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Marketing Math

Marketing Math

How to Back Into a Budget for Advertising

We have all heard the quote from John Wannamaker regarding advertising, “Half the money I spend on advertising is wasted; the trouble is, I don’t know which half.”  However, when your begin to understand that advertising is an investment instead of cost item in your profit and loss statement, you can create a simple formula to determine exactly how much you should be investing in advertising and how much of a return you can expect from that investment.

The starting point for determining an advertising budget is to identify either the expected profit margin (PM) from each sale of your product or, if you expect multiple sales over time from the same customer, determine a Customer Lifetime Value (CLM) for your customers.  Once you have those numbers, you need to determine the appropriate ratio for your advertising spend in relation to your profit margin (PM) per sale in order for your business to remain profitable. That ratio will differ from company to company.  You will need a higher ratio, perhaps 7 to 1, if your company has a lot of operational or production costs for your products or services. You can have a much lower ratio, perhaps 3 to 1, if your company does not have high operational or production costs.

The next step is to determine what your maximum cost per lead (CPL) will need to be. A “lead” is defined as a potential customer that has taken some action to express their interest in your product or service, i.e. called your 800 number, or filled out a website form to receive more information. When you run advertising campaigns, you will invest “x” amount of dollars for a certain amount of time. As long as you have methods in place to measure your advertising, you will then be able to determine how many leads have been captured as a result of your advertising investment. For new campaigns, the cost per lead will be higher than for campaigns that have had more exposure to the marketplace and have had the chance to be optimized over time. Simply put, if you have invested in a 6 week advertising campaign, you can see what pieces of your advertising campaigns have worked best in the first 3 weeks, and then for the final 3 weeks, you will do more of what worked and less of what didn’t.  We actually coined a phrase for this reality, “your first campaign should be your worst campaign.”

The next number to determine is your conversion rate (CR). Your conversion rate is the percentage of interested leads that actually “convert” to paying customers.  If your conversion rate is 20%, that means 1 out of every 5 interested leads will convert to a paying customer.  A 50% conversion rate would be 1 out of every 2 leads.

Now we can put this all together. We’ll use some easy numbers to demonstrate the formula to determine what you will need your cost per lead (CPL) to be.  Let’s say the profit margin (PM) on your product is $1,000.  You want your conversion ratio (CR) to be 5 to 1, meaning for every $1,000 you invest in advertising you want to see a return of $5,000 in profits. If we anticipate your conversion rate to be 20%, we can now plug in the numbers to determine what your maximum cost per lead (CPL) will need to be to achieve the 5 to 1 ratio.  Let’s run the numbers for 100 leads at a cost per lead of $40.

100 leads x $40 cost per lead (CPL) = $4,000 in advertising spend

Those same 100 leads will convert into 20 paying customers at a 20% conversion rate (CR)

20 paying leads multiplied by $1,000 in profit margin (PM) = $20,000 in profit

$20,000 in profit subtracted by $4,000 in advertising spend = $16,000 net profit after advertising

Your Net Profit to Advertising ratio is exactly 5 to 1.

In the example above, in order to obtain your 5 to 1 ratio you will need to ensure that you pay no more than $40 per lead – and you will want to strive to pay even less by optimizing and improving your advertising over time. So if your first campaign is your worst campaign, let’s see what happens to your investment when you improve campaigns by optimizing which parts are working best and eliminate the parts that aren’t. An example of this could be that you’ve discovered that your ads that run on ESPN and CNN work better than the ads that run on Fox News.  So you stop spending money on Fox News and move all that money over to CNN and ESPN. Let’s say that by doing so you can get your cost per lead (CPL) down to $30.  Let’s rerun the numbers:

100 leads x $30 cost per lead (CPL) = $3,000 in advertising spend

Those same 100 leads still convert into 20 paying customers at a 20% conversion rate (CR)

20 paying leads multiplied by $1,000 in profit margin (PM) = $20,000 in profit

$20,000 in profit subtracted by $3,000 in advertising spend = $17,000 net profit after advertising

Your Net Profit to Advertising ratio just jumped to 6.67 to 1.

These scenarios are based on some very simple figures, but the formula works. The biggest variables in advertising will be your cost per lead (CPL) and your conversion rate (CR). However, your desired advertising spend to profit margin ratio should remain consistent, so you can continually optimize your campaigns to improve your CPL and CR numbers. In fact, it will be imperative to do so.

Our final example will use the same cost per lead of $30 but a lower conversion rate of 15% to demonstrate how that figure can also affect your return on investment.

100 leads x $30 cost per lead (CPL) = $3,000 in advertising spend

Those same 100 leads still convert into 15 paying customers at a 15% conversion rate (CR)

15 paying leads multiplied by $1,000 in profit margin (PM) = $15,000 in profit

$15,000 in profit subtracted by $3,000 in advertising spend = $12,000 net profit after advertising

Your Net Profit to Advertising ratio returns to 5 to 1.

In our next post, we’ll cover one advertising option that can truly make a difference in your advertising budgets and spending. It’s called “per inquiry” advertising and is based on agreeing in advance to what your cost per lead dollar amount will be BEFORE spending any money.