Chapter 7 Budget Decisions

Major Decisions in Advertising

Budget Decisions Establishing the budget Budgeting approaches Allocating the budget

Establishing the budget Marginal Analysis Sales response models Additional factors in budget setting

Marginal Analysis Advertising / Promotion in $ Sales in $ Point A Profit Sales Gross Margin Ad. Expenditure

BASIC Principles of Marginal Analysis Increase Spending . . . IF: The increased cost is less than the incremental (marginal) return. Decrease Spending . . . IF: The increased cost is more than the incremental (marginal) return. Hold Spending Level. . . IF: The increased cost is equal to the incremental (marginal) return.

Problems with Marginal Analysis Assume that sales are a direct measure of advertising and promotional efforts. Assume that sales are determined solely by advertising and promotion.

Advertising Sales/Response Functions A. Concave-Downward Response Curve B. S-Shaped Response Function Sales Sales Middle Level High Effect Initial Spending Little Effect High Spending Little Effect Range A Range B Range C Advertising Expenditures Advertising Expenditures

Factors Influencing Advertising Budgets

The Dorfman-Steiner Condition The firm is a monopoly. Demand function: Q = D(P, A), where P is the price and A is the advertising budget. Profit function: π = (P – C)Q – A = (P – C) D(P, A) – A, where C is the marginal production cost. εP: the price elasticity of demand; εA: the advertising elasticity of demand. In the equilibrium, A/Sales = εA/εP.

Factors Considered in Budget Setting Source: The Advertising Age Editorial Sounding Board consists of 92 executives of the top 200 advertising companies in the United States (representing the client side) and 130 executives of the 200 largest advertising agencies and 11 advertising consultants (representing the agency side).

Budgeting Approaches Top-down budgeting Bottom-up budgeting

Top-Down Budgeting Top Management Sets the Spending Limit The Promotion Budget Is Set to Stay Within the Spending Limit

Top-Down Budgeting Arbitrary allocation The affordable method Historical Method Percentage of Sales Competitive parity Return on investment (ROI)

The Affordable Method It is used when a company allocates whatever is left over to advertising. It is common among small firms and certain non-marketing-driven large firms. Companies using this approach don’t value advertising as a strategic imperative. Logic: we can’t be hurt with this method. Weakness: it often does not allocate enough money.

Historical Method Historical information is the source for this common budgeting method. The inflation rate and other marketplace factors can be used to adjust the advertising amount. This method, though easy to calculate, has little to do with reaching advertising objectives.

Percentage-of-Sales Method It compares the total sales with the total advertising budget during the previous year or the average of several years to compute a percentage. Two steps Step 1: past advertising dollars/past sales = % of sales. Step 2: % of sales X next year’s sales forecast = new advertising budget.

Percentage-of-Sales Method Based on (future or past) sales dollar or unit product cost Method 1: Straight Percentage of Sales 2007 Total dollar sales Straight % of sales at 10% $1,000,000 $100,000 2008 Advertising budget Method 2: Percentage of Unit Cost Cost per bottle to manufacturer Unit cost allocated to advertising $4 $1 Forecasted sales, 100,000 units Advertising budget (100,000*$1)

2007 Advertising-to-Sales Ratios by Industry Sector

Percentage-of-Sales Method Pros Financially safe Reasonable limits Stable

Percentage-of-Sales Method Cons Reverse the cause-and-effect relationship between advertising and sales. Stable? Misallocation, e.g. S-shaped curve. Difficult to employ for new product introductions. Sales↓ → Advertising budget↓

Competitive-Parity Method This method uses competitors’ budgets as benchmarks and relates the amount invested in advertising to the product’s share of market. Logic: share of media voice → share of consumer mind → share of market. Share of media voice: the advertiser’s media presence. The actual relationship above depends to a great extent on factors such as the creativity of the message and the amount of clutter in the marketplace.

