On-line advertisements should be counted as channel cost, not marketing

Any b-school professor will not hesitate to tell you that in general Marketing and R&D are the two main factors that drive long-term profitability for a company. This applies naturally to consumer electronics startups as well. At the Hardware Club especially we spend a fair amount of time assessing the marketing intuition of the young co-founders and keep monitoring and advising on the marketing activities of the companies after we've done the investments.

However, marketing expenditure could be very misleading in hardware startups. All founders should have a clear picture in mind whether a certain marketing expenditure is really spent on marketing activities that feed into the brand value and generate long-term benefit.

The truth is, today a lot of the expenditures categorized as marketing in accounting are actually channel costs. Specifically I'm talking about the on-line advertisements on Google, Facebook, Twitter or any other social network platforms.

Whether it's in the forms of texts, images or videos, the kind of on-line advertisements that lead the users to the product pages on the web stores usually do not contribute to the general perception of the brand.

This is contrary to the traditional advertisements on TVs, newspapers, magazines, bus stops, metros, etc. Those traditional advertisements couldn't lead to immediate transaction closing so they usually focus on communicating values of the products and the brands. Consumers that see these traditional advertisements might leave an impression overall about the products and the brands. If done successfully, the brand values will be enhanced, which lead to long-term profitabilities of the companies.

On-line advertisements, however, usually is tied to deal closing – enticing viewers to pay to buy products on-line. Majority of these campaigns are thus created in the form that's most effective in closing deals. As a result, they don't necessarily leave an impression on viewers who do not click through, unlike TV or newspaper ads that will almost always leave an impression, good or bad.

In other words, most deal-closing oriented on-line advertisements are closer to some traditional channel promotion tools such as supermarket coupons. They might carry the name of "marketing" or be categorized in accounting in the marketing expenditure, but in running the businesses they should be treated as channel costs – each dollar spent on acquiring a consumer doesn't have much effect on attracting the other consumers in the long-term.

You might say that this is nitpicking but failing to recognize this could be a disaster for a hardware startup as they make the wrong conclusions and prioritize the wrong thing.

Take the following example:

Here we see the typical channel mix for a hardware startup:

  • Physical stores such BestBuy, Brookstone, Fnac, etc
  • E-commerce stores such as Amazon
  • Web store on the startup's own website

We assume that MSRPs are the same across all three channels and we assume shipping costs for Amazon and own web store are added on top of MSRP and paid by the consumers.

BOM costs, or specifically the average per-unit manufacturing cost including BOM and manufacturer's margin, are 30% of MSRPs across all three channels.

  • Physical stores usually charge the highest channel margin. Here we assume it's 50% of MSRP.
  • Amazon's channel margin is assumed here to be lower as 30% of MSRP.
  • Own Web Store obviously doesn't incur channel margin so therefore it's 0%

Some innocent founders would then jump to the conclusion that Own Web Store is the best channel since there's no extra margin charged.

If that's the reality, Amazon and physical stores would have died a long time ago.

The reality is

  • Physical stores could charge 50% margin since they have natural traffic – consumers still like shopping in them
  • Amazon could charge 30% since it's the dominant e-commerce channel for consumers who prefer to shop on-line
  • Own Web Store of a startup does not usually have organic traffic if no "marketing" is done

In fact, even for a transaction to be closed on Amazon, a startup might still need to pay for certain advertisements – Google ads, Facebook ads, Amazon marketing fees – to bring traffic there, otherwise they will just be buried in tons of similar products on Amazon. Here we assume it's on average 20% of MSRP.

As for Own Web Store, it's almost a foregone conclusion that the startup has to acquire customers itself via on-line advertisements. This can run up very quickly to 50% of MSRP since fewer consumers will trust a startup's own web store so the advertisement conversion will be lower than that of Amazon, which also provide potential buyers reviews about the product by other buyers.

These on-line advertisement costs that don't feed into long-term brand value should be treated as CAC, Customer Acquisition Cost, for a hardware startup, rather than marketing expenditures.

In our stylized example, eventually all three channels give the same Profit Margin for this startup: 20%. In this example, therefore, none of the three channels is better than another. A certain mix of the three channels should be kept based on other strategic rationales, not on margins.

On the other hand, if a founder fails to see this picture clearly, he might simply decides to cut off physical stores and Amazon and only sells through Own Web Store.

That would be a big mistake.

Conclusion: for on-line advertisement expenditures, always ask yourself if they really enhance the brand's perceive values. If they're just a means to bring potential buyers to close a transaction, they should be treated as channel costs. 

And I don't care where your accountant, with the term "CPA" dangling after their names, put these expenditures in the Income Statements. When you come to the Board Meeting, I expect to see something like the graph above.

 

Marketing via Facebook v.s. emails

#NetworkEffects : Fitbit Q1 2016 Earnings Call