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Fusion for ProfitHow Marketing and Finance Can Work Together to Create Value$

Sharan Jagpal and Shireen Jagpal

Print publication date: 2008

Print ISBN-13: 9780195371055

Published to Oxford Scholarship Online: September 2008

DOI: 10.1093/acprof:oso/9780195371055.001.0001

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Choosing Marketing Policy in the Short Run

Choosing Marketing Policy in the Short Run

Chapter:
(p.5) 1 Choosing Marketing Policy in the Short Run
Source:
Fusion for Profit
Author(s):

Sharan Jagpal (Contributor Webpage)

Publisher:
Oxford University Press
DOI:10.1093/acprof:oso/9780195371055.003.0001

Abstract and Keywords

This chapter introduces key financial tools necessary for understanding Fusion for Profit. This chapter shows how different ownership structures (i.e., whether the firm is publicly or privately held) affect the firm's tradeoff between risk and return. It also distinguishes the cases where the firm sells multiple products or has multiple divisions; in particular, it shows how privately and publicly held firms should coordinate their marketing and financial decisions under uncertainty.

Keywords:   certainty-equivalent profits, market segmentation, marketing-finance fusion, ownership structure, risk-adjusted ROI, risk premium

This chapter and the next will introduce you to some financial tools that are essential for understanding Fusion for Profit. For simplicity, we will assume that marketing policies (e.g., price and advertising) have short-term effects. In the next chapter, we will consider the more general case where the firm's marketing policies have long-term effects.

The information covered in this chapter will be useful when you are faced with the following types of decisions:

  • How should my firm measure profitability under uncertainty?

  • How should my firm use the return on investment criterion (ROI) for marketing decision making?

  • How should my firm choose marketing policy if my firm is privately held?

  • How should my firm choose marketing policy if my firm is publicly held?

  • How should my firm use the ROI criterion if my firm sells multiple products or has multiple divisions?

The following terms will be introduced in this chapter (see glossary for definitions):

  • accounting cost

  • cash flows

  • certainty-equivalent profit

  • cost of capital

  • cyclicality

  • economic cost

  • financial cost

  • hedge fund

  • hurdle rate of return

  • inventory holding cost

  • long-term effects

  • (p.6)
  • market segmentation

  • market value

  • net profit

  • nonaccounting costs

  • privately held firm

  • profit

  • profitability

  • rate of return

  • return on investment (ROI)

  • risk-adjusted ROI

  • risk-neutral

  • risk premium

  • short-term effects

  • uncertainty

  • volatility

1.1 Should the Firm Use Profits to Choose Marketing Policies?

Before we address this issue, it is necessary to define profits. Profit is defined as:

profit = revenue - costs
in any given time period.

◣ Is profit a well-defined quantity? How should profit be computed?

On the surface, profit appears to be a well-defined quantity. However, it is easy to mismeasure profit. The primary danger is omitting hidden, nonaccounting costs.

Example 1: Consider an entrepreneur who has invested his or her own money in a business. Since the firm does not have any financial obligations to outsiders, the accounting cost of this investment is zero. However, the financial cost of this investment is clearly nonzero, since the entrepreneur could have invested the money elsewhere. Similarly, instead of running his or her own business, the entrepreneur could have taken a job elsewhere. The income that the entrepreneur forgoes by running his or her own business is a hidden cost that should be deducted from the firm's gross revenues in order to compute profits.

Example 2: Consider an electronic retailer who has to decide how many DVD players to order. Suppose the retailer orders 50 units and sells 49. Then, the retailer faces an inventory holding cost for the one unit that is unsold. However, suppose the retailer orders 50 units, but the demand is 51 units. Since the retailer never purchased the 51st unit, the accounting cost of the 51st unit that could have been sold if it were in inventory is zero.

The economic cost, however, of the shortage can be considerable. It is the profit that the retailer could have earned on the 51st unit plus the future profits it could have earned via repeat purchases by that customer. In many cases, the economic cost of a shortage can exceed the cost of having unsold inventory.

(p.7) ◣ Why is the “given time period” important?

