Return on Marketing Investment: Towards Development of a New Metric
Linda D. Hollebeek
University of Auckland Business School Supervisor: Professor R.J. Brodie, University of Auckland Business School
Abstract The lack of accountability and measurement of marketing investments and expenditures, their rate of return and contribution to financial corporate objectives such as shareholder value (SHV) creation have long been recognised by academics and practitioners alike. This study proposes an integrated conceptual framework (ICF) that shows how marketing, and the brands for which marketers are responsible in particular, may contribute to the key bottomline objective of SHV creation, as measured by economic value added (EVA). The framework also addresses the potential influence of intermediary relational market-based assets measures such as customer value (CV) which is created in the organisation-customer interface in the external marketplace. The model is expected to enhance academic understanding of the value creation process in organisations with a focus on marketing, as well as contribute to (marketing) practitioners. Empirical testing of the model is envisioned subsequent to the model’s conceptual validation. Keywords: marketing performance, shareholder value, market-based assets
1.
Introduction & Purpose
The neglect in the literature to connect marketing strategy to interdisciplinary business processes (Webster 1992) and to its cash flow consequences has become commonplace in the literature (Anderson 1982). In recent years, marketing practitioners have been increasingly held accountable for their marketing expenditures and the degree to which these contribute to overall financial corporate objectives. In response to these demands a number of sales and profitability-related metrics have been developed as an attempt to measure the return on marketing investments (ROMI), which have tended to conform to traditional accounting valuation periods such as three- or twelve-monthly measures. However, the relatively shortterm nature by which these measures are characterised has limited the use and applicability of these measures in marketing practice, because marketing resources including brands tend to have multi-period pay-offs, thus extending beyond traditional accounting valuation periods. As a result, a lack of understanding has emerged among academics and managers of the medium to longer-term value-creating properties and processes attributed to marketing resources. Srivastava (2007) identifies specific types of marketing intelligence lacking suitable valuation methods including brand launch expenditures, competitive positioning resources, customer acquisition costs, and channel development. Brands have been significant potential in creating financial value for firms (Srivastava et al. 1998, 2001). These issues have
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thus led to inconsistent valuation of marketing resources/investments which has been problematic e.g. with merger and acquisition valuations and resource allocation decisions. Further knowledge in this area is expected to elevate the financial value of strategic marketing resources and decisions. A second problem associated with marketing valuation metrics to-date has been a debate regarding which measure to use, e.g. sales/profit-based methods vs. shareholder value (SHV), which has been described as the ultimate goal of business (Bughin and Copeland 1997). While SHV has been recognised as appropriate for measuring marketing performance (Doyle 2000), further debate surrounds its measurement. The purpose of this study is to introduce an integrated conceptual framework (ICF) of the SHV creation process based on a literature review, and the role of marketing therein. Empirical testing of the model is also envisioned.
2.
