Want to improve the profits you get from marketing? After all, marketing costs over $1 trillion a year globally, the biggest discretionary spend in business. Well, if you're like most managers you'll spend 90 per cent of your time discussing what to buy and 10 per cent on the sourcing and harvesting of cash flow. But if you want to know what your future cash flow looks like, you have to investigate where revenue comes from.
Marketing drives cash inflow and what is at stake is far from trivial. The largest assets of companies today are intangible assets, and marketing is their biggest driver. There are many choices to be made about where marketing budgets can be spent, but focusing exclusively on costs will destroy shareholder value.
A new approach called value-based marketing (VBM) emerged around five years ago in academia. I define it as "an entrepreneurial framework for managing marketing to maximise its financial contribution". VBM shines a light into revenue streams and profit pools. Today, it has moved from the lecture theatre into offices and boardrooms and clocked up notable successes.
Procurement has an important role in making VBM happen. First, marketing performance depends heavily on the performance of external agencies, and procurement is instrumental in establishing performance targets and measurements. Second, prices and special offers are often the domain of the procurement function, and to set them optimally requires an understanding of customer responses and elasticities. Third, the fine balance between product quality and input costs is vitally important, and it is essential that procurement understands the revenue implications as well as the costs.
This article explains what value-based marketing means and provides case examples based on researching the practices of 40 leading organisations, where senior executives were asked to describe and explore what makes marketing accountable for delivering financial performance, and what are the problems and limitations. The "Primo" good-practice framework that emerged from this research has the potential to be used as a blueprint for VBM.
What is profitable marketing?
In recent times easyJet, Tesco Metro, the iPod and Innocent smoothies have all been hailed as marketing triumphs. Customers flocked to them and they enjoyed healthy revenues. The drive was different in each case, but advertising was not the main factor. EasyJet is price-driven. Tesco Metro is a distribution story. The iPod and Innocent's fruit drinks are both product innovations.
Marketing disasters also warrant some attention. Bic launched a perfume, packaged on cards that hung from wall displays. This, together with a low price, was meant to motivate consumers, but they turned their back on the product. Copies of the iPod and Innocent smoothies are now on the market, but they have not enjoyed the success of the originals.
To answer the question "what does profitable marketing look like?", we need an effective definition of marketing. Customers are often cited in definitions of marketing, but these suffer from difficulties where profit analysis is concerned. A better definition is "marketing decisions are ones that influence revenues".
Many will involve procurement – advertising, direct mail, packaging and websites all involve external purchases. However, some marketing decisions – pricing, price promotions, samples and free products, product design and distribution – do not.
Revenue may seem on the surface to be just like cost – it's only money, so why should it necessitate special treatment?
The answer is that revenues and costs behave fundamentally differently. Costs are active. They drive activity and cause effects – "cost and effect", as Harvard professor Robert Kaplan dubs them, and for most situations linear equations are adequate. Revenues are passive and the effects of past activity, so understanding them involves looking back at the many events that influenced current sales, and the non-linear Pareto relationships that govern them.
The difference is most visible in the equations and charts in the cost accounting textbooks that every accountant must master. The cost/volume/profit mathematical relationship generally assumed in cost accounting is linear (figure 1), and the associated charts are straight lines. However, revenue is non-linear (figure 2), and assuming it is linear causes major problems.
Cost accounting's linearity assumptions imply that revenues can be stretched infinitely and profits will follow. In reality, revenue and its drivers – advertising, sales promotion, direct marketing, product innovation – obey the Pareto or 80/20 principle: that is, demand tails off as people's tastes become satiated and prices have to be lowered to push volumes ever upwards.
This non-linearity, which is also termed "saturation" or "wearout" by marketers, is important as it implies an optimum value or the "right" amount of each factor. You can have too much direct mail, too much advertising – even too much innovation – just as you can also have too little.
The knowledge needed to deal with the mathematics of revenue streams is different in many ways from the knowledge that resides in most companies within cost and management accountants. This is where value-based marketing comes in. VBM provides a set of techniques that enable marketing profitability to be maximised.
The limits of creativity
However, before moving on to these techniques, a few comments need to be made about creativity and marketing, because it is a line of argument that often clouds the debate about marketing and profitability. At the heart of the creativity debate is the argument that creative people are in high demand and merit higher rewards than less creative people.
Three problems arise in assessing the value that should be assigned to creativity: judging creative merit itself; linking creativity (as judged above) to its revenue effects; and apportioning credit for creativity between agency and client
Creativity should be judged in its own right in terms of the artistic merit of marketing. Advertisements that win creative awards do so for their aesthetics, style, wit and charm. The aesthetics test is probably the most direct way of assessing the creative talent of an agency's creative team.
