## Gross Margins and Return on Advertising Investment

Category: Fresh CatchBob’s is the only hardware store in Elk Snout. Bob’s buys a weekly quarter page in the Elk Snout Gazette for $230. Bob’s grosses $6,700 per week, year round (since there are no seasons in Elk Snout).

One day, the new Gazette salesperson convinces Bob’s manager to purchase an additional $200 ad in the Graduation Issue of the paper. That week, Bob’s revenue jumps to $7,100. “Well, I guess the new kid was right,” says Bob’s manager, “we just doubled our money.”

But, as the manager adds up all of Bob’s payables, he seems to have $64 dollars less to pay the bills than he expected. How could he be short? He even had the extra profit from the extra Graduation ad.

By some odd coincidence, you operate a small factory in Elk Snout making stone trivets. You sell them to hardware stores like Bob’s. That salesperson for the Gazette must have been pretty good. He got you to buy one of those $200 ads in the Graduation Issue.

Your gross increased by the same $400. At the end of the month, after you’ve paid the trivet factory bills, you find that you have an extra $15.

You and Bob’s weren’t alone in that Graduation Issue. The injection molding company and the nightclub also purchased $200 ads, and amazingly, they too each saw sales increases of $400 that week.

But when they reconcile their payables, the nightclub seems to have picked up an extra $170, but the injection molding company comes up short $332.

What’s going on??

### It’s the effect of gross margin.

Gross margin is profit divided by selling price.

Let’s look at your trivet company financials. Every trivet costs $4.50 to produce. You sell them to Bob’s, and similar stores, for $9.75. Your gross margin is $5.25 divided by $9.75, or 53.8 percent. This means that for every dollar you take in, 53.8 cents falls to the bottom line, while 46.2 cents is consumed in the production of trivets.

The injection molding company operates with a gross margin of only 17 percent, using up 83 cents of every dollar manufacturing the plastic parts which they sell for that dollar.

But over at Bob’s Hardware, each dollar of gross sales produces 34.1 cents in net profit, which means that 65.9 cents of each of Bob’s dollars gets used to purchase and stock the hardware.

And at the nightclub, forty cents worth of rum and 5 cents worth of cola costs the customer $6.00, and provides an astonishing 92.5 percent gross margin.

So, what does gross margin have to do with advertising?

### It isn’t simply dollars in minus dollars out.

In Hope is Not a Strategy for Greater Return on Advertising Investment, I said, “*If advertising is an investment, you should expect to see a predictable profit from that investment. Invest a dollar in advertising, get back four, or five, or six. At the very least, shouldn’t you get back a dollar ten?*”

Alas. A dollar ten returned on a dollar invested will have three of our four fictitious companies losing money. You see, each company’s revenue is in gross dollars, but each ad is purchased with net dollars. When a portion of each gross dollar is eaten up in the expense of generating sales, it takes more of the remaining net dollars to do the job.

You won’t know whether your advertising is profitable until you calculate Return on Advertising Investment (ROAI), wich is the reciprocal of gross margin. If you have a 50 percent margin, your advertising must return at least double your investment. At a 20 percent margin, you’ll need five times the investment. At 5 percent margin your ROAI needs to be 20 times.

Let’s look at this in chart form.

Gross | Breaks Even | ||

Investment | Margin | at ROAI of: | |

Nightclub | $1.00 | 92.5% | $1.08 |

Trivet Company | $1.00 | 53.8% | $1.86 |

Bob’s Hardware | $1.00 | 34.1% | $2.93 |

Injection Molding | $1.00 | 17.0% | $5.88 |

The last column shows the sales increases each company needs to justify each dollar that company invests in advertising.

If the nightclub gets back anything in excess of $1.08, their advertising is profitable. But, if the injection molding company doesn’t see sales increases greater than $5.88 for each dollar invested , they’d be better off not advertising at all.

Your trivet company breaks even when each dollar spent returns $1.86. Bob’s breaks even when $2.93 returns. Compared to Bob’s Hardware, you get a $1.07 advantage in every dollar you invest in advertising. But compared to the injection molding company, each dollar your trivet company invests buys $4.02 more.

### What about that $200 ad in the Gazette?

The nightclub did well. Your trivet company did, too.

Gross | Breaks Even | Effect of $400 | ||

Investment | Margin | at ROAI of: | Sales Increase | |

Nightclub | $200.00 | 92.5% | $1.08 | $170.00 |

Trivet Company | $200.00 | 53.8% | $1.86 | $15.20 |

Bob’s Hardware | $200.00 | 34.1% | $2.93 | $-63.60 |

Injection Molding | $200.00 | 17.0% | $5.88 | $-132.00 |

OUCH! Bob’s Hardware and the injection molding company not only didn’t make a profit on their $200 advertising investment, they actually lost operating capital.

And it all has to do with Gross Margin. If you don’t know your margin, how do you know whether your ads are “working?” How do you even know how much to budget?

Most companies don’t produce only one product. They need to calculate an average gross margin by dividing total operating profit by total gross sales.

What is your company’s average gross margin? What is the ROAI you need to stay profitable?

Fishing for Customers isn’t simply being ready to “hook ‘em.” Sometimes it’s knowing how much you can afford to spend on “bait,” too.

Your Guide,

*Chuck McKay*

Your Fishing for Customers guide, Chuck McKay, gets people to buy more of what you sell.

Questions about using your gross margin to measure the success of your advertising may be directed to ChuckMcKay@ChuckMcKayOnLine.com. Or call Chuck at 304-208-7654.

Question: Say I am spending 72K on ads to generate 500K in gross sales at 13% GM (after all expenses not just ads) and I analyse my ads and see that I can cut ad spending to our core ads which cost 24K but this reduces my gross sales to 270K (55% of original gross sales).

My original 13% GM should require 7.69 times in ROAI and I am only getting 6.66 (500 divided by 75) cutting ads would now give me an ROAI over 10 which is acceptable at 13%GM, but the gross sales would be cut by 45% and significantly reduce total net income.

To put it another way with more accurate figures….Right now I can clear 110K net profit. My core advertising is 33% of my total ad cost and it brings in 55% of my gross sales and provides about 80K profit in my pocket. The rest of my advertising accounts for 67% of my total ad cost and provides only 30K additional net profit. A smaller return, but cetainly I would not want to lose the 30K in my pocket!!!! It seems I do not need to acheive the ROAI calculated as the reciprocal of GM to add profit even if it is at a lower return.

So how do I know where to draw the line? Where am I making a mistake? Why should I try to hit the proper ROAI of 7.69 when right now I am at 4.16 (500K divided by 120K net profit) and making an extra 30K?

Should I be looking at hitting 7.69 ROAI for best profit? How would I go about analysing this is there a curve/graph/formula?

Any help is appreciated on this board or in a private email. Thanks for the informative article.