Marketing costs: back to basics.

In 1952, the General Electric Co. announced the adoption of the "marketing concept" as the principle on which the company would be integrated. Planning, manufacturing, finance, and administration would all work together with marketing to achieve the single goal of satisfying the customer. Among other things, this meant that all the cost elements required to generate sales revenues - not just the sales force, advertising, promotion, catalogues, samples, and market research, but also technical services, quality and customer services, packaging, physical distribution, shipping, inventory carrying costs, and credit and collection would be counted as marketing costs.

GE's decision to integrate the company under the marketing concept stemmed from the recognition that all of its activities were affected by marketing results, as, for example, when manufacturing costs jumped because a certain product mix was on order at a particular time, or when more dollars had to be committed to inventory because more customers demanded on-time delivery, or when receivables rose because customers demanded more credit. Accordingly, the performance of the marketing activity, and within it, that of product management, distribution channels, and major customers, would be evaluated on some measure of profitability or return on investment.

GE was not alone in adopting the marketing concept. In the 1950s, many other American manufacturing companies followed suit. And so did many companies in Japan.

But the marketing concept was only a passing fad in this country. During the 1960s and 1970s, American manufacturers reverted to older methods, once again putting marketing in the back seat.

Putting the concept to work

Like the statistical quality control techniques developed by the renowned W. Edwards Deming, the marketing concept arose in America, but was more consistently and steadfastly applied in Japan. A good description of how it works in one field of conspicuous japanese success, new-product pricing, is given by T. Hiromoto. He wrote in a 1988 Harvard Business Review article that Daihatsu, an auto manufacturer, does not "simply design products to make better use of technologies and work flows; they design and build products that will meet the price required for market success - whether or not that price is supported by current manufacturing practice."

Compare this with the method used by most American companies. Pricing starts with the standard manufacturing cost of the new product. To this are added marketing and other costs, plus a desired profit. The total is the price.

But the last few years have witnessed a ma or move to reform cost accounting for manufacturing operations and to improve product costing for decision making. At the same time, product lines and marketing channels have proliferated. Direct labor represents a small fraction of costs, but marketing and distribution, along with engineering and other overhead functions, have expanded. America has rediscovered marketing.

Elements of marketing

So to what extent is the marketing concept applied by American manufacturers today.? Not much, according to a survey of 236 controllers of American manufacturing companies we conducted early last year.

One characteristic of a company operating under the marketing concept is that it counts all the elements required to generate sales revenues as marketing costs. Our survey asked which of 12 cost elements respondents normally included in their company's marketing costs. Their responses, which were not significantly affected by company size, are summarized in Table 1. All 12 cost elements are incurred to generate sales revenues. Yet only the top five are included in marketing costs by at least 90 percent of the respondents' companies; the bottom four - physical distribution, shipping costs, credit and collection, and packaging - are included by less than one-third of the companies.

These last four elements often represent significant costs. The fact that so many companies exclude them from marketing costs strongly supports a charge made in 1988 by R. Cooper and R. S. Kaplan, who wrote in the Harvard Business Review that "managers in companies selling multiple products are making important decisions about pricing, product mix, and process technology based on distorted information."

Evaluating performance

Another characteristic of a company operating under the marketing concept is that it evaluates the performance of its marketing activity on some measure of profitability or return on investment. So we asked our respondents how the marketing activity is evaluated in each of their companies.

We found that almost three-fourths (74 percent) of the companies surveyed evaluate their marketing activities as a cost center - that is, on its ability to control costs. Only 11 percent of the companies evaluate marketing as a profit center, 5 percent as a revenue center, and 3 percent as an investment center. So marketing gets high marks for staying within budget, but management has no idea how effectively the budgeted resources are used.

We also asked how companies evaluate the performance of important components of the marketing activity - product management, field sales operations, advertising management, channels of distribution, and customers - on some measure of profitability or return on investment (ROI). Their responses are summarized by percentages in Table 2.

Product managers generally have responsibility for the design, pricing, packaging, and advertising of a product. In meeting these responsibilities, they work closely with manufacturing management. Yet the survey shows that their performance was most often evaluated on gross profit or market share. Only 25 percent were evaluated on net income or ROI.

The field sales force is responsible for the Mix of customers purchasing a company's products and for the sales volume generated. In meeting these responsibilities, it incurs its own operating costs and affects several other marketing costs, such as technical support, service support, and costs resulting from the frequency and size of orders. Yet most of the companies surveyed evaluate the field sales force on sales or market share.

Advertising management is also evaluated primarily on sales and market share, though this component is somewhat more likely to be evaluated on ROI than are most others. Perhaps some companies view advertising as a capital investment and use some measure of profitability to arrive at ROI.

