A Simple Explanation of the Math Behind 7 Common Marketing Metrics

    by Ryan Ghods

    Date

    April 2, 2013 at 9:00 AM

    marketing-mathThere's this misconception that marketers don't know how to do math. Instead of debating whether there's any validity to that statement (because that debate is ridiculous), let's help any marketers out there that aren't confident in their math skills. How? I figured we could start by explaining the math behind some common metrics we use every day -- or at least every month.

    Whatever career path you choose in the marketing world, it'll do you a world of good to have an understanding of and level of comfort with the math behind the metrics you cite every month. These metrics allow you to assess the health of your marketing team, and show a more tangible impact of your team's activities. Armed with this information, you'll be able to make better decisions in long-term strategy, planning, and budgeting of your team, and walk into any presentation with the CMO or CEO and talk to these numbers with confidence. (Hint: We know the C-Suite cares about numbers like these because our own CMO Mike Volpe told us so in this blog post, "The 6 Marketing Metrics Your CEO Actually Cares About.")

    A Note About These Metrics

    Before we dive into explaining these metrics and the math behind them, I’d first just like to say that there is no one, best way to calculate these formulas -- any MBA you know will tell you that. Based on your specific business and the industry you operate in, you may want to tweak these formulas to better represent the conclusions you’re after. The metrics I’ve handpicked below are accepted, time-tested formulas in the marketing world, and a good place to start from.

    It's paramount you and your team are consistently using the same formulas for any metrics you're tracking across your organization. If your company has already been calculating and recording a metric with historical data, be sure to research what the exact formula is that they are using to measure, so everyone measures the same way.

    Marketing ROI

    Return on Investment is one of the most important metrics for marketers to be aware of. After all, we need to know how the effort and dollars we’re putting into our marketing campaigns is affecting our bottom line.

    There is common debate about whether marketers should use sales revenue or gross profit (also called gross margin) as the structure for calculating their ROI. Traditionally, ROI can be calculated as:

    (Revenue - Investment)
    Investment 

    However, using sales revenue overstates our ROI since we are not taking into account our cost of goods sold (COGS). So for our marketing ROI metric, we will use gross profit. Gross profit is your company's revenue minus its cost of goods sold (COGS). This is different than operating profit, which takes into account overhead and payroll, and is your earnings before interest and taxes.

    First let’s talk about vanilla ROI. ROI is calculated as:

    (Profit - Investment)
    Investment

    So, marketing ROI is:

    (Gross Profit - Marketing Investment)
    Investment

    As a marketer, you will want to keep in mind marketing ROI of your activities. Your company is a money-making machine, and your managers care about how much is going in, and how much is coming out. Break down your marketing by activities or channels, and identify what brings the most return for your investment. This allows you to get a scope of how your activities are individually contributing in your marketing strategy, and will allow you to decrease or increase investment in specific efforts accordingly.

    Let’s take an example. Let’s say over the past 6 months Rubber Ducky Factory Inc. has spent $5,000 on freelance writers for blog posts. These posts brought in 150 leads, converting at a rate of 10%, generating 15 customers. These 15 customers had an average order size of 800 rubber ducks. Our rubber ducks have a COGS of $1 each, and sell for $2.50.

    Gross Revenue - Costs of Goods Sold = Gross Profit
    (15 orders * 800 rubber ducks * $2.50/duck) - (15 orders * 800 rubber ducks * $1/duck) = $18,000

    (Gross Profit - Marketing Investment) / Investment = Marketing ROI
    ($18,000 - $5,000.00) / $5,000.00 = 260%

    A marketing ROI of 260%. This means for every dollar we spent on freelance writers for our rubber ducky blog, it brought a return of $2.60. Not too shabby! This may be worth looking into to increase expenditures to drive more revenue. Even with diminishing returns, there is still growth to expand with a marketing ROI of 260%. And using closed-loop marketing software, you can easily identify which sources specific leads come from.