Having judged creativity in its own right enables us to answer the second question: is creativity necessary for profitability? Many direct marketing and print advertisements are very dull, yet also effective. Pricing and promotions are often the drivers of profitability, and are manifestly not artistic or aesthetic. Although some agency people and clients hate to admit it, sometimes horrid, uncreative advertisements drive profits. Take the Unibond sealant, winner of one of the UK-based Institute of Practitioners in Advertising effectiveness awards in 2005. The company repackaged the product in different colours and with a new typeface to provide clearer labelling – hardly an artistic triumph. Successful marketing is often solidly competent but not artistically daring or exciting.
Many brilliantly clever and creative campaigns fall flat on their faces where sales and profits are concerned. Just look at the fashion world: every year companies launch tens of thousands of new products and only 10 per cent stay the course. Yet marketing managers are addicted to this creative activity even when most of what it generates is waste.
Clients should also claim some credit for creative merit. It is a matter of judgment as to how credit should be apportioned between the agency and the client, because of the client's contribution in the creative brief, creative ideas and inspiration, and creative execution (aspects such as casting and straplines may come from the client).
Lastly, a creative paradox needs addressing. It concerns the intrinsic difficulty of the creative task for some products but not for others. Some marketing communications are intrinsically difficult – for instance, boring products such as table salt or bank current accounts. Others are correspondingly easy: exciting products such as the iPod.
More creativity is needed to market dull products, yet the chances of success are intrinsically lower than for exciting products that "sell themselves". This paradox needs to be taken into account in assessing the link between scarce creative resources and client profitability.
Achieving profitable marketing
Those organisations in our research that were confident that they were managing their marketing for profit have adopted five key practices. Implementation of VBM involves adopting these practices and learning to use an integrated set of management tools, for which the acronym "Primo" – plan, review, interpret, measure, optimise – is a mnemonic (see figure 3).
1. Plan
Good-practice organisations that are implementing VBM tend to approach planning differently from traditionalists, and their objectives and strategies for attaining them are different too. Marketing planning practices are adopted alongside traditional budgeting, mirroring the approach found in several textbooks. Implementation requires significant training, and most organisations have developed their own versions of the textbook frameworks, using templates to guide the planners in writing the plans.
A global IT firm adopted a standardised marketing planning template to support its senior marketing executives. At the same time, it provided coaching to help them craft the plans. It also introduced a structured challenge process at key points in the planning cycle to ensure that constructive debate would happen and potential issues with the plans would get resolved.
The disconnect between words and numbers is a significant shortcoming of all the marketing planning frameworks cited above. Typical planning phrases, such as "build selectively" or "manage for earnings", do not convey the magnitude of budgets needed to put the plans into action. To make this connection, good-practice organisations link planning to optimisation and use models as an integral part of the planning process.
In another example, the lubricants division of a global petroleum company has developed an optimiser model to help its planners allocate its marketing spend across regions, channels and product types. This model is used during the planning and budgeting cycle.
2. Review
Review is the flipside of the planning coin. Reviews make little sense without plans and plans make little sense without reviews. Traditional organisations have a predominantly financial review process – if they have any reviews at all. Good-practice organisations have made several changes to the traditional approach, including regular meetings to review confidence in the plans and changing course if necessary; using models to understand the significance and implications of variances; and using non-financial scorecards and dashboards.
For good-practice organisations, the primary purpose of reviews was seen to be testing confidence in the plans and deciding when these needed to be changed. Checking results was seen as a secondary activity. A UK brewer holds monthly planning review meetings during which results are discussed and confidence in the plans evaluated. Three main topics are on the agenda are, first, executive actions – did they conform to the plan? Second, reforecasting – what are the longer-term implications of current results? And third, assumptions – have they changed since the plan was written? The purpose of the review meetings is to get early warnings of the need to alter course.
Brand equity monitors, balanced scorecards and other non-financial reviews have been adopted by several organisations. Reports are produced periodically showing a basket of non-financial measures. This approach has been championed by Kaplan and his co-author David Norton for the past decade. However, several participants in our study that had been using scorecards expressed dissatisfaction with their usefulness as a management tool. This is mainly because soft measures tend to fluctuate in response to "market noise" whose significance is unclear (this seems to be particularly true of brand-tracking measures), or conversely because the metric stays unchanged for lengthy periods (this is associated with customer satisfaction metrics).
