The Resource-Allocation Framework
Resource allocation is a four-step process. The first step is to determine the objective function. What is the metric the company wants to set as its goal for optimization? This may be one of any number of methods of assessing business success, including conversion rates to sales, incremental margins and profits, CLV, near-term sales lift, new buyers, repeat sales, market share, retention rates, cross-sell rates, future growth potential, balance sheet equity, and business valuation.
The second step is to connect the marketing inputs of a firm to the objective of resource allocation. Business managers’ intuition is of paramount importance in this step, as it allows the marketer to correctly decompose a metric. For example, if a company is examining gross profits, what are the attributes of the business that contribute to those profits, and are the relationships between the various components empirical or computational (such as identity relationships)? Figure 1-1 shows one way in which gross profits might be broken down. Sales is a function of price, advertising, sales force, and trade promotions. Because gross profits minus marketing yields net profits, manipulating marketing channels can improve sales, but the different channels are also cost centers.
Figure 1-1 A system-of-metrics framework for net profits
Source: Created by case writer and adapted from Marketing Metrics.1
Once the marketing inputs are mapped to the objective, as shown in Figure 1-1, the marketing manager must determine the relationships that are accounting identities versus those that are empirical. An accounting identity can be computed without any unknowns. For example, in Figure 1-1, net profit is gross profit minus marketing costs. If both gross profit and marketing costs are known, net profit can be computed easily. On the other hand, the relationship between marketing costs and unit sales is more complex and driven by numerous unknowns. You cannot directly sum the investments in marketing (for example, price, advertising, sales force, and trade promotion) to obtain sales. The relationship is termed empirical because the manager must analyze historical data to develop a function that transforms the marketing inputs into sales (for example, a function that describes the relationship between price and sales). The transformation function ideally develops a weight that translates a product’s price into sales. These weights do not provide a perfect transformation, but rather a best guess based on historical data, wherein several factors in addition to price also affect sales. This is the main difference between an identity relationship and an empirical relationship: Empirical implies a best guess or prediction; identities are certain.
The third step in the resource-allocation process is to estimate the best weights for the empirical relationships identified in the second step. A common method for identifying these weights is to build an econometric (regression) model. Which marketing inputs of interest (for example, price, advertising, sales calls) should be considered as having an effect on the dependent variable? Once this regression model is obtained, the marketing manager can predict the precise shape of the objective function. This is the mathematical model that describes the relationship between the independent variables (for example, price, advertising, sales calls) and the dependent variable (for example, market share, profits, CLV).
In the last step of the resource-allocation process, a firm can reverse the process to identify the optimal value of the marketing inputs to maximize the objective function. This gives a detailed picture of what the company’s precise marketing spend should be on each channel it uses to market its product.