No doubt all online marketers are familiar with this question. The expected answer of course, usually has something to do with “ROI” along with a convoluted explanation of what that is.
The problem is, it’s a trick question. Your client, or potential client, knows more about their product or service than you do, and no matter what your explanation for ROI, it is likely not going to answer their question.
The problem you see, is that ROI seems to be a concept that only accountants know how to accurately determine, yet it’s thrown about all “will-nilly-like” by us marketers.
Don’t believe it’s a trick question? Here’s an example:
The common method (probably recognizable to many reading this) of calculating marketing ROI looks something like this:
Total Sales Revenue ÷ Marketing Costs
For example The Acme Safe Co. made $50,000 in revenue and spent $7,000 in Marketing costs to generate that revenue:
$50,000 ÷ $7,000 = $7.14
In other words, for every $1 spent in marketing efforts Acme Safe Co. generated $7.14 in revenue.
Because, even if your clients are nodding their heads in agreement, this is what they’re actually thinking:
Sadly, this method of calculating ROI falls well short of answering these questions.
“Contribution Margin” he says, as the hearts of a million accountants out there sing with the melodies of a thousand harps and doves descend around them.
What exactly is this “contribution margin” then?
In short, contribution margin (or CM) is a way of forecasting cost per acquisition at the product or service level. As long as your marketing efforts cost less than your contribution margin, you have paid your bills and met the expectation of profitability. This also allows us to measure historical campaign performance while accurately forecasting the effectiveness of future marketing efforts.
The actual equation is rather simple:
A – B – C = Contribution Margin
A = Average Sale Value
B = The Cost To Deliver A Product Or Service
C = Stakeholders Expectation Of Profitability.
Perhaps an example will help explain this concept:
Acme Safe Co. sells $50,000 bank safes. The cost to deliver a bank safe is $35,000. The company has an expectation of profitability of 20%. The math works out as follows:
A = $50,000
B = $35,000
C = $10,000 (20% of $50,000)
Contribution Margin = $5,000
IN THIS SCENARIO, ACME SAFE CO. CAN AFFORD TO INVEST $1 IN MARKETING EFFORTS FOR EACH PADLOCK THEY SELL, AND $5,000 FOR EACH BANK SAFE THEY SELL WHILE STILL PRESERVING PROFITABILITY.
See our handy dandy Contribution Margin ROI calculator to determine your own Contribution Margin.
So Now I Know My Contribution Margin – Why Is This Useful And What Does This Tell Me?
1. CM accurately measures campaign efficiency:
2. CM accurately predicts the success of future campaigns:
3. CM allows you to scale your marketing budget accurately:
For more reasons and explanation, see our Contribution Margin Calculator, or my SEOMoz blog post fleshing this idea out a little further. Either way I’d love to hear your feedback on Twitter, Facebook or Google +.