A good mix is vital for profitability

Pretend for a minute you had won a super-lottery and had a spare 100m or so to invest in a packaged goods company. You decide you want to maximise your returns over a four to five-year period, and your advisers show you companies with the following characteristics:

1a) Companies with excellent track records in innovation and b) low or non-innovators;

2a) Companies in rapidly growing markets and b) in slowly-growing or declining markets;

3a) Companies with number one brands and b) brand followers;

If you (like me) chose a) options for your answers, congratulations! You can join the well-populated ranks of mediocre performers: according to recent research by PIMS Europe a) was the right answer in only one case: it’s always best to be a number one brand.

PIMS’ disconcerting results are the product of a study of 500 US and European fmcg companies across 200-plus business measurements over four years. It has produced clear statistical correlations which suggest that rapid-fire innovation companies tend to have lower profits than non-innovators and that the most profitable markets tend to be slow or declining ones. By simply analysing hard comparative data without any preconceptions, you often come up with counter-intuitive results, declares PIMS director Dr Tony Hillier, who recently told the European Commission that its attempts to create jobs by encouraging multinationals to invest in hi-tech plants in the region was leading both to reduced jobs and profits.

His latest findings are the side product of a more focused piece of research: to discover a “correct” marketing mix, if such a beast exists. The answer is clearly “yes”. The second answer – which is also very clear – is that it’s highly complex, and risky. If the PIMS results really can be applied, relatively minor adjustment in advertising or promotional spends can have dramatic effects on brands’ profitability, such as doubling – or even quadrupling – its return.

Having crunched the data, PIMS suggests that seven key factors influence the optimum marketing mix. They are: brand rank, concentration of the trade, pace of innovation, market growth, sister brands, breadth of offering and historic brand image. Sensitivity to mix variations is frighteningly high in some areas and startlingly low in others.

For example, no matter what a brand leader does with its mix, statistically speaking it will always generate better profits than number twos and threes. Thus, if brand leaders spend less than 50 per cent of their budget on media they’ll earn, on average, a 39 per cent return on capital employed over four years, whereas a spend of 70 per cent or more on ads sees returns rise, but only slightly, to 43 per cent.

However, if a number two brand spends between 50 and 70 per cent of its budget on media advertising it earns its highest possible return, at 28 per cent, but if it tips over to 70 per cent-plus, its profitability is likely to be exactly halved. For also-ran brands the difference between optimum and non-optimum mix is the difference between a maximum 11 per cent return and losses. Hillier comments: “For the brand follower the penalties of getting it wrong are much greater.”

A more startling, and uncomfortable, set of results emerge when looking at the pace of market growth. The best rate of return in very rapidly growing markets is just 18 per cent, compared with 40 per cent and 42 per cent in slow-growing and declining markets. Generally speaking, if the market is growing rapidly, emphasising promotions boosts profitability. If it’s declining, advertising does far more to sustain demand.

Big money can be made in relatively fast-growing markets – but only if you get the mix exactly right. If you create a minimum advertising exposure and then put the emphasis on promotions, average returns are as high as 45 per cent over the four years. Get the mix wrong, however, and the effect is dramatic. Too little advertising sees returns cut by a third. Too much and they collapse fourfold to ten per cent.

There are similarly unsettling results for innovation. Maximum returns among heavy innovators were between 30 and 33 per cent over four years. This compares with 44 per cent for non-innovators. But again, mix can be crucial. Heavy innovators who lean towards advertising rather than promotions see their profitability collapse from 30 per cent to only eight per cent. For rare innovators, an advertising-led strategy delivers 53 per cent returns, but if they tilt towards promotions, returns plummet to 19 per cent.

How exactly are marketers supposed to interpret such results? With difficulty. For a start, the PIMS analysis is frustratingly general. For this, the marketing mix consists of only two elements: advertising (which includes direct marketing) and promotion (which includes any advertising or direct marketing promoting a promotion). It therefore throws no light on more detailed questions such as media choice, where effects may be just as startling.

Also, beware confusing correlations between cause and effect. Are big innovators less profitable simply because companies are investing heavily in their futures? And are low-growth markets more profitable because companies are using them as cash cows?

The data does, however, challenge some current conventional wisdoms. For example, it suggests that there are no startling differences in profitability for standalone or umbrella brands (though standalone brands should go for heavier advertising). It also suggests that the current obsession among market leaders, such as Procter & Gamble, with rationalising stock keeping units (SKUs) could well have a detrimental effect on long-term profitability.

“The right strategy and tactics for a dominant market leader are quite different to those of a number three,” says Hillier. The research shows, he claims, that “the profit impact of maintaining market dominance far outweighs the cost advantage of SKU reductions, which goes against the current trend of reducing variety and reducing complexity”. (P&Gers insist their SKU rationalisation is only cutting duplication and won’t leave significant gaps in the market.)

More generally, three key points, emerge. First, a brand’s overall level of profitability is largely predetermined by circumstances outside its immediate control, such as brand rank, retail power and rate of market growth. Second, within these parameters the decisions marketers make about the marketing mix can have stunning effects on returns. Third, even in areas as basic as this, we clearly have a lot to learn.