Profit has two dimensions: money and time (e.g., profit per month or profit per year). Unless one specifies the time period, the profit maximization criterion is ambiguous.

Example: If a high-tech firm such as Microsoft seeks to maximize profit over a short time period (say three months), the optimal level of R & D will be zero. Such a policy is likely to lead to poor long-run performance.

1.2 Should the Firm Use the Return on Investment Criterion for Marketing Decision Making?

The firm's return on investment for a given product is defined as follows:

ROI = profit in a given time period investment

The ROI criterion explicitly recognizes that the goal of the firm is profitability and not profit. For example, suppose a retailer can make a profit of $1 million per year by investing $10 million in one store. Then, the retailer's ROI from the store is 10% (annual profit/investment).

Now suppose the retailer establishes two identical stores by investing a total of $20 million. As one would expect, the retailer's profit will increase. Let's say that the retailer's annual profit increases from $1 million to $1.5 million per year. Then, the retailer's ROI from opening two stores is 7.5% (1.5/20 × 100%). Note that when the retailer expands its operations, profits increase from $1 million to $1.5 million. However, profitability (ROI) decreases from 10% to 7.5%. Hence the optimal strategy for the retailer may be to open one store only.

As this example shows, the ROI criterion is appealing because it focuses on profitability and not on profits per se. However, in spite of the intuitive appeal of the ROI criterion, one needs to be careful in measuring ROI.

Valuation and the Single-Product Firm

The metric for investment should reflect market valuations. Consider the following example. Suppose Samsung produces semiconductors using an old plant. Let's say that Samsung purchased the plant several years ago. Suppose Samsung has taken tax write-offs on the plant and that the plant (p.8) has a book value of $1 million (purchase price of $10 million - accumulated depreciation charges of $9 million).

Suppose Samsung expects to make an annual profit of $1 million by producing and selling semiconductors made at this plant. Then, the ROI based on accounting valuations is 100% (annual profit/book value of the plant). Now suppose that, because of robust demand for semiconductors, there is a shortage of plant capacity. Hence Samsung can sell its old plant in the marketplace for $5 million (> $1 million). Then, Samsung's “true” investment in the old plant is $5 million. Hence, based on market valuations, Samsung's annual ROI from the old plant is only 20% (annual profit/market value of the plant). Note that the ROI that is based on accounting data (100%) is seriously overstated.

Point to consider.

What are the policy implications of using historical valuations to measure ROI?

In general, book values and market values will differ. Suppose that the book values of old plants are lower than the corresponding market values. Then, the firm will overstate the ROIs of old plants. Consequently, it will allocate too many resources to old plants and too few to new plants. In addition, the firm will use the wrong performance metrics to measure and reward managerial performance. Thus, for purely fortuitous reasons, the firm will reward managers of old plants for “superior” performance and penalize managers of new plants for performing poorly.

Multiple Products.

The standard ROI metric should be adjusted if the firm's product lines are related either on the demand side or on the cost side.

Example 1: AOL generates revenue from selling Internet subscriptions and from advertising revenue generated from AOL's Web site. Since AOL's advertising revenue is based on the number of AOL's paid subscribers, the standard single-product measure of ROI will understate the effect of AOL's Internet subscriptions on the company's overall profitability. In particular, the optimal policy for AOL is to give up some profits on paid subscriptions (i.e., earn a lower ROI on that product) in order to increase profits from paid advertising on the AOL Web site (i.e., earn a higher ROI on that product).

Example 2: When Pfizer bought Pharmacia Upjohn, it integrated the two sales forces, since the two product lines were related on the cost and demand sides. After the merger, it would have been incorrect for Pfizer to attempt to maximize the separate ROIs for each product line.

(p.9)

Time Frame

The time frames used to compute ROI should differ across products.

Example: Suppose PepsiCo introduces a new line of soft drinks. Then, PepsiCo may have to advertise the new product line of soft drinks heavily to build demand. Hence the new product line will produce a lower ROI in the short run than PepsiCo's existing products.

Suppose PepsiCo uses the same time frame to evaluate the ROIs of all its products. Then, PepsiCo will underinvest in the new product line.

