The Effect of Marketing on Company Profitability

The Effect of Marketing on Company Profitability

Marketing is misunderstood. Marketers are thought of as spenders, rather than profit generators. Many are skeptical that marketing dollars spent will increase incremental revenue. These misunderstandings are a result of a number of factors, including the lack of exposure to research on the subject. In this post, I’ll do my best to clear up these misunderstandings by:

  • Discussing the question “What is the purpose of a firm?” and providing common responses.
  • Exploring the effect of a market orientation on company profitability.
  • Examining marketing budget processes.
  • Analyzing the measurement of marketing effectiveness.
  • Addressing the dichotomy of interests between marketing and finance, and proposing methods for reconciling differences to increase company profitability.

What is the purpose of a firm?

A compelling and much-debated question is “What is the purpose of a firm?” Traditional economic theory calls for a single, simple goal: the maximization of shareholder value. In other words, increase the wealth of the owners. Most organizations focus on maximizing profits, which may or may not increase shareholder value. Other organizations shun economic theory and choose a different strategic objective—increase market share. They assume that beating the competition will lead to increased profitability.

Honored as one of the world’s leading marketing thinkers, Philip Kotler is the S. C. Johnson Distinguished Professor of International Marketing at the Kellogg School of Management. He argues against a strategy focused solely on profit: “Private firms should not aim for profits as such, but rather to achieve profits as a consequence of creating superior customer value.” At the core of this perspective—from a marketing expert—is the customer.

Creating customer value involves 3 steps:
  1. Use targeted market research to identify customer needs and wants.
  2. Develop and enhance your product or service to fulfill those needs and wants.
  3. Execute an integrated marketing plan that focuses on the customer experience. The company profits through customer satisfaction.

Focusing solely on profits or shareholder wealth—instead of creating customer value—has its problems. Such a strategy neglects the long-term financial health of the organization. A company that lives and dies by the quarterly profit numbers can certainly boost its share price—in the short term. Over time, companies must adapt to the changing market and current financial conditions to remain successful.

From the finance perspective, corporate goals are much more complex than profit maximization. Goals must incorporate proper rate discounting and adjustments for future risk. And, there is no definitive proof that increasing market share always leads to increased profits.

The effect of a market orientation on company profitability

While there are disagreements as to the purpose of a firm, the purpose of marketing is clear: create customer value. By concentrating on the customer and satisfying their needs and wants, marketing can achieve the ultimate goal of profit maximization.

Many studies have connected marketing to the profitability of a firm. The academic research of John Narver and Stanley Slater serves as the foundation. They use the term “market orientation” to illustrate the importance of this connection.

Market orientation consists of three behavioral components:
  • Customer orientation is a sufficient understanding of target buyers to be able to continuously create superior value for them.
  • Competitor orientation refers to understanding the short-term strengths and weaknesses and long-term capabilities and strategies of both the key current and key potential competitors.
  • Inter-functional coordination is the coordinated utilization of company resources to create superior value for target customers.

Narver and Slater maintain, “For a business to maximize its long-run profits, it must continuously create superior value for its target customers. To create continuous superior value for customer, a business must be customer-oriented, competitor-oriented, and inter-functionally coordinated.” As a result of their research, they concluded that organizations with the highest degree of market orientation had the highest profitability.

In another academic study, Roland Rust, Christina Moorman, and Peter Dickson compared two strategies:

  • Revenue emphasis focuses on growing demand through catering to consumer preferences for quality.
  • Cost emphasis focuses on reducing expenses through both operational efficiencies and cost cutting.

Their conclusions also support the connection between market orientation and firm performance. “…our empirical findings suggest that firms can achieve greater financial returns from quality improvements by emphasizing revenue generation solely, along with its underlying focus on customer satisfaction and retention.” The adoption of a cost emphasis, on the other hand, was connected with lower profitability.

The current financial crisis has caused many companies to shift to a cost emphasis strategy. Such a shift may be effective in the short term. But to reach long-term profitability goals, it’s clear that companies must concentrate on the true definition of marketing—creating customer value.

Marketing budget processes

If you’ve ever been involved in determining a marketing budget, you know how difficult it is. Deciding how much to spend on marketing promotions, and how to allocate those funds, can be the difference between success or failure, continued operations or bankruptcy. With so much on the line, it’s critical to choose the right process for your organization. Marketing expert Philip Kotler has identified four different budgeting methodologies:

1. The affordable method

This method involves setting the promotional budget at what the company thinks it can afford.

Drawbacks: It ignores the role of promotion as an investment and the immediate impact of promotion on sales volume. It is arbitrary, leads to an unpredictable annual budget, and hampers long-term planning.

2. The percentage-of-sales method

With this method, expenditures are set at a specified percentage of sales—either current or anticipated—or of the sales price.

Advantages: It satisfies many financial managers, who believe that promotion expenses should be closely related to sales revenues. Moreover, it encourages management to consider the relationship between promotion cost, selling price, and profit per unit.

Drawbacks: It lacks justification and the chosen percentage is arbitrary. It views promotion as the consequence of sales, instead of the precursor of sales. Furthermore, this method sets the budget based on the availability of funds rather than by analyzing market opportunities.

3. The competitive-parity method

This method involves setting the promotion budget to achieve “share of voice” parity with competitors.

Advantages: It may enable an organization to maintain market share.

