In tough economic times chief financial officers inevitably look at cutting costs, and most chief marketing officers can sense their colleague’s hatchet pausing over their marketing budget. Research by PwC late last year showed that more than two thirds of CMOs believe marketing spend comes under particular scrutiny at such times.
Why is it brand marketing that gets cut?
Corporate chieftains are often skeptical about the power of marketing. But in our view this is not the main reason why brand marketing budgets are vulnerable in a downturn.
The real reason is that accounting standards lead companies to see reducing adspend as a ‘quick and easy’ way of protecting earnings.
Forgive us a quick detour into the world of accounting, but the first step towards influencing the CFO is to understand their motivations.
At the heart of financial accounting and reporting are two primary statements:
- The Profit & Loss account (P&L, or income statement), which is revenues less costs for the current year, to give profit
- The Balance Sheet (B/S), which is where assets and liabilities relating to future years are recognised.
Operating expenses (opex) are costs recognised immediately in the current year, in the profit and loss account. Capital expenses (capex) are deferred (or capitalised) to the balance sheet, to be recognised over future years as depreciation or amortisation.
Examples of the latter type of spending include the building of a factory and investment in technology, but unfortunately not brand marketing.
We’ll return to capex shortly. Before we do, one more important concept is EBITDA i.e. Earnings Before Interest, Tax, Depreciation and Amortisation. This is a commonly used measure of profit that is supposed to approximate free cash flow.
Capex has two key differences to opex in financial reporting: first, it is deferred to the balance sheet and only hits future periods; and second, when it is eventually recognised as a cost in future years, it is as depreciation or amortisation and so falls outside EBITDA.
Imagine a CFO under pressure to hit a profit number in the current year. What levers are available to them?
Cost of goods sold (COGS) varies directly with revenue anyway. Employee numbers and salary costs are fixed in the short term. Leases are fixed in the medium term (and in a recent accounting change are now mostly capitalised anyway). Travel budgets are much smaller than in pre-Covid times. Much of technology spend is capitalised or fixed.
One of the few levers available is marketing spend, thanks to those accounting rules. (And, of course, the majority of management performance and incentive targets are linked in some way to earnings and/or margin.)
The phenomenom was researched in 2019 by German broadcaster ProSieben Sat1. It analysed the adspend of its publicly-listed customers and found that companies whose financial results were in line with expectations maintained it while those that lowered their financial expectations cut it by an average of 10%.
But why is marketing spend always opex and not capex?
Given that brand marketing in particular is meant to drive long-term value, it’s fair to ask why such spend is always expensed and never capitalised.
Blame the accounting standard IAS 38 Intangible Assets, which defines an intangible as a non-monetary asset, without physical substance, whose cost can be measured reliably and that generates future economic benefits.
Brand marketing would appear to meet this definition: it’s a non-monetary asset that yields benefits in future years.
However, IAS 38 explicitly disallows the capitalisation of internally generated brands, because (a) in practice it is hard to definitively separate brand from performance marketing, and (b) other factors contribute to the building of brand equity e.g. consumer touchpoints such as customer service. This means the cost of building the brand, in an accounting sense, cannot be measured reliably.
Since all marketing must be expensed within the year, CFOs are tempted to focus spend on those activities most likely to also generate revenue within the same year. This means accounting standards generate an unintentional ‘bias’ in favour of performance marketing over brand-building. This is one factor contributing to the well-documented broader shift in the marketing world away from the Binet/Field 60:40 ratio of brand vs performance spend.
What can CMOs do to protect brand marketing?
This situation puts the onus on the CMO to convince the CFO (and CEO) of the value of brand marketing.
We advocate speaking the language of the CFO and focusing on shareholder value.
Here are some of the key points a CMO could raise:
- Advertising is ‘intangible capex’. Although the accounting standards require marketing to be capitalised, it’s important to remind the CFO (and CEO) that, just as companies invest in physical equipment such as factories to grow long-term sales, brand marketing is the same sort of investment in an intangible asset. You wouldn’t pause building a factory and brand spend should be viewed in the same way (nor would you cut corners on costs, at least not if you wanted the best outcome).
- The term ‘RoI’ is beloved by many marketers but is often viewed by accountants, analysts and investors as an inherently narrow and short-term metric. Marketers should instead use Net Present Value (NPV) to more accurately reflect the value of the brand to the whole business.
- Brand marketing impacts shareholder value. Contrast the long-term loss in sales, profits and shareholder value from reduced marketing with the uplift in each of these from well-optimised brand spend. This is crucial. Management teams are under pressure from investors and the financial markets to cut costs. Marketers need to give them the confidence to resist such pressure by demonstrating the value created.
- Brand marketing makes your customers more willing to stomach price rises. As commodity prices feed into macroeconomic inflation, the companies with strongest brands are those best placed to pass cost increases to consumers. Such price increases tend to be permanent in nature while many input costs are likely to fall (and, in some cases, are already doing so). That raises the prospects of higher long-term margins which should be music to a CFO’s ears.
- If there is a downturn it is a better idea to cut performance marketing (since consumers won’t have money to spend) and maintain brand marketing since the latter will yield benefits when the economy picks up later.
- In a downturn it is inevitable that some companies will cut marketing and advertising, but this will mean relative value will improve in demand/supply driven markets like TV advertising and biddable (auction-based) media. Brands that spend bravely can take advantage of lower prices and will emerge stronger on the other side.
- Marketing teams can eliminate waste and improve efficiency: for example, our work on digital advertising has consistently shown that digital advertising can be optimised by 10-20% or more.
- It is worth investing in more sophisticated conometric modelling to measure marketing effectiveness, going beyond the ‘Ordinary Least Squares’ approach inherent in most Marketing Mix Modelling. In our experience, the more sophisticated the econometrics, the higher the value usually ascribed to long-term brand-building.
This list will hopefully inspire really innovative organisations to make the case even more strongly for brand marketing as intangible capex and report it as such to analysts and investors in their Adjusted Operating Profit – which is basically a way of reporting results in a way that the company believes more accurately reflects the underlying commercial and economic reality.
Accounting standards govern Statutory Profit & Loss figures, but in presenting Adjusted Operating Profit a company can elect to adjust certain items, provided each such change is well-justified, clearly explained and applied consistently year over year.
Such a change would mean that, over time, analysts and investors are more likely to reward groups for consistent investment in their brand.
Could marketers get those accounting standards changed?
The International Accounting Standards Board (IASB) is always looking for views from industry on how accounting standards should evolve to reflect changes in the business world.
There is certainly an opportunity for UK marketers, working through trade bodies such as ISBA, to constructively question the current treatment of brand marketing under IAS 38 and ask the IASB if it would consider alternatives.
Given the pace at which accounting standards are reviewed and updated, this won’t be a short-term fix – appropriately, it would be a long-term investment in time and effort that might pay off in many years! – but it’s an effort we think could potentially be really interesting for the marketing world.
Sam Tomlinson is partner and media leader at PwC. Ian Whittaker is founder and managing director of Liberty Sky Advisors and writes the Investor View column for Campaign.