Uncertainty

Another critical issue is that the standard measure of ROI does not allow for uncertainty. As will be discussed shortly, the standard measure of ROI will lead to poor resource allocation decisions and suboptimal marketing policies.

◣ Can the firm choose marketing policy to maximize profits when demand and costs are uncertain? Assume that investment is fixed and that the firm produces one product only.

Example: Suppose a privately owned shoe retailer needs to price a new line of designer fashion shoes it purchases from Nine West. The problem is that demand is uncertain. If the retailer charges a price of $100 per pair, the demand could be either 5,000 or 10,000 pairs of shoes. If the retailer charges a lower price of $90 per pair, the demand could be either 8,000 or 12,000 pairs.

◣ Assume that the retailer can purchase the shoes from Nine West at a price of $60 per pair. Furthermore, there is no time delay between the time an order is placed and the time that the order is fulfilled. Which price strategy ($100 or $90 per pair) will maximize the retailer's profits?

Consider the price of $100 per pair. Depending on the number of pairs sold, the retailer will make a profit of either $200,000 or $400,000. If the retailer (p.10)

Table 1.1 Nine West Example: Comparison of Low- and High-Price Strategies

Demand 1

5,000 pairs

Demand 2

10,000 pairs

Demand 3

8,000 pairs

Demand 4

12,000 pairs

Revenue scenarios

Price A ($100)

$500,000

$1,000,000

Price B ($90)

$720,000

$1,080,000

Cost scenarios

Cost per pair ($60)

$300,000

$600,000

$480,000

$720,000

Profit scenarios

Price A ($100)

$200,000

$400,000

Price B ($90)

$240,000

$360,000

charges a lower price of $90 per pair, it will make a profit of either $240,000 or $360,000 (table 1.1).

Comparing the profits across both pricing plans, we see that the price of $100 per pair could lead to the highest profit ($400,000). However, if demand is weak, this pricing strategy could lead to the lowest profit ($200,000).

◣ If the firm cannot maximize profits under uncertainty, how should the firm choose its marketing policy?

The firm should simultaneously consider several factors: the uncertainty in cash flows, its risk attitude, and its ownership structure (i.e., whether the firm is privately owned or owned by stockholders). Furthermore, the firm needs to choose an appropriate metric for measuring profitability.

1.3 How Does the Ownership Structure of the Firm Affect How Marketing Policies Should Be Chosen?

The Privately Owned Firm

◣ What criterion should the privately owned firm use in choosing its marketing policy?

Some marketing strategies are more aggressive than others. Hence it is necessary for the firm to determine the trade-off between risk and return for each strategy.

(p.11) Example: Consider the case of Google prior to the time it went public. Suppose Google had to choose between two marketing strategies. Assume that each strategy required the same level of investment.

Under the first strategy (Strategy A), Google could have allocated resources to obtain new customers in a fast-growing but volatile market segment. Under the second strategy (Strategy B), Google could have attempted to increase the retention rate of its current customers.

◣ Which strategy should Google have chosen?

Strategy A is more aggressive and could have produced a higher average profit than Strategy B. However, it is much riskier. Hence, without quantifying the risks and returns from the two marketing strategies, one cannot determine which strategy Google should have chosen.

◣ What is the simplest way for the privately held firm to compare the risks and returns for any given marketing strategies?

The simplest approach for the privately held firm is to ignore volatility completely and to choose the marketing strategy for which the expected profit is the highest. If the firm uses this expected profit criterion, we say that the firm is risk-neutral.

In the Nine West shoe example discussed earlier, suppose that each of the demand levels for the two pricing policies has an equal chance (50%) of occurring. Then, the expected profits for both pricing strategies are equal ($300,000) (table 1.2). Hence risk neutrality implies that the retailer will be indifferent between the two pricing plans.

◣ Should the firm choose marketing policies to maximize its expected profits?

