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Ratios can be Tricky Just because one sounds true doesn’t make it so!

Ratios can be Tricky Just because one sounds true doesn’t make it so!. Ted Mitchell. Four Possibilities The Scenario …. 1) Sounds True and it is True 2) Sounds False and it is False 3) Sounds True but it is False 4) Sounds False but it is True. Rewarding Return on Investment.

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Ratios can be Tricky Just because one sounds true doesn’t make it so!

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  1. Ratios can be TrickyJust because one sounds true doesn’t make it so! Ted Mitchell

  2. Four PossibilitiesThe Scenario … • 1) Sounds True and it is True • 2) Sounds False and it is False • 3) Sounds True but it is False • 4) Sounds False but it is True

  3. Rewarding Return on Investment • You have two stores. One in Reno and one in Sparks. You want to reward the store manager who made the best use of his marketing budget to generate profit.

  4. Return on Marketing “Investment” • In 2010 Roy has spent $20k in advertising and has made a profit of $2k in your Reno store. • What is Roy’s return on marketing expense? • ROME = PROFIT/EXPENSE • ROME = $2/$20 = 0.10 = 10%

  5. Reno Store ROME = 10% Profit $4 Rome = 10% $2 $20 $40 Advertising

  6. Words Get in the WAY • Return on Investment = Profit/Investment • Or • Return on Marketing Investment = (Profit after Marketing Effort)/(Marketing Effort) • Or • Return on Marketing Expense = ROME • Or • Profit Returned by the Marketing Effort

  7. In general we see that • Profit Returned on an Investment = Profit/Investment • The key equation is • Profit = Return on Investment x Investment • Profit = (Profit/Investment) x Investment • Z = ROI x I • Z = (Z/I) x I

  8. Return on Marketing “Investment” • In 2010 Sam has spent $20k in advertising and has made a profit of $4k in your Sparks store. • What is Sam’s return on marketing expense? • ROME = PROFIT/EXPENSE • ROME = $4/$20 = 0.20 = 20%

  9. Sparks Store ROME = 20% Profit Sparks Rome = 20% $4 Reno Rome = 10% $2 $20 $40 Advertising

  10. Conclusion • In 2010 the Sparks store with a 20% ROME was more efficient at converting marketing effort into profits than the Reno store with a 10% ROME. • Sam with the store in Sparks got the bonus for being more efficient than Roy. • Does this scenario sound True or False • A) True • B) False

  11. Sounds True and Is True • The conclusion is consistent with the information given. • The 2010 scenario sounds plausible and is true.

  12. A Different Scenario • The Next Year for Sam and Roy

  13. In 2011 Sam in the Sparks store maintained his 20% Return on Marketing Effort. Roy in the Reno store improved his Return on Marketing Effort to 25%. • Roy got the bonus for being more efficient in using his advertising than Sam. • However, Roy made less profit than Sam this yearand he made less profit in 2011 than in 2010. • Does this scenario sound plausible? • A) True • B) False

  14. The scenario sounds inconsistent and implausible How can his Efficiency (ROME) go up and his profits go down at the same?

  15. The scenario sounds False but it can be True. • In 2011 Sam in Sparks invested $20,000 in advertising and with a 20% ROME earned a profit of $4,000. • In 2011 Roy in Reno invested $6,000 in advertising and with a 25% return on investment earned a profit of $1,500 compared to his profit of $2,000 in 2010.

  16. Why did it sound false or implausible? • The reader or the audience assumes that both stores invested the same amount into advertising as in 2010. • We expect to be comparing like-things! • However, the denominator in the ROME changed. Roy spent less in advertising. • He made profit more efficiently but he made less overall profit!

  17. As a manager you must be very sensitive to comparing performance ratios. • 1) Watch out for the implied consistency of the context. Are you comparing apples and oranges. • 2) Your brain wants it easy to compare and so it will fill in the blanks. • 3) It wants to ignore the function and concentrate of the ratio as whole number • Profit = ROME x Marketing Expense • Z = ROME x Total Promotion Budget

  18. Average rates, ratios and percentages are particularly tricky

  19. Return on Marketing “Investment” • In 2010 you made a ROME of 10% in Reno and a ROME of 20% in Sparks. What was your average return per store? • ROME = PROFIT/EXPENSE • The Answer is • Average return per store is 15%

  20. Average ROME = 15% Profit Average Rome = 15% Sparks Rome = 20% $4 Reno Rome = 10% $2 $20 $40 Advertising

  21. Looks like Sparks store is more efficient at making profits than the average!

  22. Hand In Your Answers to the following Problem for Participation Points

  23. Let’s Try Productivity • Every salesperson in your call center must make 20 calls per day. You want to reward the person who has the highest average productivity over two days. Tom and Sally are your top two producers.

