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
We should
do
some
–Classic response Yes!
to the
advertising too
Traditional Institutional
As much as
Orientation we can afford.
Favorite Accountant
How much can we afford?
HOW MUCH CAN WE AFFORD?
Revenue R = PQ
Cost of goods Sold,
CoGS = VQ
Gross Profit Margin
Advertising, A
$200,000
110,000
$90,000
??????
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
We know it all
PQ - VQ - A - F = Z
but the Advertising
Reorganize to Solve for A
A = PQ -VQ - F - Z
A = $200,000 - $110,000 - $60,000 - $18,000
A = $16,000
Favorite Accountant
Solve for Affordable Advertising
To reach our
Revenue - Total Coststarget
= Profit
profit
our forecasted revenues
PQ - VQ - A - Fwith
=Z
and costs
Reorganize to Solve for
A afford
we can
to spend $16,000
A = PQ -VQ - F - Z on advertising
•
•
•
•
• A = $200,000 - $110,000 - $60,000 $18,000
• A = $16,000
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
Cost of goods Sold
$200,000
110,000
Gross Profit Margin
Advertising
General Overhead
Net Profit Margin
$90,000
$12,000
$60,000
$18,000
45%
6%
30%
9%
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 Sold
Gross Profit Margin
110,000
$90,000
Advertising
$12,000
6%
General Overhead
Net Profit Margin
$60,000
$18,000
30%
9%
45%
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
At the
end of the year
Marketing
Budget!
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
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?
•
•
•
•
R = R/TP x TP
∆R = R/TP x ∆TP
$200,000 = 400% x ∆TP
∆TP = $200,000/400% = $50,000
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.
• 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,
∆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
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 Revenue – Advertising)
Advertising
• Overly Hopeful ROI
ROI =
(Sales due only to Advertising – Advertising)
Advertising
Middle of the road approach to ROME
• 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
o
o
o
MC = Marketing’s contribution to profits
R = Sales Revenue
COGS = Cost of Goods Sold
TP = total promotion costs for the period
• ROME = MC/TP
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)
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 2
Forecast for
Period 3
Quantity Sold
110,000
112,000
2,000
+1.8%
$ markup
$68
$70
$2
Gross profit
$7,480,000
$7,840,000
Advertising
$1,480,000
Marketing
Contribution
$6,000,000
ROMI or
ROME
405%
+120,000
1,600,000
$1,600,000
$6,240,000
405%
390%
-15%
Setting Budget on the
Average Return on MKT
Period 2
Forecast for
Period 3
Quantity Sold
110,000
112,000
2,000
+1.8%
$ markup
$68
$70
$2
Gross profit
$7,480,000
$7,840,000
Advertising
$1,480,000
+120,000 =
1,600,000
$1,600,000
Marketing
Contribution
$6,000,000
Forecast
6,486,000
$6,240,000
ROI or ROME
405%
405%
390%
-15%
Simple Average Return
FORECAST
Profit after
Advertising NMC
$6,480,000
Forecast
$6,000,000
$1,480,000 1,600,000
Advertising
Simple Average Return
FORECAST
Profit after
Advertising MC
$6,480,000
MROI
$6,000,000
$1,480,000 1,600,000
Advertising
Simple Average Return
FORECAST
NOTE The Profit
Profit after
Advertising NMC
$6,480,000
Function Based
on AdvertisingMROI
$6,000,000
$1,480,000 1,600,000
Advertising
Simple Average Return
FORECAST
Profit after
Advertising M
MROI
$6,000,000
$1,480,000 1,600,000
Advertising
Simple Average Return
The danger in
FORECAST
simply using
Profit after
Advertising NMC
$6,480,000
average ROMI
for forecasting
MROI
$6,000,000
$1,480,000 1,600,000
Advertising
Simple Average Return on
Advertising
Profit after
Advertising NMC
MROI
Average MROI is always declining
Advertising
• Increases in Advertising Increases Units
Sold
• Increases in Advertising Increases
Sales Revenues
• Increases in Advertising Do Not
Necessarily Increase Profits
Need to known the incremental
changes. The elasticity of MROI
to Advertising
Profit after
Advertising M
MROI
$6,000,000
$1,480,000 1,600,000
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?