In the Nine West shoe example above, suppose the privately owned retailer has incurred debt and will need to pay $210,000 in interest charges. Then, if the retailer chooses the high-price plan ($100 per pair), there is a 50% chance that the retailer's gross profit ($200,000) will be insufficient to meet its interest charge ($210,000). However, if the retailer chooses the low-price

Table 1.2 Nine West Example: Effect of Demand Uncertainty on Profits

Demand 1

5,000 pairs

Demand 2

10,000 pairs

Demand 3

8,000 pairs

Demand 4

12,000 pairs

Expected Profit

Price A ($100)

$200,000

$400,000

$300,000

Price B ($90)

$240,000

$360,000

$300,000

Note: Each demand scenario's probability is 50%.

(p.12) plan ($90 per pair), the corresponding probability of failing to meet its interest obligations is zero (since the minimum gross profit is $240,000). Thus, the low-price plan is safer, even though both the low- and high-price strategies provide the same expected profits (see table 1.2).

◣ How can the privately held firm choose the optimal marketing policy by balancing risk and return?

Suppose the Yam Company is a small electronic goods manufacturer and has developed a new gadget. Let's say that Yam plans to introduce the product in the marketplace at a price of $100 per unit. Suppose there is a 50% chance of making a net profit of $2 million and a 50% chance of making a net profit of $6 million. Then, Yam's expected profit is $4 million ({2 + 6} × 0.5). For simplicity, assume that the gadget will become obsolete after one period.

◣ Suppose a large manufacturer of electronic goods is willing to purchase all rights to Yam's new gadget. What floor price should Yam be willing to accept?

If Yam is risk-neutral, the volatility of cash flows does not matter. Hence the floor price that Yam should be willing to accept is $4 million (the expected profit). However, if Yam is risk-averse, the value of the project is reduced because of the uncertainty in profit. Hence Yam's floor price will be less than $4 million.

Suppose Yam's floor price is $3.5 million. Then, we say that Yam's certainty-equivalent profits from the electronic gadget are $3.5 million. Equivalently, we can say that Yam's risk premium is $0.5 million ($4 million - $3.5 million). Thus, we have the following definition:

certainty-equivalent profits = expected profits - risk premium

(p.13) ◣ How should marketing policies be chosen under uncertainty? Assume that the firm sells one product and that the level of investment is fixed.

Suppose that Yam has invested $10 million to manufacture the new electronic gadget. In particular, Yam can choose two marketing strategies:

  1. 1. If Yam uses the conservative strategy, it will spend less money to promote the new product. For this scenario, Yam's expected profit is $4 million and its certainty-equivalent profit is $3.5 million. Hence, Yam's average ROI is 40% (expected profit/investment) and its risk-adjusted ROI is 35% (certainty-equivalent profit/investment).

  2. 2. If Yam uses an aggressive marketing strategy, it will promote the product aggressively via its sales force. Suppose the average profit is $5 million. However, because this strategy is risky, the certainty- equivalent profit is only $3 million. Then, the average ROI for this strategy is 50% ($5M/$10M × 100). However, the risk-adjusted ROI is only 30% ($3M/$10M × 100), which is lower than the corresponding risk-adjusted ROI (35%) for the conservative strategy. Consequently, Yam should choose the more conservative strategy even though it provides a lower expected rate of return.

The Publicly Held Firm

◣ Should marketing policies be chosen to maximize the return on investment to shareholders?

As discussed above, the effect of marketing policies on profit is uncertain. Hence the publicly held firm cannot maximize profits. Since ROI is based on profits (an uncertain quantity), the ROI corresponding to any marketing policy and investment decision is also uncertain. Consequently, the publicly held firm cannot maximize ROI for a product or product line.

◣ How should the publicly held firm allocate resources across products under uncertainty?

The publicly held firm should allocate resources across products and choose marketing policies using the appropriate risk-adjusted ROI for that product.

(p.14) ◣ What is the risk-adjusted ROI from a given marketing policy for any given product? Assume a fixed level of investment for that product.

Example: Suppose Apple expects that it can make a profit of $200 million next year by investing $100 million in the iPhone. However, because of demand and cost uncertainty, the iPhone's profits could be lower or higher than $200 million.

◣ What is the guaranteed sum of money for which Apple will be willing to give up its title to the uncertain profits from the iPhone?