Literature Review and Conceptual Development
2.1 Financial Fundamentals Brealey et al (2001) suggest three fundamental decisions are made by firms that have financial implications including the investment decision, the financing decision and the dividend decision. The investment decision asks which projects the firm’s scarce resources should be allocated to such as the construction of a new factory, office building or brand. The bundle of projects a firm enters into constitutes the operations of the firm. Second, once the firm has decided which projects to invest in, the financing decision asks whether these projects should be financed by debt or equity. The firm can invite investors to put up cash in exchange for either a share in profits (equity) or a series of fixed payments (debt). A firm’s long-term mix of financing constitutes its ‘capital structure’. The firm effectively sells financial assets in the financial markets in order to fund the purchase of real assets to carry out the operations of the firm. Third, the dividend decision asks how much cash should be returned to shareholders and how much should be reinvested in the firm. For example, a firm that has produced $100m cash might decide to pay a dividend of $40m and reinvest the remaining $60m in the firm so that it is available for allocation to future projects. Organisations typically aim to maximise SHV through investing in suitable projects, financing with the appropriate mix of debt and equity and reinvesting the right proportion back into the business. Modigliani and Miller (1958, 1961) show that the financing and dividend decisions can only create value in very limited circumstances. Therefore, value is predominantly created through the investment decision. Two fundamental concepts, cash flows and cost of capital, are required for understanding investment decisions. Established economic theory teaches that the value of any resource equals the present value of the returns expected from the resource, discounted at a rate that reflects the risk inherent in those returns (Jones 2003). However, the contentious issue is whether cash flow or accounting earnings should be used as the measure of returns. Stickney and Brown (1999) consider that valuation should use cash flows as the measure of returns instead of accounting earnings, for example because cash serves as a measurable common denominator for comparing investment opportunities. Other authors who have critiqued the use of accounting earnings include Rappaport (1998). Hence cash-flow based valuation models are preferable to earnings-based models. Second, the discount rate or ‘cost of capital is a necessary component to calculate the present value of projected cash flows. It is the rate that investors require the firm to generate in order to induce them to commit capital, given the level of risk involved (Rappaport 1998). For example, the cost of capital for a food processing firm will be less than
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for a biotechnology firm reflecting relative risk. Debt and equity are the two possible sources of capital and each have their own cost. Brealey et al. (2001) summarise that investors expect a reward for both waiting and worrying (as reflected by CAPM). The greater the worry, the greater the expected reward. The waiting component is known as the ‘risk-free rate’ and the worrying component is known as the ‘equity risk premium’. The cost of capital should be adjusted to reflect any differences between the risk of new assets and the risk of existing assets (Ehrbar 1998; Brealey et al. 2001). Returns to shareholders consist of a dividend yield and a capital gain. Shareholder wealth increases when the market value of that equity increases. It is irrelevant whether or not that increase in market value is retained or distributed in the form of a dividend. When a firm enters into a positive-NPV transaction it has created value. However, it does not necessarily follow that SHV has been created several reasons. Hence there is an intermediate step in the ICF in Figure 1 between value creation and SHV creation requiring that any value created must be transferred to shareholders through an increase in the market value of the firm’s equity or through a distribution to shareholders (such as a cash dividend). Further, a step entitled ‘Availability of Positive-NPV Projects’ is included in the ICF as a prerequisite to value creation. However, discounted cash flow techniques such as NPV fail to explicitly take into account indirectly generated opportunities, which is not necessarily a limitation of the discounted cash flow in itself but due to a failure of management to consider indirect effects of adopting certain projects. Therefore, the output of NPV analysis is only as good as its input (GIGO principle). If a positive-NPV opportunity is available to a firm then this means that the firm is able to earn a return higher than its cost of capital resulting in an economic profit. If an average firm can consistently generate an economic profit (i.e. monopoly rents) then the market would be classified as attractive (Doyle 2000). 2.2 The Marketing-Finance Interface: Metrics for Marketing Performance Marketing performance is the root source of SHV because the firm’s opportunity to create cash is primarily based on its ability to attract and retain customers (Doyle 2000). However, marketing has sometimes been marginalised in senior management due to a lack of demonstrable financial accountability. Thus by furthering integration of marketing/finance, marketing has an opportunity to solidify its strategic position and credibility within the organisation. This may be achieved by using SHV, since traditional marketing objectives such as profitability may actually destroy SHV (Brealey et al. 2001) and thus diverge from finance objectives. SVA (shareholder value analysis) is a technique for ranking alternative marketing actions according to their effect on SHV by using tools such as NPV in marketing investment decision-making. SVA recognises the importance of SHV maximisation as the ultimate business objective. SHV is maximised through entering into projects with first, positive NPVs and second, these positive NPVs should be maximised. Srivastava et al. (1998) identify four broad manners in which marketing may contribute to maximisation of the NPV of future cash flows: Accelerating cash flows, enhancing cash flows, influencing the vulnerability/volatility of cash flows, and enhancing the residual value of cash flows. Ehrbar (1998) advocates the use of Economic Value Added (EVA) as a performance measure because it is more highly correlated with SHV than any other measure. Originally conceived as an adjustment to accounting earnings through imposing a charge on debt and equity capital (i.e. the opportunity cost of capital), EVA was further developed to incorporate cash flows rather than accounting earnings. Grinblatt and Titman (2002) assert that this alternative form