  24. Tom’s Average Productivity • Tom makes 10 calls for each sale on Monday and makes 5 calls per sale on Tuesday. What is Tom’s average rate of productivity over the two days? • A) 15 calls per sale • B) 7.5 calls per sale • C) 6.67 calls per sale • D) not enough information to calculate

  25. Sally’s Average Productivity • Sally has to make 6.667 calls for each sale on Monday and makes 6.667 calls per sale on Tuesday. What is Sally’s average rate of productivity over the two days? • A) 13.334 calls per sale • B) 7.5 calls per sale • C) 6.67 calls per sale • D) not enough information to calculate

  26. Which person has the highest productivity over the two days and gets the bonus? • A) Tom • B) Sally • C) Both have the same productivity • D) Not Enough Information to Calculate

  27. The popular answer is Tomand its Wrong • Which person has the highest productivity over the two days and gets the bonus? • A) Tom appears to have a productivity of(10 + 5)/2 = 7.5 calls per sale • B) Sally • C) Both have the same productivity • D) Not Enough Information to Calculate

  28. The Correct Answer is • Which person has the highest productivity over the two days and gets the bonus? • A) Tom • B) Sally • C) Both have the same productivity at 6.67 calls per sale • D) Not Enough Information to Calculate

  29. Why the same productivity?

  30. Sally’s Monday Productivity 6.67 calls/sale Calls Calls per sale = 6.67 40 calls 20 calls 6 2 4 3 Sales

  31. Sally’s Two Day Productivity 6.67 calls/sale Calls Calls per sale = 6.67 40 calls 20 calls 6 2 4 3 Sales

  32. Sally made an average of 20 calls per day with an average of 3 sales per day for an average productivity of • 20/3 = 6.67 calls per sale • Or • 40 calls/6 sales = 6.67 calls per sales

  33. Check Tom’s productivity

  34. Tom’s Monday Productivity 10 calls/sale Profit 40 calls Calls per sale = 10 20 calls 2 4 Sales

  35. Tom’s Tuesday Productivity 5 calls/sale Calls 40 calls Calls per sale = 10 20 calls Calls per sale = 5 2 4 Sales

  36. Tom’s Two Day Productivity 6.67 calls/sale Calls Calls per sale = 6.67 40 calls Calls per sale = 10 20 calls Calls per sale = 5 6 2 4 Sales

  37. Tom made an average of 20 calls per day with an average of 3 sales per day for an average productivity of • 20/3 = 6.67 calls per sale • Or • Made 40 calls/6 sales = 6.67 calls per sale

  38. I suggest this table

  39. I suggest this table

  40. I suggest this table

  41. Key Learning Point • “Common Sense” Can lead you astray! • You can get into Big Trouble taking the averages of rates and ratios • For example: How did you actually solve the first lecture problem?

  42. Rewarding Return on Investment • You have two stores. One in Reno and one in Sparks. You want to reward the store manager who makes the best use of his marketing budget to generate profit.

  43. Average ROME = 15% Profit Rome = 15% Rome = 20% $4 Rome = 10% $2 $20 $40 Advertising

  44. Average ROME = 15% Profit $6 Rome = 15% Rome = 20% $4 Rome = 10% $2 $20 $40 Advertising

  45. The average advertising expense in each of the two stores was $20,000 and the average profit in each of the two stores was $3,000 and the average return on marketing expense was ROME = $3k/$20k = 0.15 = 15%

  46. Key Learning Point • Don’t take the average of the ratios • Start with the full set of numbers and take the average of the component parts • Remember the basic equation • Profit = Return on “investment” x Investment • Store 1: $2k = 10% x $20k • Store 2: $4k = 20% x $20k • Average profit = ROME x Average Investment • Average store = $3k =ROME x $20k • Average ROME = $3k/$20k = 15%

  47. Do A Third Example for Participation

  48. Market Share is a ratio: (Firm’s sales)/(total industry sales) • There is a total of 5 firms in your industry. Your share is 15% of the industry sales • Competitor A has 10% market share • Competitor B has 5% market share • What is the average market share in the industry? • A) 10% • B) 20% • C) Not enough Information to solve

  49. The Correct Answer is There is a total of 5 firms in your industry. Your share is 15% of the industry sales • Competitor A has 10% market share • Competitor B has 5% market share • What is the average market share in the industry? • A) 10% • B) 20% • C) Not enough Information to solve

  50. If you had the market shares for all 5 firms, then you could add them up to 100% and divide by 5 and get an • average market share 100%/5 = 20%

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