Since Apple's stockholders are risk-averse, the certainty-equivalent profit from the iPhone will be less than $200 million. Suppose the certainty-equivalent profit is $150 million. Then, iPhone's risk-adjusted ROI is 150% (certainty-equivalent profit/investment = $150M/$100M × 100).

◣ How do the firm's marketing policies affect the risk-adjusted ROIs? Assume that the firm sells one product and that the level of investment is fixed.

The firm's expected cash flows and the volatilities of those cash flows depend on the firm's market segmentation strategies, its production processes, and the competition in the marketplace.

Example 1: Suppose Hewlett-Packard targets the business segment whereas Dell focuses primarily on the individual consumer market. Assume that the revenues from the business segment are more sensitive to the business cycle than those from the individual consumer market. Then, for any given distribution of cash flows, it is riskier for investors to hold Hewlett-Packard stock than to hold Dell stock. Hence Hewlett-Packard's risk-adjusted ROI will be lower than Dell's.

Example 2: Consider two automobile manufacturers, say Toyota and Rolls-Royce. Toyota uses capital-intensive methods to produce cars for the mass market, and Rolls-Royce uses labor-intensive methods to produce customized cars. (p.15) Suppose Rolls-Royce's costs are more cyclical than Toyota's. Then stockholders will face greater risk if they hold Rolls-Royce stock. Hence, other factors being the same, Rolls-Royce will earn a lower risk-adjusted ROI than Toyota.

Comparing Privately Held and Publicly Held Firms

◣ Suppose two firms face the same market conditions. One is privately held and the other is publicly held. Should both firms choose the same marketing policies?

In general, the answer is no. Suppose a firm's cash flows are highly uncertain. To compensate for the high degree of uncertainty, the owners of the firm will demand a high risk premium, regardless of whether the firm is privately or publicly held. However, there is an additional factor that affects the risk premium for the firm that is owned by shareholders.

In contrast to private owners, stockholders can diversify. Hence they are only concerned with the residual risk after they have diversified their holdings to achieve their preferred combinations of risk and return.

Consider two extreme scenarios for the publicly held firm:

  1. 1. Suppose the profits from a particular stock are perfectly correlated to the performance of the economy. In this case, the firm is a “clone” of the market. Hence an investor cannot reduce his or her risk at all by diversifying.

  2. 2. Suppose the firm's profits are uncorrelated to the performance of the economy. In this case, the investor can eliminate his or her risk completely by diversifying.

In most real-life applications, the truth will be somewhere between these two extreme scenarios. Hence, the more highly correlated the firm's profits are to the economy, the higher the risk premium.

(p.16) Example: Suppose two firms introduce two identical food products in the marketplace. One firm is publicly held (e.g., General Foods), and the other, Omega Foods, is privately held. Since both products are new to the marketplace, the cash flows for both firms are volatile. Assume that the volatilities of cash flows for both firms are equal (A). Furthermore, suppose the demand for the new food product is not strongly related to the condition of the economy. Hence the cash flows for both firms have a low correlation to the market (B).

◣ Which firm has the higher risk premium?

Since the owners of Omega Foods (the privately held firm) cannot diversify, the correlation coefficient B is irrelevant. Hence the risk premium for Omega is proportional to the volatility of cash flows, A. In contrast, the shareholders of General Foods can diversify. Hence the risk premium for General Foods depends on both A and B. Specifically, the risk premium for General Foods is proportional to the product AB.1

Note that the risk premiums for both firms are fundamentally different even though both firms anticipate the same cash flows for their products. In our example, the cash flows from the products are not highly correlated to the economy (i.e., B is small). Hence, other factors remaining the same, the risk premium for General Foods is likely to be smaller than the risk premium for Omega.2

Point to consider.

Suppose a privately held firm and a publicly held firm face the same market conditions. Which firm will choose a more aggressive marketing strategy?

In many cases, the risk premium for the publicly held firm will be lower than that for the privately held firm. Hence the publicly held firm should choose a more aggressive marketing strategy. For example, it should spend more money on advertising to increase future demand.3

Point to consider.

Are there any market conditions under which the publicly held firm should choose marketing policies to maximize expected profits?

