Multichannel Retailing Week: The CFO

As we complete the transition from catalog and retail to "multichannel retail", we find we don't have the technology solution or marketing strategy necessary to meet the needs of our customers.

This is where the multichannel CFO comes into play.

The multichannel CFO determines the investment strategy for the business. The CFO has a set budget, one largely determined by the growth trajectory of the business. As sales increase, investment can increase (though hopefully at a slower rate than sales, yielding more profit).

In the early days of the internet, some incremental sales were being added to the business. Coupled with competitive pressures, multichannel CFOs invested tremendous amounts of capital building and improving e-commerce enabled websites.

However, in our post-Google multichannel environment, things have changed. Direct-to-consumer sales are growing at subtle rates. This introduces risk in the investment portfolio of the multichannel CFO.

Take the traditional catalog CFO. This individual likes to look at the 'ad-to-sales' ratio on the profit and loss statement. If you sum catalog advertising and online advertising, and calculate the ad-to-sales ratio, you will likely see an increase in this ratio over the past five years. This means that the introduction of e-commerce has not grown sales at a sufficient rate to offset the increased advertising expense necessary to support multiple channels.

The traditional catalog CFO, armed with the information, is likely to challenge the CMO or Database Marketing executive to "mail smarter", and better leverage online marketing strategies, shifting dollars out of catalog and into paid/natural search, affiliates, portal advertising and e-mail.

Until ad-to-sales ratios improve, it will be difficult to convince traditional catalog CFOs to invest in multichannel solutions.

The traditional retail CFO has a different set of concerns. To please shareholders, the CFO must grow comp store sales, and must increase the number of new stores in new markets.

Ultimately, the traditional retail CFO has to decide whether it is a better to invest in multichannel technology improvement, multichannel advertising increases, new stores, remodeled stores, and all other internal investment needs necessary to run the business.

This is where we really fail the traditional retail CFO.

The traditional retail CFO has several "knowns":

• If the CFO invests in a new 6,000 square foot store, the business will probably get $2,000,000 of net sales per year. It might cost $1.7 million dollars to build the new store.
• If the CFO invests in remodeling a 6,000 square foot store, the business will probably get an additional $400,000 of net sales per year. Maybe it costs $0.7 million dollars to remodel a store.
• If the CFO invests in catalog or online advertising, there is a known incremental rate of return for the increased investment.

For multichannel investments, the CFO has a great big "unknown".

• Say the multichannel CFO invests $1.7 million in inventory systems and point-of-sale systems to facilitate "buy online, pickup in stores".
• What are the incremental sales that will be generated by this strategy? Will the incremental sales be more than what is observed in a store remodel? Will the incremental sales be more than what is observed when a new store is built?

The CFO depends upon the multichannel advocate (the CMO or the Database Marketing executive or the catalog/online executive) to "prove" that a multichannel investment will generate a better ROI than a new store or remodeled store.

So, the multichannel advocate uses research reports, anecdotal information, 'our competitors are doing it so we have to do it', 'our customers demand it', and the time-honored "multichannel customers are 'x' times more valuable than single channel customer" metric to "sell" the multichannel strategy.

CFOs don't like flimsy comments like these. CFOs want to know, with certainty, that multichannel investment yields a competitive ROI that exceeds the internal cost of capital.

It is my opinion that this relationship, as described above, limits the pace at which multichannel organizations implement true multichannel solutions.

This would be a great place for a vendor, research organization, or consulting firm to provide actual facts that help the CFO. The CFO is going to look at Circuit City, the poster child for 'buy online and pickup in stores', and say 'Gee, that strategy hasn't helped them financially, why should I make the same mistake?' The vendor, research organization, or consulting firm is going to have to provide actual facts, positive and negative, if they want the CFO to advance shared objectives.

The Database Marketing team has to view the business differently, illustrating the long-term impact on the customer file. The potential long-term impact on the customer file is what fuels the investment in multichannel strategies.

Over the next decade, your multichannel CFO is going to become even more critical of the ad-to-sales ratio, and will demand that total net sales increase at a fast rate. If total net sales do not increase at above-average rates, it is unlikely we'll see CFOs supporting multichannel initiatives at the level we'd all like to see happen.

