Simplistic and static policies decision-rules, such as ‘spend no more than $X per month‘ or ‘spend Y% of revenue on marketing‘ are clearly way off what is best in most cases, so what exactly is wrong with them? We have repeatedly emphasized that our main aim in commercial cases should be to grow profits or cash-flow, so perhaps our policy on advertizing spend should be based on that measure? Neither of our simplistic policies above takes any account of profit, so they are not likely to be especially effective.

We can make up a simple policy for advertising spend to launch the consumer brand discussed in previous Briefings that adjusts advertizing spend according to its impact on profits, e.g.

• If we previously increased advertizing and profits went up, repeat the increase, and keep doing so until profits stop rising. An increase might also seem best if a previous cut in advertizing led to a fall in profits.
• If, on the other hand we previously reduced advertizing and profits increased (or vice versa), a further reduction should be best.

Unfortunately, this policy does not work too well. A reduction in advertizing spend today raises profit immediately, simply by reducing the amount of this cost in the income statement. Although the lower spend still brings in new consumers, albeit at a slower rate, we still get pushed to cut advertising further and further until we spend nothing.

We really need to give advertizing enough time to bring in new consumers and sales before deciding whether the spending was useful, but how long should we wait? If we evaluate the profit impact of an increase after three months rather than one, it still has not captured enough consumers to justify its cost, so the policy again results in a continuing cut in spending, and sales and profits disappoint once more. At some point, however, if we wait long enough, the growth in customers does indeed come through and justifies the higher spend [figure 1].

Figure 1: Results of a policy to change advertizing spend based on change in profit six months later. (Click image to view larger)

This is rather disappointing. We have a policy that is explicitly linked to the performance outcome we are pursuing, yet it appears very difficult to define that policy in a way that gives something like the best outcome with much confidence. This disappointment is a direct reflection of a deeply important consequence of accumulating and interdependent asset-stocks – that it is not possible to extract a reliable relationship directly between a causal item (advertizing) and a dependent outcome (profit) when one or more accumulating factors exist between the two.

Until next time…

If you would like to receive the series from the beginning in your email inbox, please register on the strategy Dynamics website and subscribe to Briefings in “My Account”

The tyranny of investor expectations

Much has been written about the possibly negative consequences of managers trying to hit performance expectations over short time-scales, the clearest cases being publicly quoted companies for which stock analysts produce quarterly earnings ‘forecasts‘. These effectively become targets, because management gets criticized if they are missed. Worryingly, research suggests that stock analysts have, over many decades, over-estimated persistently profit growth by a factor of two!

The damage mechanism is simple – if management looks likely to miss a forthcoming target, they will cut spending in order to do so. Such cuts will, though, likely hit the business’s ability to grow resources to deliver future profit increases.

This briefing summarises material from chapter 8 of Strategic Management Dynamics, pages 538-541.

Read more about the book on our website