A global beverages company has been running a brand equity monitor for over three years. The basket of key performance indicators, both financial and non-financial, are reported to the board. An issue it raised is that the "traffic lights", which show green, amber and red depending on whether the KPI is on target, would change and fluctuate in an apparently random way that management found difficult to interpret. Actions were not easily taken on the basis of this reporting. As a result, the company is reconsidering the effectiveness of the tool in the light of its experience.
Models can have an important role in testing confidence in plans, as they can enable management to explore the consequences of changing the plans. They also offer a way of filtering out the "noise" that seems to be a problem with scorecards and dashboards.
For example, a global entertainment company has a dynamic revenue analysis and profit optimisation (Drapo) model that it uses in the UK. This takes data on a daily basis, filters the patterns and identifies media performance in the previous time period. It then makes recommendations for media buying in the next period based on the wearout patterns of its media channels.
3. Interpret
All organisations interpret data, most of the time informally. We found that good-practice organisations develop more formal and explicit methods of interpreting the hidden meaning behind the pattern of revenue streams and profit pools, and take a more scientific approach to managing knowledge.
Revenue streams and profit pools are a focus of interpretation. Revenue streams are put under the microscope to discover the magnitude of the driving forces that cause oscillating patterns, trends and spikes. Highly skilled people – in particular, econometricians – are needed to interpret these patterns effectively.
A large global consumer products firm has established a team with econometrics and optimisation skills to support revenue analysis and profit optimisation. It supplements its internal resources by hiring econometrics and modelling people from external consultancies.
In another example, a large supermarket group has taken part-ownership of an analyst organisation with over 70 statisticians on its staff. Initially their brief was to analyse the retailer's loyalty card database, but as management gained confidence they used them to interpret patterns in its electronic point of sale data. The company now believes this capability gives it significant competitive advantage.
Even with skilled analysts, it is important to manage them effectively. Cultural barriers can arise between the marketers and the analysts, who are viewed as "boffins". Ignorance on the part of line managers can result in the analysts being poorly deployed. Therefore it is important that these scarce resources are directed at the most strategic issues and that they are protected from having their time wasted on trivial pursuits.
The UK brewer made a breakthough in its interpretation of marketing and profitability when it realised that none of its market research analysts were spending any time on strategic issues. The reason was that the analysts were traditionally seen as a service function to marketing staff, and hence spent most of their time answering tactical questions. The company addressed this problem by taking a small team of analysts out of the service role and dedicating them to strategic analysis of markets and revenue patterns.
Empirical generalisations are another important part of the interpretive process. These are the so-called "laws of marketing" that emerged from repeatedly carrying out interpretive analyses. The existence of such generalisations may come as a surprise to traditional marketers, who often regard their work as unique and beyond codification. However, there is ample evidence that many marketing activities can be codified and are highly predictable.
One global food firm has been using interpretive studies for over a decade. Commenting on price elasticity, the head of its European business unit noted that "price elasticity for most of our products is usually about two" – in other words, for every 1 per cent reduction in price, the revenues go up by 2 per cent. The company has built up an extensive knowledge base of empirical generalisations that it regards as an important competitive weapon.
4. Measure
All organisations measure things, and most are awash with raw data. But we found that good-practice organisations use different measurements and manage data differently from the rest of their peer group. Customer relationship management (CRM) and enterprise resource planning (ERP) systems have been implemented by both traditional and good-practice organisations.
However, these systems have made little impact on VBM, because they do not possess the necessary functionality. Consequently, good-practice organisations have adopted a DIY approach, building their own systems to hold the necessary marketing measurements.
Financial data on marketing costs and activities tends to be of poor quality. Although CRM is going some way towards tracking activities of sales forces and call centres, most activities are not tracked effectively. This includes advertising, direct marketing, sales promotion and PR activities, product extensions and launches, and pricing changes. Even in good-practice firms, tracking these activities and costs is a major challenge, and few can boast that they have solved it completely.
The global entertainment company has established a data feed from its media agency and is archiving media spot data so that it will have a historical record to analyse. PC desktop technology is all that the system requires, and it provides a low-cost alternative to expensive databases and packaged software.
Integrating the data silos is one of the goals of good-practice firms. Traditionally financial data is kept separate from activity data, and separate again from consumer research, trade customer and channel research, and customer satisfaction data.
The lubricants division of an international oil company developed an integrated database and corporate intranet on which to capture, disseminate and present data for 60 countries. It decided against using the IT department's "business intelligence" system because the timescales were too slow, marketing's priority was too low, and IT staff lacked sufficient knowledge of marketing.
5. Optimise
Optimisation is formalised in some areas of the organisation, such as the supply chain. VBM uses optimisation tools for allocating marketing resources in a way that maximises value. As a technique, it is used to compare alternative marketing decisions to find the one that maximises an objective. Profit maximisation is the objective that is most often used in good-practice organisations.
