In this article, we’re going to look at the nuts and bolts of assessing the return on investment (ROI) of a marketing activity.
The better you can understand how likely someone is to convert from one level of the marketing funnel to the next, the more accurately you can forecast the return on investment of your marketing activities.
This is critical for creating your first sales forecast and judging if you can achieve the sort of volume you need to cover the costs of your business.
We’ve talked about “conversion” already as the final stage of the marketing funnel. But this is only the last stage in a series of conversions that make up marketing and sales funnels.
In order to make this calculation, you need to know how likely these conversions are going to happen. You need to know your conversion rates. So, let’s return to your marketing funnel and take a look at this context.
- Approachable market size
- Percentage that you convert to leads
- Percentage of leads you convert to sales
- 10,000 people targeted by my Facebook ad
- 200 click the ad taking them to my website
- 25 purchase something from my website
My Facebook advert converts at 2% (200/10,000*100)
My website converts at 12.5% (25/200*100)
You’ll find that these conversion rates are applicable across a range of marketing activities, from newspaper adverts to YouTube videos to the poster on your shop window!
They will all have an equivalent metric for how many customers they can reach.
The chance they will cause the desired action moving someone toward interacting with your company and a chance for a sale.
Some of them will be harder to measure than others but you should at least be able to make some assumptions around their performance.
Now, in order to completely judge the ROI of a campaign you need to look at a few more metrics:
- Average order value
- Cost per acquisition
Continuing my Facebook example:
Average order value
- 25 people purchase goods worth £800
- The cost of goods sold was £200 (material costs, transaction fees etc.)
- Average order value is therefore 600/25 = £24 profit per customer
Cost per acquisition
- A 12.5% conversion rate means 1 in 8 people buy after clicking my ad.
- Facebook is charging me an average of £1.50 per advert click.
- The cost for acquiring every new customer is, therefore, 1.5*8 = £12
So the ROI for this campaign neatly works out to be £24 – £12 = £12 per customer.
Now, if you remember back in Week 4, in order to validate your business model you needed to know if it’s possible to reach enough customers at the price you want to charge in order to cover the costs of running the business.
The ROI exercise is how you start completing that circle. Let’s do some more napkin maths to show how.
Let’s say at the moment your rough figure for monthly business costs is sitting at around £5,000.
You’ve just demonstrated that you can make £12 profit per customer through a Facebook campaign. If you divide the cost you need to cover by your profit per customer you’ll get the volume of customers you need to reach.
So, 417 is the number of customers you’d need to reach each month with your campaigns in order to break even at that ROI level (£12 per customer).
You might be thinking that’s fine! I’ll just dial-up my Facebook spend, the campaign is clearly profitable. Unfortunately, it’s not that easy. The first metric we looked at was reachable market. Spending more won’t help to reach more people because there are no more people to reach with the current campaign targeting!
You’ll need to do a range of campaigns overtime to reach the volume you need. The ROI for different channels will likely be different and as you launch your business you must pay careful attention to this. Measure them properly to find out what level they are performing at.
But we still haven’t quite got the ROI calculation right. We’ve assumed that a customer will purchase something once from your company and then be lost forever. However, hopefully, many of your customers will become returning customers.
So, let’s introduce another metric.
Customer lifetime value.
Over a useful period (1 year, 2 years, 3 years?), how much will an average customer spend?
The useful period is defined by you. It might be true that a customer is still spending money in 3 years time but that is not useful to the business right now. If you want to judge your campaigns on how much money they will make in the short term then pick a shorter period to calculate lifetime value.
To judge this you’ll need to consider how likely it is your customer will return after their first experience. How ‘sticky’ is your product or service?
When you have a good idea, replace the profit per customer with the profit you’ll make over that period. This new number can all be fairly attributed to the original ad that brought them in, changing its ROI.
Alright, we’ve gone through the theory. Next, how you can practically create a sales forecast driven by the marketing activities you intend to run?
Financials – how to build your first sales forecast
What is the sales forecast?
Your sales forecast starts as a 12-month projection of your expected revenue, broken down by different product categories. It’s useful to demonstrate both the expected volume of units sold as well as the total revenue each month too.
The forecast has to be explainable. That means when someone asks you why you think you’ll achieve £4000 in month 3, you can clearly explain your theory.
You’ll need to build it up in a spreadsheet or in Brixx. If you have already been adding in your costs as you’ve been progressing through this book you can combine your sales forecast with your on-going costs to begin to see the complete picture.
Eventually, when we get to creating your business plan later in the book we’ll extend this to a 5-year financial forecast demonstrating what might be possible in the business’ future.
Create your base case with industry benchmarks
Since we are dealing with uncertainties, you need to create multiple sales scenarios covering best, worst and a base cases. Your base case is the most neutral position. Let’s start here.
We saw when calculating campaign ROI that if you know your conversion rates you can calculate how many sales you’ll make if you put a certain amount of budget in at the top.
But how do you calculate those conversion rates now if you haven’t started trading and gathering data yet?
You need to fall back on other peoples’ expertise here. Either yours, if you already have experience in the industry or other experts and industry benchmarks.
If you really want to make a sales forecast that isn’t just pure guesswork you need to spend the time to research your industry and the marketing benchmarks for those industries.
Those benchmarks will assume that you’re doing your marketing activities at least as well as the industry average. What will give you confidence in your assumptions is the quality of the market research you’ve done and the quality of campaigns you make to match.
If you are doing all this for the first time, it’s safe to assume that you’ll launch campaigns that will perform lower than the industry benchmarks at least initially.
Once you have your benchmarks, you need to decide your budget. Your budget will drive the total sales falling out the bottom of the campaign. Again, your decision here is a question of confidence. If you’re confident you’ll smash those industry benchmarks then your budget can start high. If you’re not so confident, start with a lower budget and increase it each month as you learn how to improve your conversion rates.
You can reflect this in your sales forecast too. Calculate your first few months assuming a lower budget, lower conversion rate and therefore lower sales. As each month goes by you can calculate increased sales assuming that you’re improving conversion rates each month.
By now, you should be able to see that your first sales forecast is a factor of known information combined with educated guesswork. You might think investors won’t be interested in these kind of inaccuracies. In reality, they are experienced enough to know that any forecast you make now will be wrong. They are keenly interested in the assumptions you’ve made to get there. How well thought through are they and are you in a position to test them as you launch your business?
If you demonstrate this, you’ll be in a great position even if you have your own concerns over accuracy.
In this post we covered:
- Conversion rates
- Average order value
- Cost per acquisition
- Customer lifetime value
- How to build a sales forecast
With all marketing activities, you’ll need to try out different activities and let them run for a bit to gain some data. This data will allow you to make better decisions and adjustments for future campaigns.
This blog post forms part of our series on how to start a business in 90 days. For an overview of the series and all the blog posts so far click here.