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of EVA constitutes a more accurate system whereby managers are encouraged to take on positive-NPV projects since they will be evaluated according to the same criteria as they themselves use when evaluating investments. If managers adopt a positive-NPV project and their calculations are accurate then the managers will, by definition, have added economic value. Whereas NPV analysis is a prospective tool used in decision making, EVA is a retrospective tool used in evaluating past performance. In essence, the NPV of a project is simply its discounted EVA stream. In summary, it is asserted that EVA is the most appropriate performance measure in the context of the SHV creation process as set out in the ICF. 2.3 The Resource-Based View of the Firm The resource-based view of the firm (RBV) posits that defining a firm in terms of its resources and firm capabilities offers a more durable basis for strategy than a definition based upon the customer needs the business seeks to satisfy (Srivastava et al. 2001). The rationale underlying the RBV is that resources which are increasingly convertible, rare, inimitable and non-substitutable may contribute to increasing value creation and competitive advantage (Hunt and Morgan 1995). Barney (1991) defines competitive advantage as the ability to leverage a firm’s unique skills and resources to implement a value-creating strategy that its competitors cannot implement as effectively. Kotler et al. (2001) note that a competitive advantage may be achieved broadly through lower-priced offerings or through provision of additional benefits justifying higher market prices. When such advantage is immune to erosion by competitors’ actions, it is construed as sustainable competitive advantage (Porter 1980). Competitive advantage can only be achieved through co-ordinated, company-wide efforts. The ICF in Figure 1 implicitly incorporates this concept by showing that a firm’s competitive advantage reflects the functional integration of business disciplines including marketing and finance. Hence competitive advantage may act as a ‘bridge’ to achieving the ultimate goal of SHV creation/maximisation. This view on competitive advantage also illustrates the importance of cross-disciplinary acceptance and understanding within firms, for which a pressing need exists (Varadarajan and Jayachandran 1999). The ICF hypothesises that a firm’s competitive advantage serves to determine, among other factors, the level of that firm’s financial performance. Another factor that may impact this is customer value, which will be addressed later. Competitive advantage is built upon the three types of market-based processes, which by using intellectual and relational market-based assets, must be absorbed, transformed, and leveraged as part of some organisation process if they are to convert inputs into products or solutions that customers desire, and thus, generate value for the organisation (Srivastava et al. 2001). The three types of market-based processes identified include Product Innovation Management (PIM), Supply Chain Management (SCM) and Customer Relationship Management (CRM). An analogous classification of ‘core business processes’ was developed by Doyle (2000, 2001) with each process subsuming a number of sub-processes. Each of these market-facing processes is cross-functional with marketing playing different yet important roles within each (Lehmann 1997; Srivastava et al. 2001). The PIM process aims to create solutions that customers need and want. Sub-processes within PIM practice include determination of new customer needs, new product solution design and network development with external organisations. Second, the SCM process incorporates acquisition of all tangible and intangible inputs, and the efficiency and effectiveness with which these are transformed into customer solutions. SCM sub-processes consist of vendor identification, installation and maintenance of process technologies and co-ordination of
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outbound logistics. Third, the CRM process addresses all aspects of customer identification, customer knowledge creation, customer relationship initiation and maintenance, and customer perceptions management regarding the organisation and its products. CRM sub-processes comprise identification of potential new customers, determination of customer needs, development and execution of advertising programmes and enhancement of customer trust and loyalty (Doyle 2000). A fourth type of market-based process was also added to the ICF which was termed ‘Information and Research Management’ (Lehmann and Jocz 1997) or IRM. The addition was based on PIM, SCM and CRM not fully capturing the nature of all market-based processes by omission of (prospective) customer and competitive environment intelligence through systematic inquiry and consequent intelligence generation (i.e. market research). Hence the IRM process was included to reflect this in the ICF and is in line with the view of firms as learning organisations largely dependent on knowledge assets for gaining competitive advantage (Lehmann and Jocz 1997). Srivastava et al. (2001) further postulate that a firm’s market-based processes are governed by its market-based capabilities. These capture and reflect how well a firm performs each key customer-connecting