Drawbacks: It assumes that competitors are better qualified to set budgets.

4. The objective-and-task method

With this method—the most widely used budget process—marketers develop promotional budgets by defining specific objectives, determining the tasks that must be performed to achieve these objectives, and estimating the cost of performing these tasks.

Advantages: It is less arbitrary than the others, even though costs are estimated and can end up being completely incorrect. It is derived from company goals, and delivers the justification the finance team will want to see.

Drawbacks: It is the most time-consuming and challenging of the 4 methods.

I would also add another arbitrary method I’ve had to use in the past. I call it The Bargaining Method. You may be familiar with it too. Here are the steps:

  • Management reviews what was spent last year and sets the same budget for this year.
  • Marketing starts bargaining for an increase and ends up proposing 20%.
  • Management settles on a small increase, sometimes as much as 10%.
  • Marketing celebrates.

While it’s apparent that the objective-and-task method is the most effective budget process, many organizations continue to rely on the others, diminishing their ability to set marketing budgets that maximize profits.

The measurement of marketing effectiveness

Determining the effectiveness of marketing and justifying expenditures continues to be one of the greatest challenges businesses face. Finance executives are looking for hard numbers, but marketing results are difficult to quantify. Even with today’s sophisticated business analytics, it is impossible to connect a single customer purchase to a single marketing expenditure.

Purchase decisions

In the distant past, someone would receive a direct mail letter promoting a product, call the company, and make a purchase. The company could easily calculate the expense of sending the letter to determine the profitability of the campaign. It was a straightforward process.

Purchase decisions are no longer linear. Today, they look more like a complex web, comprising the company and its marketing methods, as well as potential and current customers and their friends.

The Internet has destroyed information access barriers. Decisions are now based on multiple marketing “touches,” which may or may not involve the company. Despite this complexity, it is critical to connect customer purchases to all of the preceding marketing touches, not just the most recent one.

Adding to the difficulty, the effects of marketing decisions are almost always delayed. Yes, some customers will immediately click a link in a promotional email and make a purchase on an ecommerce site. But this is not the norm.

Scrutiny from finance

During challenging economic periods, marketing comes under increased scrutiny. If marketing cannot prove the value of its expenditures, it becomes much easier to reassess marketing budgets. Finance yields a great deal of power; therefore, marketing cannot ignore the need to provide tangible metrics to validate project effectiveness.

Although more general measurements of marketing effectiveness–such as website traffic or calls to a sales line–are important, specific result analysis is much more valuable. Companies must track customers with tremendous efficiency, identifying which prospects participate in which promotions to justify expenditures to the finance department.

Ideal measurement

During my career in corporate marketing, I’ve worked at one company that perfected data analysis. We collected data on all marketing touches and sales conversions, and combined them with our campaign expenses. As a result, we could generate accurate reports that revealed the exact cost of each sale. Finance determined our target cost per sales dollar generated. As long as we stayed at or below that threshold, we could increase or decrease expenditures as needed.

This kind of measurement should be the norm at every organization, large and small. Understanding the effectiveness of marketing efforts is critical to maximizing profits.

The dichotomy of interests between marketing and finance

Partially as a result of marketing’s historical inability to consistently measure it own effectiveness, there is a dichotomy of interests between the CFO (finance) and the CMO (marketing). This dichotomy can also be traced to several other factors. The most apparent is fairly straightforward: accountants are about numbers, analysis and discipline, while marketers are about ideas, emotions, and creativity.

Differing perspectives

These very different backgrounds can lead to different corporate objectives. From the perspective of finance, the goal of the firm is to maximize shareholder value by focusing on cost reduction and profitability. From the perspective of marketing, the primary purpose of any business is to create customer value, which in turn would maximize shareholder value.

In their research study of CFOs and CMOs and their respective values, Pamela Hall and Terrell Williams found clear differences between the two groups of executives: “While CMOs favored strategies related to revenue generation through product and market development and improved customer services, CFOs related more to efficiency issues emphasizing cost-cutting measures.” To best serve the good of the company, finance and marketing should work together to balance customer-focused and shareholder-focused objectives.

The pitfall of market share

Another factor that has contributed to the diverging interests of marketing and finance is marketing’s traditional focus on market share. Many marketers pursue increased market share at the expense of profits. Think about organizations that price products at a loss to drive their competitors out of the market. From an economics standpoint, purposefully losing money is not a rational strategy. Yet, the practice continues. Increasing market share is simply not an effective marketing objective.

Reconciling differences to increase company profitability

Although changing this marketing objective is an important step in reconciling the differences between marketing and finance, more changes are needed. Marketing must:

  • Become more responsible with its objectives.
  • End its obsession with sales volume over profit.
  • Provide quantitative evidence to measure achievements against targets.
  • Eliminate expenditures that do not achieve objectives.

To reconcile differing interests, finance must:

  • Accept that marketing is effective and has a measurable impact on sales.
  • Understand that the effects of marketing campaigns are not always immediate, and are very difficult to measure.
  • Overcome the emphasis on cost reduction to reach corporate goals.

Conclusion

Setting appropriate corporate and marketing objectives is crucial to company profitability. Moreover, the diverging interests of marketing and finance must be reconciled before these objectives can be reached. Marketers must address the misunderstandings they have helped to create in order to provide evidence that marketing does create customer value, and that marketing matters.