that you're in and what the cost to pay the rent on the office. These are all overhead expenses that are assumed to be kind of fixed expenses for the business as a whole. And you're allocating portions of those expenses to each new, you know, each new unit of sales revenue. But it's not, these are not expenses that would go up or down if you sold more or less.
And so the kind of the key question is, if we suddenly sold nothing this month, you know, what would our expenses be if we sold twice as much this month, how would our expenses change? You know, so if we, you know, let go of the sales team, let go of the marketing team, just went to zero activity on all of those, you know, you know, obviously revenue would go down. But the, you know, but, but these aspects of expenses for the business are considered, considered variable costs, meaning that they're going to go up and down as revenue goes up and down in a way that, that, you know, the size of HR, for instance, is going to go up or down each month based on what not revenue when up or down. You know, long term is the business grows.
HR will grow with the, you know, essentially relative to the size of the business as a whole. But it doesn't fluctuate up and down for month to month.