process, and in designing and managing sub-processes within the CRM process (Srivastava et al. 2001, 1999). The IRM process is also used to connect with customers, e.g. through undertaking consumer research. Analogous to Srivastava et al., Doyle (2001) defines his core capabilities as an organisation’s ability to co-ordinate resources effectively. Resources form the lowest-order link in the RBV value creation process (Srivastava et al. 2001) and serve as inputs to a firm’s market-based processes. A resource or asset is defined as any physical, organisational, or human attribute that enables a firm to generate and implement strategies that improve its efficiency and effectiveness in the market place (Barney 1991). Resources may be either tangible (physical, e.g. factory) or intangible (lacking physical attributes, e.g. brands) in nature. Intangible assets have traditionally been neglected in asset valuations. Thus while tangible assets have traditionally been emphasised in literature and practice, this has made way for a growing importance of intangible assets which valuecreating properties have not been well-developed to date. Despite this Srivastava et al. (1998, 1999, 2001) and Doyle (2000, 2001) have highlighted the significant contribution of intangible assets to value creation in organisations. In their seminal article, Srivastava, Shervani and Fahey (1998) coin the term market-based assets, which is further developed in subsequent work (e.g. Srivastava et al. 1999, 2001). Market-based assets are defined as intangible assets that arise from the commingling of the firm with entities in its external environment. Two types of market-based assets exist. First, relational market-based assets are outcomes of the relationship between a firm and key external stakeholders such as distributors, retailers or end customers e.g. brand equity or consumers’ familiarity with and favourable, unique brand associations. Second, intellectual market-based assets are defined as the types of knowledge a firm possesses about the environment such as the emerging state of the environment including competitors and customers (Srivastava et al. 1998), subsumed in the IRM process in the ICF. The authors show that market-based assets may be used to lower costs, attain price premiums, generate competitive barriers, provide a competitive edge by making other resources more productive, and provide managers with increased options (e.g. by creating trial for brand and category extensions). The foundation level of the ICF denotes organisational assets, of which marketbased assets are a subset. The value of any asset is realised in the external market place (Srivastava et al. 1998).
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Brand assets have been identified as the primary responsibility of the marketing function (e.g. Doyle 2001). A brand is defined as a name, term, symbol, sign, mark or a combination of these that identifies the goods/services of one seller and distinguishes it from its competitors (AMA, Boone and Kurtz 2001). Thus a focus on brand assets is adopted in the present study with a view to future empirical testing of this particular type of organisational resources. Future testing of the ICF is also expected to generate improved insights into the dynamics of the RBV, which has sometimes been critiqued for its predominant conceptual focus and a lack of empirical validation. Finally Doyle (2001) notes that assets require investment in order to maintain or enhance their value. The ICF depicted does not only incorporate extant literature, but also extends on it by providing further classifications of hybrid asset types, which have characteristics of more than one asset class discussed in the literature to date. The newly proposed asset types are first, hybrid tangible/intangible assets which show elements of both these asset types. For example, commercially available information technology (IT) packages may be adapted or extended by individual companies to better suit their needs. Thus while the physical product is a tangible asset, unique intellectual property or IP (intangible asset) may reside in IT packages in organisations. Another example is, while software produced by an IT company ready for distribution is a tangible asset (stock), it simultaneously represents an intangible resource based on the IP inherent in the product. Second, hybrid relational market-based assets/non market-based assets were identified in the ICF. An example here is Human Resources (HR) through staff spending part of their jobs commingling with the external environment, while focusing on internal duties for the remainder of the time. Similarly, organisational culture may be viewed as interacting with the external environment (e.g. through product/service positioning) some of the time, whilst also partially being internally focused (e.g. administrative procedures for staff). In contrast to relational market-based assets, the definitional nature of intellectual market-based assets prohibits hybrid forms of these: Resources involving knowledge about the external environment (intellectual market-based assets) necessarily arise from some form of commingling with that external environment. Non market-based assets are also shown as a sub-class within the broader intangible assets categorisation. Although Srivastava et al. (1998, 1999, 2001) emphasise the role of intangible market-based assets, the role of other, non market-based types of intangible assets receives limited attention. An example of such asset type is internal support activity required to assist the core operations of the firm such as secretarial/administrative tasks. Although these are in part covered by HR assets, their unique supportive role calls for a separate asset class of non market-based intangibles. This also raises a need for distinction of core staff (performing core operations of the organisation), and support staff (providing supporting services/assistance). While staff carrying out the core operations were previously identified as potentially relational market-based/non market-based resources, support personnel tend to be much more non-relational in nature.
