Cost Based Advertising Ted Mitchell

Three Methods for Setting Advertising Budget Cost Based Advertising Competitive Based Advertising Customer Based Advertising

Cost Based Advertising  1) Affordable Method  2) Advertising to Sales Ratio  3) Various Returns on Advertising  Units sold per thousand  Revenue per thousand  Exposures per thousand  Cost per thousand GRPs  4) Average Profit Returned on Promotional Investment (Effort) ROMI or ROME

Affordable method –Classic response to the Traditional Institutional Orientation Favorite Accountant

Affordable method –Classic response to the Traditional Institutional Orientation We should do some advertising too Yes! As much as we can afford. Favorite Accountant

How much can we afford?

HOW MUCH CAN WE AFFORD? Revenue R = PQ$200,000 Cost of goods Sold, CoGS = VQ 110,000 Gross Profit Margin$90,000 Advertising, A ?????? General Overhead, F$60,000 Net Profit Margin, Z$18,000 The budget tells us what the firm expects for revenues, costs, profits

Solve for Affordable Advertising Revenue - Total Costs = Profit PQ - VQ - A - F = Z Reorganize to Solve for A A = PQ -VQ - F - Z A = $200,000 - $110,000 - $60,000 - $18,000 A = $16,000 Favorite Accountant We know it all but the Advertising

Solve for Affordable Advertising Revenue - Total Costs = Profit PQ - VQ - A - F = Z Reorganize to Solve for A A = PQ -VQ - F - Z A = $200,000 - $110,000 - $60,000 - $18,000 A = $16,000 To reach our target profit with our forecasted revenues and costs we can afford to spend $16,000 on advertising Favorite Accountant

What we can afford Method Weakness The assumption is that “Advertising is necessary, but we don’t know why it is important or how to measure advertising effectiveness.” Sales volumes are predicted without any knowledge that advertising causes sales

Advertising by The Normal Budget Percentage

Setting Advertising Budgets Based on the Normal Advertising to Sales Ratio Accountants love ratios with sales revenue in the denominator such as Markup, Return on Sales, Advertising to Sales, etc.

Advertising to Sales Ratio Fits nicely in the margin of the traditional income statement Revenue$200,000 Cost of goods Sold110,000 Gross Profit Margin$90,00045% Advertising$12,0006% General Overhead$60,00030% Net Profit Margin$18,0009% Everything as a percentage of sales

Advertising to Sales Ratio Use the advertising to sales ratio to provide a “flexible budget” and keeps or final goals in line if sales volumes fluctuate Revenue$200,000 Cost of goods Sold110,000 Gross Profit Margin$90,00045% Advertising$12,000 6% General Overhead$60,00030% Net Profit Margin$18,0009% Everything as a percentage of sales

Accountants Love the Advertising to Sales Ratio as Means to control the Marketing Budget! Marketing is always trying to waste money on advertising Favorite Accountant

Accountants Love the Advertising to Sales Ratio as Means to control the Marketing Budget! At the end of the year you must not have spent more than 6% of sales on advertising Favorite Accountant

Accountants Love the Advertising to Sales Ratio as Means to control the Marketing Budget! To stay on budget when your sales drop, you must cut your advertising Favorite Accountant

Flip the Budget to Sales Ratio Sales Revenue Return on Advertising Method

Advertising is a cost driver to accountants Advertising is a revenue and profit driver to marketers!

How much Revenue do we get for the budget? $20,000 in advertising cost is 6% of the$333,333 in sales revenue or $20,000 effort generated $333,333 Or $16.67 in sales for every advertising dollar spent Or 16.67% revenue return on marketing investment (total promotion)

You want to predict how much more sales revenue you’ll get if you spend an extra $100,000 on Total Promotion You know your normal Sales Revenue (returned) on Total Promotion is R/TP = 450% You plan on a change in Total promotion of ∆TP =$100,000 What increase in revenue, ∆R, do you anticipate? R = R/TP x TP ∆R = R/TP x ∆TP ∆R = 450% x $100,000 = $450,000

How to set a total promotion budget with a target level of Revenue You want a sales revenue next period of $6,000,000. You know your normal revenue return on total promotion is TP = 450%.How big a promotion budget will you need? R = R/TP x TP $6,000,000 = 450% x TP TP = $6,000,000/4.5 = $1,333,333 You can set a total budget based on the Revenue Return from Promotion with a given Revenue Objective

More Likely. You will set an incremental change the current budget to reach a target change in sales revenue

R = R/TP x TP ∆R = R/TP x ∆TP $200,000 = 400% x ∆TP ∆TP = $200,000/400% = $50,000 You want to increase your sales by ∆R=$200,000 in the next month. Your normal rate of revenue return on total promotion is R/TP = 400%. How much more do you need to spend on total promotion to generate the extra revenue?

What additional information do you need to calculate the breakeven revenue need to cover $50,000 in additional promotion expense? BER = F/Mp Need the Markup on Price, Mp A plan to increase sales revenue by, ∆R=$200,000 by increasing total promotion by ∆TP = $50,000 will always be checked for ‘do-ability’ with a breakeven calculation.

Your normal markup on price or gross profit margin is Mp = 40% BER = TP / Mp BER = $50,000/40% = $125,000 The bigger the spread between BER and target revenue the more do-ability the plan has A plan to increase sales revenue, ∆R=$200,000 by increasing total promotion by ∆TP = $50,000 will always be checked for ‘do-ability’ with a breakeven calculation.