Competitors’ Advertising Outlays Do Not Always Hurt

Competitive-Parity Method Pros Take advantage of the collective wisdom of the industry Spending what competitors spend helps prevent promotion wars. Cons Companies differ greatly. There is no evidence that budgets based on competitive parity prevent promotion wars. (Prisoners’ Dilemma)

Prisoner’s Dilemma Cooperate Fink 2, 2 -3, 3 3, -3 -2, -2 Player 1 ╲ Player 2 Cooperate Fink 2, 2 -3, 3 3, -3 -2, -2

Discussion Question In 1981, American Airlines first introduced the AADVANTAGE frequent-flier program. When other airlines copied this strategy, did they engage in the prisoner’s dilemma? How can a firm escape from the prisoner’s dilemma?

Return on Investment (ROI) In this method, advertising and promotions are considered investment, like plant and equipment. Thus, the budgetary appropriation leads to certain returns. ROI has received a great deal of attention by practitioners over the past few years, with many still disagreeing as to how it should be measured. Aegis Rated ROI of Various Media While the ROI method looks good on paper, the reality is that it is rarely possible to assess the returns provided by the promotional effort – at least as long as sales continue to be the basis for evaluation.

Bottom-Up Budgeting Total Budget Is Approved by Top Management Cost of Activities are Budgeted Activities to Achieve Objectives Are Planned Promotional Objectives Are Set

Bottom-Up Budgeting Objective and Task Method Payout Planning Quantitative Models

Objective and Task Method It looks at the objectives for each activity and determines the cost of accomplishing each objectives. Three steps: Defining the communications objectives to be accomplished Determining the specific strategies and tasks need to attain them Estimating the cost associated with performance of these strategies and tasks

Objective and Task Method Establish Objectives (create awareness of new product among 20 percent of target market) Determine Specific Tasks (advertise on market area television and radio and local newspapers) Estimate Costs Associated with Tasks (television, $575,000; radio, $225,000; newspaper, $175,000)

Objective and Task Method The major of advantage of this method is that the budget is driven by the objectives to be attained. The major disadvantage of this method is the difficulty of determining which tasks will be requires and the costs associated with each. This method is not as easy to perform or as stable as some of the methods discussed earlier. It is especially difficult for new product introduction (There is no past experience to use as a guide).

Payout Planning The first months of a new product’s introduction typically require heavier-than-normal advertising and promotion appropriations to stimulate higher levels of awareness and subsequent trial. The average share of advertising to sales ratio necessary to launch a new product successfully is approximately 1.5~2.0. This means that a new entry should be spending at approximately twice the desired market share.

Share of Advertising/Sales Relationship

Share of Advertising/Sales Relationship

Payout Planning The basic idea is to project the revenues the product will generate, as well as the costs it will incur, over 2 to 3 years. Based on an expected rate of return, the payout plan will assist in determining how much advertising and promotions expenditure will be necessary when return might be expected.

Example of a three-year payout plan ($ millions) Payout Planning To determine how much to spend, marketers develop a payout plan that determines the investment value of the advertising and promotion appropriation Example of a three-year payout plan ($ millions) Year 1 Year 2 Year 3 Product sales 15.0 35.50 60.75 Profit contribution (@$.50 per case) 7.5 17.75 30.38 Advertising/promotions 15.0 10.50 8.50 Profit (loss) (7.5) 7.25 21.88 Cumulative profit (loss) (7.5) (0.25) 21.63

Quantitative Models For the most part, these methods employ computer simulation models involving statistical techniques such as multiple regression analysis to determine the relative contribution of the advertising budget to sales. Attempts to apply quantitative models to budgeting have met with limited success. Such methods do have merit but may need more refinement before achieving widespread success.

Allocating the Budget Allocating to IMC elements Client/agency policies Market size Market potential Market share goals Economics of scale in advertising Organizational characteristics

Allocating to IMC Elements

Allocating to IMC Elements

Share of Voice Effect Decrease–find a defensible niche Increase to defend Attack with large SOV premium Maintain modest spending premium Competitor’s Share of Voice High Low Your Share of Market