Your turn: Does your multichannel CFO have the right information necessary to make multichannel investment decisions? What information does your multichannel CFO need to improve multichannel systems and strategies?

Return On Investment When Business Is Good

If you're one of the lucky folks managing online or catalog marketing at a company that is "winning", you have an interesting opportunity.

Let's say that this profit and loss statement represented what you expected to happen in April.

Demand	$100,000
Net Sales	$85,000
Gross Margin	$42,500
Less Marketing Cost	$25,000
Less Fulfillment Expense	$10,200
Operating Profit	$7,300
% of Net Sales	8.6%
Ad to Sales Ratio	29.4%
Average Order Size	$85.00
Number of Purchasers	1,176
Cost Per Purchaser	$21.25
Profit Per Purchaser	$6.21

You expected to generate $7,300 profit, and 1,176 new customers.

You execute this marketing plan, and observe these actual results for the month of April:

Demand	$115,000
Net Sales	$97,750
Gross Margin	$48,875
Less Marketing Cost	$25,000
Less Fulfillment Expense	$11,730
Operating Profit	$12,145
% of Net Sales	12.4%
Ad to Sales Ratio	25.6%
Average Order Size	$85.00
Number of Purchasers	1,353
Cost Per Purchaser	$18.48
Profit Per Purchaser	$8.98

Courtesy of the magic of your merchandising team, customers loved what you offered them, spending 15% more than expected.

Here's the challenge. If you believe that during the month of May you will see similar results, you can pocket a similar level of sales and profit.

Or, you can increase your advertising, and acquire more names, while still generating the same level of profit you promised to your CFO. This example shows what could happen, if you boosted your advertising spend:

Demand	$143,635
Net Sales	$122,090
Gross Margin	$61,045
Less Marketing Cost	$39,000
Less Fulfillment Expense	$14,651
Operating Profit	$7,394
% of Net Sales	6.1%
Ad to Sales Ratio	31.9%
Average Order Size	$85.00
Number of Purchasers	1,690
Cost Per Purchaser	$23.08
Profit Per Purchaser	$4.38

This is one of those unique mysteries that complicate the lives of those of us who manage profit and loss statements for online or catalog channels.

Choice number one allows us to pocket an additional five thousand dollars of profit.

Choice number two allows us to achieve our budgeted profit, but grows the top-line by an additional $28,000, and adds an additional 337 customers that contribute to future sales and profit.

I've always advocated spending more money when times are good, and spending more money when times are bad (to liquidate merchandise, but not at liquidation prices) --- holding to the marketing budget when business is close to plan.

What would you do? Would you pocket the profit today, or, would you spend more to acquire more customers, customers that deliver future sales and profit? Your thoughts?

Executive Compensation

A few months after the end of the fiscal year, publicly traded multichannel businesses are required to share Executive Compensation with the public.

It is always easy to pick on Executive Compensation. There are hundreds of examples of leaders being rewarded, while employees are downsized, or shareholders struggle to receive an adequate return on investment.

Compensation works in different ways, depending upon where an employee stands in a multichannel company.

The vast majority of employees are placed in "salary bands". These bands are determined by competitive reviews of comparable jobs at similar companies. Once an employee is "banded", s/he will earn an annual salary increase that is roughly similar to the increase in the cost of living over the past year. Outstanding performers may earn a bigger increase, employees at the bottom of the salary band may earn a bigger increase.

Executive Compensation is more complex.

Take a CFO at a multichannel company. Her compensation is comprised of at least three components:

• Annual Salary. Let's say her annual salary is $350,000 per year.
• Performance Bonus. The bonus is usually based on the company achieving sales and profit objectives. This bonus might vary between 0% and 100% or more of her salary. During an average year, the bonus might be 50% of base salary --- maybe $175,000, paid after the close of the fiscal year.
• Stock Options. If the business is publicly traded, the employee is granted shares that can be redeemed. The employee might be granted 100,000 shares at a price (say $10 per share). The shares usually vest in increments, so that they are fully vested in four years. After four years, the share price should have hopefully increased enough to please investors. Say the share price, after four years, is $20. This employee could earn in 100,000 * ($20 - $10) = $1,000,000 in four years. The brand may elect to grant new shares each year, at the current price of the shares of stock.