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Figure 1 - Integrated Conceptual Framework (ICF) Shareholder Value Creation (EVA) Value Transferred to Shareholders
Value Creation - Adoption of Positive NPV Projects
Indirect Generation of Future Opportunities
Availability of Positive NPV Projects Competitive Advantage Customer Value
MARKETBASED PROCESSES
Market-Based Capabilities
RESOURCES
TANGIBLE ASSETS E.g. Plant Equipment Factory Warehouse Hybrid Intangible Assets, e.g. Hybrid (Rel.) market-based/non-MB assets - e.g. HR, Org. Culture INTANGIBLE ASSETS Relational Intellectual Non-Market Based Market-Based Assets, e.g. Market-Based Assets, e.g. Assets, e.g. Brand Assets Strategic Assets Internal Support
Hybrid tangible/intangible Assets - e.g. Information Technology
2.4
Customer Value Investment
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A lack of consensus about the definition and measurement of customer value is observed in the literature (Zeithaml 1988). Building on this work, customer value may be conceptualised as a trade-off between customer perceptions of the perceived benefits (functional and/or emotive product/service features that determine perceived quality) and sacrifices/costs (prices and non-monetary costs) (Brodie et al. 2007; Rust et al. 2000). Monroe (1990) terms this the “worth what paid for” trade-off. In addition to established scales, the construct can be measured using utility theory, where utility is assumed to be maximised by individuals making their choices (Campo et al. 2000). The basic paradigm is that individuals allocate time, financial resources and effort in the production of utility, which they seek to maximise. When considering the value of a product/service, each entailing particular costs and benefits, value assessments are assumed to be driven by a cost/benefit trade-off with perceived utility (net benefits) maximisation outcomes most likely to be selected in current and future periods. Three cost types are distinguished, which are substitution costs, transaction costs and opportunity costs (Campo et al. 2000). Customer value has been found to have a strong relationship with consumers’ behavioural intentions (Cronin et al. 2000) and loyalty (Bolton and Drew 1991). The relationship between customer value and financial performance has also been identified in the literature (Reichheld et al. 2000; Srivastava et al. 2001), such as SHV. Empirical investigation of the customer value-financial performance relationship is of particular interest in service contexts, since insights in this area are limited to date. Vargo and Lusch (2004) argue that the provision of any good or service entails a service component with customers as value co-producers of value propositions made by the firm. Thus the linkage between service branding and SHV creation has not been well-understood to date.
3. Summary & ANZMAC Feedback Areas Based on a literature review, an integrated conceptual framework (ICF) was developed as an initial step towards achieving improved understanding of marketing performance measurement based on established financial theory. Next steps include the development of an empirical research design for model testing. This may take place in service contexts, where insights into the marketing-financial performance relationship are particularly limited. Feedback may focus on: 1. Reflection/comments on conceptual model: Relevance, accuracy, missing concepts 2. Suggested research questions/directions and methodological feedback
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