    (Tip: You may also calculate Gross Profit as Gross Revenue * Profit Margin = Gross Profit)

    Marketing Expense to Revenue

    Marketing Expense to Revenue is a similar metric to Marketing ROI, but provides a different perspective. For this metric, we are going to focus on total marketing expenses, including salaries of the marketing employees. This metric shows you how much you're spending on marketing compared to how much revenue is generated by the company. This metric is for a Marketing Manager or Director's perspective to see the overall allocation of their department in respect to overall revenue generated.

    Marketing Expense to Revenue is calculated as follows:

    Total $ Marketing Cost
    $ Revenue Generated

    This gives you the ratio of your marketing cost to your revenue generated. If it cost our rubber ducky factory $210,000 last year for two salaried employees and their marketing budget, and we generated $1.4 million in revenues, that would be:

    $210,000
    $1.4 million

    Thus, our marketing expense to revenue generated is 0.15. Looking at a real world example, in Q1 2011 Google's Marketing and Sales expense was $1.01 billion, and their revenues were $8.58 billion. This makes for a marketing (and sales) expense to revenue ratio of 0.12. Marketing expense to revenue ratio can vary widely in different industries and companies based on growth goals and gross margin. So a startup SaaS company, for instance, will have a very different ratio than a slow growing manufacturing company.

    Customer Acquisition Cost (CAC)

    This metric is also known as Cost of Customer Acquisition (CoCA). There are a variety of ways to calculate CAC. It is best to split up CAC by channel, so you can clearly see the direct costs of acquiring a customer from each of the channels your company focuses on.

    Total Sales and Marketing Cost
    Number of New Customers

    This metric could be over any time period -- a month, a quarter, or a year. Total Sales and Marketing cost is all the program and advertising spend, plus salaries, plus commissions and bonuses, plus overhead.

    As an example, let’s say we spent $450,000 between our sales and marketing teams last quarter, and we acquired 45 new customers. This would calculate to a CAC of:

    $450,000
    45 customers

    That means the cost to acquire each customer last quarter was $10,000 per customer.

    CAC is an important metric to have. It serves as a base for the next two metrics we will cover that are critical for a business to know: Time to Pay Back CAC and LTV:CAC.

    Time to Pay Back CAC

    Time to Pay Back CAC is a metric that tells you the number of months it takes your company to earn back the CAC you spent to get a new customer.

    In businesses where customers pay one time upfront, this metric is not necessary as it should be 0, i.e. the customer’s upfront payment is greater than CAC. Otherwise you are losing money on every customer.

    However, in businesses where customers pay a monthly or annual fee, it is best to aim for Payback Time to be under 12 months. This means that if you break even on a customer after 12 months, from then on you start making money from the customer.

    Here’s how to calculate Time to Pay Back CAC:

    Customer Acquisition Cost (CAC)
    (Revenue Per Month for Avg. Customer - Expenses Per Month for Avg. Customer)

    This metric will give you the number of months to payback. Expenses Per Month for the Average Customer is how much money you spend directly servicing that customer: COGS + services like training and support.

    Let’s use our $10,000 CAC figure from the last example, and calculate our Time to Pay Back CAC. Let’s also say our average customer has a monthly revenue of $1,200 per month, costing us $250 per month in COGS and $300 per month of a combination of technical support and training, totaling $550 in Expenses Per Month for the Average Customer.

    $10,000
    ($1,200 - $550)

    = 15.38 months. This means if we pay $10,000 to acquire a customer, we will break even and start to make money on the customer about 15 months later. This number is a bit higher than we should be comfortable with for a SaaS business, since keeping a customer signed on for a minimum of 15 months can be challenging, depending on the competitiveness and necessity of your product in your industry.

    If you're running a business where customers pay monthly or yearly, it's critical to evaluate your churn rate. If your average customer sticks around less than your Time to Pay Back CAC, you’re in trouble because if you’re not yet operating at a loss, you will be soon. Two strategic ways to approach this is to reduce your CAC, or increase the average number of months a customer sticks around. You may also look into increasing the price of your product, or decrease expenses associated with an average customer.