The knowledge needed to construct and operate optimisation models is completely different from the knowledge of econometrics. A common error when hiring specialists is to assume that the two skill-sets are the same. Techniques used in optimisation include linear and non-linear programming, what-if and scenario analysis, and "Monte-Carlo" models, none of which are part of the econometrics syllabus.
A number of companies in our research hired external experts to help conduct optimisation analysis:
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A large global electronics company hired a major consulting firm to optimise marketing spend allocation by product. The study took 18 months to complete and after that a global roadshow was used to get buy-in for the findings.
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The European division of a motor manufacturer asked its media agency to optimise its advertising spend across products and countries. The media agency subcontracted the optimisation to a boutique consultancy, as it lacked the expertise internally.
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A global consulting firm discovered that its optimisation system contained mathematical flaws – in particular, predicting negative sales in some situations. It subcontracted to a firm of mathematical specialists to devise an algorithm to overcome the limitations of its original system.
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A European tour operator had to optimise over one million price points across 30 product ranges. It only had an eight-day window, so it hired a pricing optimisation specialist to construct a pricing model and run it in this tight time period.
Value-based marketing is no longer an academic theory: it is being adopted and implemented in business. Those organisations that have begun to implement it are enjoying significant benefits, but they have not broadcast their achievements because they regard them as significant competitive weapons.
Good-practice organisations that we studied are implementing the "Primo" framework. For them, the elements that most urgently need attention are interpretation and optimisation, but it is important that linkages with planning, review and measurement are developed at the same time.
Overall, the framework has the potential to be a benchmarking method for organisations that want to assess just how profitable (or not) their marketing activities really are.
Case study
An effective brand investment
A global consumer goods company was performing badly in the late 1990s. Its brand portfolio had ballooned after a spate of mergers and acquisitions, and the problem was exacerbated by numerous new product launches that were cannibalising existing product sales. Its advertising spend had rocketed and, under pressure from powerful retailers, it was offering price promotions, free goods and heavy discounts on an unprecedented scale.
By 2000, with investors voicing their dissatisfaction, the company's finance function decided to act. Although throughout the company's history, finance had remained at arm's length from marketing, circumstances forced it to take direct action, and it created a task force to implement an "effective investment in brands" programme. All five areas of the "Primo" framework were tackled.
Plan. Financial budgeting and marketing planning had traditionally lacked alignment, so bringing the two together on to a common footing was a high priority. Decentralisation of budgets to countries and regions had added another layer of complexity, and this was addressed by developing global plans for the key brands in the portfolio. These global plans redistributed marketing spend to those markets and brands with the highest profit potential. Portfolio planning was introduced at the same time to ensure that innovation was driven by commercial needs and not simply because of a fondness for novelty. One of the technical challenges for finance was re-engineering the budget cycle to align with these new planning disciplines.
Review. Management reporting and review had been predominantly a local process, aimed at limiting discretionary country spending to pre-agreed limits. After 2000, a new review process was introduced to enable the brand planners to check their confidence in the plans. In addition, procurement became involved in reviewing agency and media performance. Global agency agreements were negotiated and performance targets set, and these were monitored regularly.
Interpret. The interpretation of revenue patterns was a priority and finance established a partnership with the marketing sciences team. Econometric analysis was used to unravel the complex patterns and to quantify the effects of advertising, sales promotions and price changes on sales volumes. This interpretive analysis was then used to calibrate optimisation models (see below).
Measure. ERP systems were more of a barrier than a help when interpreting revenue drivers, so the finance team embarked on a programme of system construction. Because database sizes were small (often megabytes rather than gigabytes), Excel and Visual Basic were sufficient and had the added advantage of being rapidly programmable.
Optimise. Maximising profitability required the construction of optimisation models - something that finance had seldom done before. External resources were brought in to undertake the difficult mathematical algorithms required for this job. The underlying technology was, again, Excel. Optimisers were used to allocate strategically across brands and markets, and to allocate tactically across media channels.
The implementation of this framework has had an impact on over 1,000 managers in finance and procurement. Around 25 specific tools and techniques were selected, and a five-year timetable set for their global implementation. The company is now about halfway through this ambitious programme; many managers have been trained, tools and techniques are in place, and significant benefits are already flowing in terms of improved financial performance.
Further reading
Robert Shaw and David Merrick, Marketing Payback: is your marketing profitable? (FT Prentice Hall, 2005)
Robert Shaw (shaw@vbmf.com) is director of the Value Based Marketing Forum and professor of marketing metrics at Cass Business School, London