So, the humble Executive can earn maybe $1,000,000 a year, about a third is guaranteed, about twenty percent is variable on annual performance, and close to half is based on market performance.

In a bad year, the CFO earns the base salary of $350,000.

In a good year, the CFO earns $350,000 base salary, $350,000 bonus.

If the business has numerous good years, the CFO can earn $350,000 base salary, $350,000 bonus, and $1,000,000 in stock options.

So, we established that about 2/3 of the Executive's salary is "variable", highly dependent upon company performance.

Now, let's go back to the base salary. Compensation Committees like to review "peer" businesses. In other words, the Compensation Committee will look at the salary of the CFO, and compare it with the salaries of CFOs at major competitors.

Let's assume that company performance is "average", compared with the peer group.

Let's also assume that this CFO is "under-compensated", from a base-salary standpoint, verses CFOs within the peer group. In other words, maybe the average CFO in the peer group earns $420,000.

Here's the situation: You like to pay your leaders at the mid-point of your peer group. Do you increase the salary of the CFO to $420,000 a year, so that your CFO is compensated at a "fair" level, compared with other CFOs?

• If your answer is "no", why? Do you risk losing your CFO to a peer company that pays a better base salary, and if you do lose your CFO, what is the risk to your company?
  
• If your answer is "yes", why? What kind of message do you send to your garden-variety employees, who are earning $50,000 a year, and are struggling to pay bills with their 3%, $1,500 cost-of-living increase? What kind of message do you send to your hourly staff, who are earning $25,000 a year, and are really struggling to pay bills with a 3%, $750 cost-of-living increase?

Setting Your Online Marketing Budget

Undoubtedly, many of you are putting the finishing touches on your online marketing, e-mail marketing, or catalog marketing budget for 2007. Oh, the excitement!

Is there anything more enjoyable than sitting across from your Chief Financial Officer, having to defend why it is important to advertise with a certain affiliate at a time when expenses need to be trimmed by ten percent?

CFO's demand rapid, financially-based answers to questions. The humble Chief Marketing Officer or Online Marketing Executive needs to be able to respond in a credible, but timely manner.

Most of the time, when asked a random question, you don't have the appropriate data with you to answer the question quickly. This is where the "square root" function comes into play.

Frequently, sales generated by advertising follow a "square root" function. In other words, if you had the opportunity to increase your marketing budget by twenty percent, your net sales would increase by the square root of 1.2. This number is (1.2 ^ 0.5) = 1.095. In other words, a twenty percent increase in marketing spend yields a 9.5% increase in net sales.

This becomes important when the CFO makes a random statement like,"Please reduce your marketing budget by ten percent, you have no choice in this, everybody must share in the pain."

Look at this example, where the online marketing budget is reduced by ten percent:

High-Level Online Marketing Scenario
		Reduce Ex-	Incremental
	Base Case	pense by 10%	Sales Lost
Orders	90,909	86,244	4,665
Average Order Size	$110.00	$110.00	$110.00
Cost per Order (CPA)	$22.00	$20.87	$42.87
Net Sales	$10,000,000	$9,486,833	$513,167
Gross Margin @ 40%	$4,000,000	$3,794,733	$205,267
Marketing Cost	$2,000,000	$1,800,000	$200,000
Pick/Pack/Ship Expense @ 13%	$1,300,000	$1,233,288	$66,712
Variable Operating Profit	$700,000	$761,445	($61,445)
Profit as a % of Net Sales	7.0%	8.0%	-12.0%
Ad to Sales Ratio	20.0%	19.0%	39.0%

Notice how the profit and loss statement changes. In this case, the CFO may have a good suggestion, as the incremental advertising dollars are not yielding a sufficient return on investment. Conversely, the numbers might work out in your favor, giving you the ammunition to actually ask the CFO for more money!

Not every business follows the "square root" rule. Your analyst can help you figure out which relationship makes the most sense to build the scenarios around. But in a pinch, go with the square root function. And then ask your CFO to quickly cost-justify some of her investments!!