    LTV:CAC

    LTV:CAC is another important metric to calculate for your business. Calculating LTV (Life Time Value) is a lengthy and industry-specific process that calls for an entire post on its own, so I won’t get into it today; I'd recommend you talk to those MBA friends of yours, or someone working in Finance of Operations within your organization, if you're curious about the ways LTV can be calculated. However, I’d like to just briefly mention the importance of your LTV:CAC ratio.

    Calculating LTV:CAC is as simple as it sounds:

    Life Time Value (LTV)
    Customer Acquisition Cost (CAC)

    The meaning behind it, however, can mean life or death for your business in the long-term. 3X CAC is viable for most SaaS, or other forms of recurring revenue, businesses. Most public companies like Salesforce.com, NetSuite, etc. have multiples that are more like 5X CAC.

    Average Lead Close Rate

    Average Lead Close Rate evaluates the health of your funnel, all the way from the top to the bottom. No business has a perfect funnel, and it's important to look at your funnel on a consistent basis to encourage activities that will nudge it in the right direction.

    For a given month, calculating Average Lead Close Rate is:

    New Customers That Month
    Leads in a Given Month

    If your Average Lead Close Rate is low, how good are you at qualifying your leads? Is your sales team wasting time calling leads that are unqualified? If it’s high, great! Your leads are highly qualified and being converted into customers. If your grow your database at the same rate and with the same quality of leads, it should turn into more customers. With a high Average Lead Close Rate, your marketing team should be focusing on increasing the number of leads coming in from the top of the funnel.

    As an example, let’s say we had 3,000 leads in February, which converted to 25 customers:

    25 customers
    3,000 leads

    That comes out to 0.83%. This means that 0.83% of our leads become customers. If you flip the equation (3,000 leads/25 customers = 120), you can find that for every 120 leads that enter the funnel at the top, we get one customer. Depending on your industry, this number could be high or low for your business goals. How are you attracting your leads? For inbound marketing tactics where your leads are coming to your website organically, this number isn’t bad. However, if you’re paying for every lead, this could become expensive fast depending on how much money a new customer nets your business.

    For companies with a long sales cycle (6+ months), this metric can become unreliable. This is due to the fact that if you were generating 100 leads per month a year ago and 10 of those leads closed today, but today you're receiving 1000 leads per month, the close rate looks like 1%, but it's really closer to 10%. Fortunately, closed-loop marketing software allows you to track lead close rates based on the month they were generated.

    Net Promoter Score (NPS)

    What is Net Promoter Score? I’m glad you asked. NPS is a customer loyalty metric developed by Fred Reichheld, commonly used in customer satisfaction research. Many organizations, including HubSpot, use Net Promoter Score to assess the happiness of their customers.

    We send an NPS survey to a group of randomly selected customers every quarter to benchmark our relationship with our customers. In its simplest form, an NPS survey simply asks: How likely is it that you would recommend [Our Company] to a friend or colleague?

    The responses are divided as follows: Customers who answer 0-6 are “Detractors”, 7-8 are “Passives,” and 9-10 are “Promoters.” The goal is to maximize the number of customers who are Promoters in our company.

    Armed with these numbers, NPS is simply calculated as:

    % of Promoters - % of Detractors

    At HubSpot, when surveying our customers about their promoter score, we also have an open-ended question for them to explain their thoughts. We have a “Reason for Response” field to get a qualitative reasoning from our customers for their score, which can often provide actionable feedback for our team to make improvements.

    There are several criticisms about Net Promoter Score being used as a customer loyalty metric. Most criticisms revolve around it being used as a be-all metric for customer satisfaction and loyalty. In my opinion, NPS is used as a snapshot into your customers’ thoughts about your company, and the products or services it provides. It should not be the sole metric that your entire company revolves around to determine your customers’ opinions of your business, but is a great way to assess how you're faring if you monitor the metric continually.

    Do you calculate or interpret any of these metrics differently? What are other marketing metrics that you use that you wish you had a better mathematical understanding of?

    Image credit: FunnyShirts.org

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