One would expect the evaluation measures used for customers and channels of distribution to be similar, since customers are components of channels. Yet the table shows some significant differences. Gross profit is used far more often in the evaluation of customers than of channels, while the reverse is true for net income. ROI is seldom used in the evaluation of channels, and almost never in the evaluation of customers.

This scant use of ROI deserves comment. When a company considers using a new channel of distribution or selling to a new customer, it analyzes the financial and other effects of doing so. Minimally, it projects the effect on sales (expected quantity of goods and expected prices), the cost to produce the goods, and the costs of marketing (field sales, technical and other customer service, sales promotion, and distribution costs) to arrive at income numbers. In addition, however, the new customer or channel of distribution will generate new accounts receivable and will require inventories to assure the delivery of goods on time. The carrying costs of these assets should be deducted from income to arrive at residual income, a variant of ROI. The survey suggests that in a great majority of companies this is not done.

The Elder case

To illustrate the errors in judgment that can result from the use of inappropriate performance measures for customers, let's examine a case derived from the records of Elder Enterprises, a manufacturer of industrial goods. Like most of the companies in our sample, Elder evaluated customers on sales and gross profit, allocating only a portion of marketing costs to the customer. Specifically, Elder left out accounts receivable and inventory carrying costs.

Looking at sales to Barton Company, one of Elder's key customers, over a three-year period, Elder noted that sales growth had been modest. Gross profit had declined primarily because of price pressures and an expanded mix of products sold to Barton at lower gross margins. And even under Elder's narrow definition, marketing costs had doubled, contributing to a significant decline in profit contribution. Management wasn't elated with this performance, but decided that it was reasonable.

Table 3 shows how the picture changed when accounts receivable and inventory carrying costs were included. What management didn't know was that Barton had been taking longer and longer to pay its bills, and had been placing smaller orders of a wider range of products. Only when the effect of these changes on carrying costs (including imputed interest) for accounts receivable and inventories were included in the analysis did the marked deterioration of Barton as a profitable customer become apparent.

Of course, the credit department knew that Barton had been taking longer to pay, but its complaints were ignored because Barton was a key customer. Inventories were managed by production management in response to sales by product as projected by the marketing department, but inventory managers did not relate inventory levels to specific customers.

Improvement through the marketing concept

Under the marketing concept, Elder would regularly have prepared reports like Table 3, and the changes in Barton's performance would have been noticed. The situation would have been examined jointly by marketing, finance, and inventory management, and strategies could have been developed to improve Barton's performance.

The marketing concept does not require the preparation of such reports for all customers on an ongoing basis, but it does prescribe and facilitate regular analysis of key customers, channels of distribution, and decisions to enter a new market or accept a major new customer.

American manufacturers are getting a lot of advice these days on how to he more competitive and profitable. Most of this advice focuses on factory management and product costing. Improvements in these areas, however important, tire not enough. American companies also need to adopt (or re-adopt) the marketing concept, with its broad definition of marketing costs and its logically consistent measures for evaluating the performance of marketing operations, in order to prosper.

Table 3:
Customer evaluation: Barton Company
                            1989         1988         1987
Sales                     $800,000     $760,000     $700,000
Cost of goods sold         640,000      593,000      525,000
Gross profit              $160,000     $167,000     $175,000
Gross profit %                 20%          21%          25%
Marketing costs[.sup.a]     32,400       24,200       16,100
Profit contribution       $127,600     $142,800     $158,900
Profit contribution %          16%          19%          23%
Carrying costs:
Accounts
  receivable @ 20%[.sup.b] $34,000      $20,000      $12,000
Inventory @ 30%[.sup.c]     60,000       39,000       31,500
Total carrying costs        94,000       59,000       43,500
Residual income            $33,600      $83,800     $115,400
Residual income %             4.2%        11.0%        16.5%
Return on assets after carrying
  costs for accounts receivable
  and inventories               9%          36%          70%

[.sup.a] excluding carrying costs for accounts receivable and inventories

  [.sup.b] average balance in accounts receivable:
1989 $170,000
1988 $100,000
1987  $60,000
    [.sup.c] average inventory carried to service this customer:
1989 $200,000
1988 $130,000
1987 $105,000
  Table 1:
    Cost elements companies include
in marketing costs
                            Percent of companies
                           that include element in
Cost element                   marketing costs
Advertising                         96%
Sales promotion                     95
Catalogues, samples                 95
Marketing research                  92
Field sales force                   90
Technical services                  55
Inventory carrying costs            55
Quality and customer services       42
Physical distribution               27
Shipping costs                      26
Credit and collection               14
Packaging                           13
  Table 2:
    How companies evaluate
important marketing components
                            Percent of companies that
                         evaluate component on measure
                                Gross     Net          Market
Component               Sales   profit  income     ROI  share
Product management        14     36       12       13    25
Field sales operations    54     15        8        2    19
Advertising               47      4        7       11    31
Channels of distribution  36     22       19        6    17
Customers                 31     36       10        2    21