Diminishing Returns On Annual Customer Behavior

Diminishing returns, and its impact on annual customer behavior, became more difficult to understand with the advent of the internet.

These days, the internet causes a level of "organic demand" to occur. If no advertising occurs, a fraction of customers will repurchase next year.

As customers are exposed to advertising, behavior changes.

First, more customers repurchase, but at a rapidly decreasing rate.

Second, customers who have already repurchased spend more than they would have otherwise.

Let's take a look at what this relationship looks like, when there is $25.00 of annual organic demand, and a 30% cannibalization rate across advertising activities.

Ad Expense	Rebuy Rate	Spend/Rep.	Demand	Profit
$0.00	28.6%	$87.43	$25.00	$8.29
$1.50	34.5%	$109.18	$37.67	$10.97
$3.00	37.5%	$120.60	$45.23	$11.98
$4.50	39.8%	$129.57	$51.57	$12.59
$6.00	41.8%	$137.18	$57.34	$12.99
$7.50	43.5%	$143.89	$62.59	$13.23
$9.00	45.0%	$149.94	$67.47	$13.36
$10.50	46.4%	$155.49	$72.15	$13.41
$12.00	47.7%	$160.64	$76.63	$13.39
$13.50	48.9%	$165.46	$80.91	$13.31
$15.00	50.0%	$170.00	$85.00	$13.18
$16.50	51.1%	$174.30	$89.07	$13.00
$18.75	52.5%	$180.36	$94.69	$12.67
$22.50	54.8%	$189.64	$103.92	$11.96
$30.00	58.7%	$205.88	$120.85	$10.08

In this table, the multichannel retailer spends an average of $15.00 per existing customer on annual advertising (catalog, e-mail, online, search, etc).

Notice two things in this table. First, "peak profit" occurs at an annual spend of $10.50. Second, there isn't a huge different in profit between $7.50 and $16.50 of spend per year per customer.

This is the seductive part of diminishing returns.

In this example, if the brand spends $7.50 per customer, the brand experiences an annual repurchase rate of 43.5%, spend per purchaser of $143.89, yielding demand per customer of $62.59.

If the brand spends $16.50 per customer, the brand experiences an annual repurchase rate of 51.1%, spend per purchaser of $174.30, yielding demand per customer of $89.07.

As a multichannel brand evolves, advertising spend per customer increases significantly. This yields a modest increase in repurchase rate, and a modest increase in spend per purchaser.

But overall profit does not significantly change, meaning that the incremental profit associated with each individual advertising activity actually decreases. People ask "what's wrong" with traditional advertising activities? People get excited about "new marketing techniques", like paid search and e-mail, because they "seem" to be doing better.

Yet, the customer generates the same amount of profit.

In multichannel cataloging, we continue to experience this phenomenon. Eventually, the advertising techniques that appear to yield lower profit levels are cut back, the techniques that appear to yield good profit levels are increased.

But in reality, across many multichannel catalogers, half of the marketing activities truly yield little incremental profit. A bump in repurchase rate, and a bump in spend per purchaser occurs. No additional cash is in the cash register, at the end of the day.

Some folks will argue that the additional advertising yields a stronger customer file, one that pays dividends long-term. These situations can be simulated, especially in catalogers, and to a large extent across online retailers.

At the end of the day, diminishing returns yield less and less incremental benefit, but require more and more resources to produce the advertising necessary to obtain the incremental benefit.

Your thoughts?

Free Spreadsheet: Diminishing Returns By Pages And Circulation

I promised that I would provide a free spreadsheet for simultaneously evaluating diminishing returns (via the square root rule) caused by page count and circulation depth within any catalog.

If you wish to play a bit with the simulation tool, please download the free spreadsheet.

The spreadsheet does not have a file forecast component, a very important part of any circulation project. The simulation is not meant to be the "official" plan for any one catalog. Instead, you use the tool to find a good combination of pages/circ-depth, then do the real work via file forecasting and RFM to obtain a circulation plan.

Diminishing Returns, The Square Root Rule and Peak Profit

We've previously talked about diminishing returns in marketing.

Understanding how diminishing returns impact profit is something that anybody can do.

You don't have to be accountable for paid search or online marketing or catalog marketing to understand how effective your strategy is at a macro level.

And the level of science is irrelevant. Most statisticians would become paralyzed by all of the assumptions being violated here. You're not trying to be a perfect statistician. You're trying to approximately understand where marketing spend is optimized.

Here's Example #1:

• Your paid search marketing budget is forecast to be $1,000,000 this year. You also expect to generate $4,000,000 demand. You convert demand to profit at a rate of 40%.

• Profit = $4,000,000 * 0.40 - $1,000,000 = $600,000.

• Using the square root rule, we can measure where "peak profit" occurs.

	Square
Spend Levels	Root	Demand	Profit
$500,000	0.707	$2,828,427	$631,371
$600,000	0.775	$3,098,387	$639,355
$700,000	0.837	$3,346,640	$638,656
$800,000	0.894	$3,577,709	$631,084
$900,000	0.949	$3,794,733	$617,893
$1,000,000	1.000	$4,000,000	$600,000
$1,100,000	1.049	$4,195,235	$578,094
$1,200,000	1.095	$4,381,780	$552,712
$1,300,000	1.140	$4,560,702	$524,281
$1,400,000	1.183	$4,732,864	$493,146
$1,500,000	1.225	$4,898,979	$459,592

Here's where you have a series of choices. You are generating $600,000 of profit at $1,000,000 of paid search spend. However, "peak profit" occurs at $600,000 of spend. If you want to achieve better profitability, you spend $400,000 less, and give up nearly a million dollars of demand.

Folks who measure lifetime value combine short-term and long-term profit, and probably end up spending more than a million dollars based on those findings. Notice how diminishing returns occur, especially after a million dollars of spend.

Also notice how few online marketers measure anything beyond "cost per order" --- there's an opportunity for online marketers to improve their "tool box" with this style of analysis.


Example #2:

• You spend $40,000,000 on catalog marketing. Although your productivity has been in decline for several years, your catalogs are still profitable. You generate $170,000,000 of demand across channels, with 40% converted to profit.

• Where does "peak profit" occur?

	Square
Spend Levels	Root	Demand	Profit
$20,000,000	0.707	$120,208,153	$28,083,261
$24,000,000	0.775	$131,681,434	$28,672,574
$28,000,000	0.837	$142,232,205	$28,892,882
$32,000,000	0.894	$152,052,622	$28,821,049
$36,000,000	0.949	$161,276,161	$28,510,464
$40,000,000	1.000	$170,000,000	$28,000,000
$44,000,000	1.049	$178,297,504	$27,319,002
$48,000,000	1.095	$186,225,670	$26,490,268
$52,000,000	1.140	$193,829,822	$25,531,929
$56,000,000	1.183	$201,146,713	$24,458,685
$60,000,000	1.225	$208,206,628	$23,282,651

Here, we see that "peak profit" occurs at $28,000,000 of catalog spend. However, the amount of profit difference between $28,000,000 of spend and $40,000,000 of spend is not significant. Most marketers would err on the side of spending more, in this instance, due to the obvious benefits of growing the customer file.

Again, you don't have to be responsible for online marketing, catalog marketing, or e-mail marketing to do this type of analysis. Take the initiative to get your hands on some data, partner with your finance team if necessary, and analyze where "peak profit" occurs in your marketing efforts. Find out where diminishing returns take a bite out of profit.