As discussed above,

  • Regardless of ownership structure, all firms should choose marketing policies to maximize the certainty-equivalent profit = expected profits - risk premium, and

  • (p.17)
  • The risk premium for the publicly held firm varies with the product of two terms: the volatility of the firm's cash flows (A) and the correlation of the firm's cash flows with the market (B).

Note that, regardless of how volatile the firm's cash flows (A) are, the risk premium for the publicly held firm disappears when B = 0. In this case, the publicly held firm should choose its marketing strategy to maximize expected profits.

1.4 What Does the Risk-Adjusted ROI Criterion Imply for Multiproduct and Multidivisional Firms?

In order to maximize performance, the firm should allocate its resources across products and market segments such that the risk-adjusted ROIs are equalized. However, risk premiums vary across products. Hence the multiproduct or multidivisional firm should use different hurdle rates of return to measure the profitabilities of different products and divisions.

Furthermore, as discussed earlier, different marketing strategies for the same product involve different combinations of risk and return (e.g., some strategies are more aggressive than others). Hence the risk-adjusted ROI for a given product is segment-specific.

Example 1: Consider a large diversified company such as General Electric. Suppose one division manufactures refrigerators and the other manufactures lightbulbs. In general, the cash flows from the refrigerator division will be more cyclical than the cash flows from the lightbulbs division. Thus, other factors being equal, the expected ROI from the refrigerator division should be higher than the expected ROI from the lightbulbs division to compensate for the additional risk involved by investing in the refrigerator division.

Suppose General Electric uses the same required rate of return (e.g., its cost of capital) to allocate resources across both divisions. Then General Electric will overinvest in the refrigerator division and underinvest in the lightbulbs division.

Example 2: Lenovo sells computers to individuals and to corporations. Suppose the demand from the corporate sector is more cyclical than that from the individual consumer segment. Then, other factors being equal, Lenovo's expected ROI from the corporate sector should be higher than the expected ROI from the individual consumer market. If Lenovo uses the same required rate of return to allocate resources across both user segments, it will overallocate marketing resources to the corporate segment and underallocate resources to the consumer segment.

(p.18) Chapter 1 Key Points

  • In the real world (i.e., a world of uncertainty), profit maximization is an ambiguous concept. Consequently, one cannot choose marketing policies to maximize profits under uncertainty.

  • All costs, especially hidden costs, should be included when the firm computes the profitability from a given marketing strategy.

  • The ownership structure of the firm has a major impact on the metric used to quantify uncertainty. However, regardless of whether the firm is privately owned or owned by shareholders, marketing policies should be chosen based on the certainty-equivalent profits that they generate.

  • In general, privately and publicly held firms should choose different marketing policies under uncertainty. For the privately held firm, the risk premium depends on the volatility of the firm's cash flows but not on how cyclical the firm's cash flows are. For the publicly held firm, the risk premium depends on both the volatility and the cyclicality of the firm's cash flows.

  • The firm should evaluate its marketing policies based on their risk-adjusted ROIs (certainty- equivalent profits/investment).

  • The risk-adjusted ROIs depend on the firm's marketing strategy, the segments the firm targets, and the production processes the firm uses. Hence the firm should not use industry-based benchmark ROIs for marketing decision making.

  • The firm should use risk-adjusted ROIs to allocate resources across multiple product lines, market segments, and divisions. In addition, the firm should use risk-adjusted ROIs to measure and evaluate performance at different levels (e.g., the divisional or product manager levels).

Notes:

(1.) For simplicity, this analysis assumes that General Foods is 100% owned by stockholders. For a technical discussion of how the firm's marketing policies affect A and B and hence the risk premium, see chapter 1 in Jagpal, Sharan (1999), Marketing Strategy and Uncertainty, New York: Oxford University Press.

(2.) In certain cases, the risk premium for a privately owned firm can be lower than that for a publicly owned firm. For example, the wealthy private owners of a hedge fund that purchases a publicly owned firm may be more willing to take risks than the stock market as a whole. In this case, after the acquisition, the hedge fund is likely to choose more aggressive marketing policies than the publicly owned firm.

(3.) See note 2 for an exception.