The Many “Returns” on Marketing Effort Classic Returns Measured as Average Revenue Generated per dollar spent Average Quantity Sold per dollar spent Average # of Leads Generated per dollar spent Average # of Customers Acquired per dollar spent Average $ Profit Contribution per dollar spent

The Hot Return is Profit from Marketing Return on Marketing Investment, MROI Profit Returned on Marketing Effort Profit Returned on Marketing Expense Profit Returned on Advertising

Where in the operating statement to I measure profit Overly Simplistic ROI found on page 240 ROI = (Sales due only to Advertising – Advertising) Advertising Overly Hopeful ROI ROI = (Sales Revenue – Advertising) Advertising

Profit due to marketing activities after cost of goods sold and total promotion costs for the period are subtracted from the sales revenue MC = R – COGS – TP o MC = Marketing’s contribution to profits o R = Sales Revenue o COGS = Cost of Goods Sold o TP = total promotion costs for the period ROME = MC/TP Middle of the road approach to ROME

Objective: achieve a target profit from promotion budget Cost-Based Model Set the promotion budget, TP, with a target profit from marketing, MC MC = R – COGS – TP MC = PQ – VQ – TP TP = PQ – VQ – MC Like all cost-based models we know the normal and expected R, COGS and MC

More likely than being told the dollar profit of the normal marketing contribution We will be told the normal return on the marketing investment or ROME MC = ROME(TP)

Objective: achieve a target profit from promotion budget TP = PQ – VQ – MC Substitute MC = ROME(TP) in the basic equation TP = PQ – VQ – ROME(TP) Reorganize TP + ROME(TP) = PQ-VQ TP(1+ROME) = Gross Profit TP = Gross Profit / (1+ROME)

You will likely know the normal markup on price and the forecasted revenue than the dollars of gross profit TP = Gross Profit / (1+ROME) Substitute Gross Profit = Mp(R) TP = Mp(R)/(1+ROME)

Total Promotion Budget that will generates the Normal Profit from marketing effort is determined by knowing the normal markup, Mp, and the forecasted sales revenue, R, and the normal percentage return on marketing expenses, ROME When Rome is presented as a hurdle rate by the finance department, then TP is the most you can spend given the Present Value of the cash flow from future gross revenues.

Sample Exam Question on Cost-based Budget Setting with a Target Profit You are to set the total promotion budget for the Home market and set it at the size that will produce the normal and expect return on marketing expense. You know that the normal gross profit is G=5 million dollars and the normal ROME is 150%. What Total Promotion Budget, TP, should you set to achieve the expected profit contribution from marketing? TP = G/(1+ROME) TP = $5/(1+1.5) = $5/2.5 = $2 million

But it is more likely you’ll know The normal markup on price, Mp, and the forecasted sales revenue and the normal hurdle rate or return on the marketing investment, ROME TP = Mp(Revenue)/(1+ROME)

Notice Similarities in Cost-Based Pricing and Cost-Based Budgeting Retail pricing based on Markup, Mp, and variable cost per unit, V. P = V/(1-Mp) Manufacturer’s pricing based on Return on Sales, ROS and average cost per unit, BEP. P = BEP/(1-ROS) Total Promotion Budgeting, TP, based on a profit contribution from marketing, ROME, and Expected Revenue and normal markup. TP = Mp(R)/(1+ROME)

Setting Budget on the Average Return on MKT Period 2Forecast for Period 3 Quantity Sold110,000112,0002, % $ markup$68$70$2 Gross profit$7,480,000$7,840,000 Advertising$1,480, ,000 1,600,000 $1,600,000 Marketing Contribution $6,000,000$6,240,000 ROMI or ROME 405% 390%-15%

Setting Budget on the Average Return on MKT Period 2Forecast for Period 3 Quantity Sold110,000112,0002, % $ markup$68$70$2 Gross profit$7,480,000$7,840,000 Advertising$1,480, ,000 = 1,600,000 $1,600,000 Marketing Contribution $6,000,000Forecast 6,486,000 $6,240,000 ROI or ROME405% 390%-15%

Simple Average Return FORECAST $1,480,0001,600,000 $6,000,000 $6,480,000 Profit after Advertising NMC Advertising Forecast

Simple Average Return FORECAST $1,480,0001,600,000 $6,000,000 $6,480,000 Profit after Advertising MC Advertising MROI

Simple Average Return FORECAST $1,480,0001,600,000 $6,000,000 $6,480,000 Profit after Advertising NMC Advertising MROI NOTE The Profit Function Based on Advertising

Simple Average Return FORECAST $1,480,0001,600,000 $6,000,000 Profit after Advertising M Advertising MROI

Simple Average Return FORECAST $1,480,0001,600,000 $6,000,000 $6,480,000 Profit after Advertising NMC Advertising MROI The danger in simply using average ROMI for forecasting

Simple Average Return on Advertising Profit after Advertising NMC Advertising MROI Average MROI is always declining

Increases in Advertising Increases Units Sold Increases in Advertising Increases Sales Revenues Increases in Advertising Do Not Necessarily Increase Profits

$1,480,0001,600,000 $6,000,000 Profit after Advertising M Advertising MROI Need to known the incremental changes. The elasticity of MROI to Advertising

4 Types of Cost-Based Budgeting Methods 1) Affordable Method 2) Percentage of Sales Method 3) Revenue Return on Promotion 4) Profit Return on Promotion or Marketing Return on Investment ‘MROI’

Virtues of Cost-Based Budgeting Methods 1) Little amounts of information Almost all from Internal sources 2) Simple to Calculate 3) A clear focus on the sales, and returns expected from promotion expenses

Weaknesses of Cost-Based Methods 1) Ignores Competitor and Customer changes and their reactions to changes 2) Too many heroic assumptions about normal costs, revenue, profits and business conditions remaining the same in the next period 3) too much emphasis on the accounting orientation that forecasted revenue should dictate marketing effort and that marketing effort does not determine sales levels

Any Questions of Cost Based Budgeting Methods?