Make Good Decisions About
Spending Money On Marketing

Make Good Decisions About Spending Money On Marketing Campaigns & Promotions

Small business ownership and management know, instinctively, that marketing their products or services is critical to growing sales. These companies often lack the sales history and business tools that support decisions in larger companies about spending marketing dollars.

This paper, based on actual experience, puts forth a simple method (a “backpack tool”, if you will) for small and mid-size business ownership and management to make good decisions about spending money on marketing campaigns and promotions.

Background

A small company’s marketing leadership has been asked to put forth a proposal to sell the company’s products through a marketing campaign/promotion. The proposed fixed spend for the campaign is $100,000. Additionally, Marketing is proposing a 10% sale discount to increase product sales. There’s often much inconclusive discussion about the return on an investment like this and the conversation often drifts to the following kind of “rationale”.

The company generally has a Gross Margin of 40% on the products it sells (this includes “some” discounting here and there).

The company has to sell only $250,000 to breakeven on the $100,000 investment ($100,000 / 0.40 = $250,000). One might say, “How could we possibly go wrong? Seems like a layup! Surely, we will do better than that and this campaign will be profitable!” Marketing’s minimum estimate for this campaign is $750,000 in sales.

The simple factors and estimates below need to be considered to make the right decision about spending $100,000 for the marketing campaign.

Evaluation / Analysis

To evaluate the marketing proposal properly the following factors need to be isolated:

What is the company’s “normal” Marginal Profit? This is different than Gross Margin.
What is the company’s “promotional” Marginal Profit?
What is the dollar value of incremental sales assumed to be as a result of the promotion?

Marginal Profit

Gross Margin Rate = (Selling Price – Cost of Sales)/Selling Price.

Marginal Profit Rate = (Gross Margin Rate – Rate of Variable Operating Expenses). Variable Operating Expenses are those expenses that occur whenever a sale occurs.

So, while the company does in fact have an overall Gross Margin of 40%, it also has (expressed as a percent of Net Sales) a rate of 4% of Variable Operating Expenses. Therefore, the company’s “normal course” rate of Marginal Profit is 36% (40% – 4% = 36%).

The company’s promotional Marginal Profit is significantly less. For example, if the company sells $100 at its normal rate of Gross Margin, its Gross Margin dollars are $40 and its Gross Margin rate is 40%. The associated rate of Marginal Profit is 36% (as discussed above). In this case the Cost of Sales is $60.

Because the marketing campaign includes a sale discount of 10%, if the company sells $100, the sale value after the discount is $90 and the promotional rate of Gross Margin is only 33%. That’s because the Cost of Sales remains at $60 and the Gross Margin dollars on the promotional sales equals $30. Therefore, ($90 – $60)/$90 = 33%. The associated rate of Marginal Profit is 29% (as discussed above).

So, in conclusion, the company’s normal marginal profit rate is 36%. The company’s promotional marginal profit rate is 29%. The promotional rate of Marginal Profit is seven (7) percentage points less than the “normal course” rate of Marginal Profit.

Incrementality

The last factor to isolate is an estimate regarding the amount of purely incremental sales that can be expected from the marketing campaign. Marketing is estimating that sales from the campaign will be $750,000, but more often than not (and there’s usually considerable confusion about this point), this means that sales touched by the promotion are $750,000 (i.e., all of the discounted sales within the time frame of the campaign). The real question to answer is how much of the sales generated by the marketing campaign is incremental? How much of the sales that occurred during the marketing campaign would have never occurred if it were not for the campaign?

Larger companies have means and methods based on database analyses and other information to better define the rate of incrementality in marketing promotions. Small and mid-market companies generally have not developed or do not have access to this kind of information. From experience, and in general, a good rule of thumb (unless the campaign/promotion is extremely unique and an extraordinary value for the customer) is that rates of incrementality can run from 10% to 25%.

It is important to remember that the flip side of incremental sales is switched sales. If 25% of the sales from a campaign are incremental (i.e., those sales would not have occurred unless there was a campaign) that means that 75% of the sales from the campaign would have occurred anyway, even if there was no campaign.

Solutions

After the factors discussed above are isolated the following analysis can be prepared:

Increment @	10%	15%	20%	25%
Total Sales	750,000	750,000	750,000	750,000
Incremental Sales	75,000	112,500	150,000	187,500
Switched Sales	675,000	637,500	600,000	562,500
MP% Incremental	0.29	0.29	0.29	0.29
MP% Switched	(0.07)	(0.07)	(0.07)	(0.07)
MP$ Incremental	21,750	32,625	43,500	54,375
MP$ Switched	(47,250)	(44,625)	(42,000)	(39,375)
Net MP$’s	(25,500)	(12,000)	1,500	15,000
Fixed Expense	100,000	100,000	100,000	100,000
Campaign Profit/(Loss)	(125,500)	(112,000)	(98,500)	(85,000)

So, unfortunately, even with sales of $750,000 the proposed marketing campaign evaluated at different “reasonable” levels of incrementality is not profitable. The above system is designed to bring together all of the relevant increments and decrements associated with Marketing’s campaign/promotion.

“Increment @” shows the rate of different increments from 10% to 25%.

“Total Sales” is Marketing’s sales estimate for the campaign.

“MP% Incremental” is the promotional rate of Marginal Profit which is 29% and was discussed above.

“MP% Switched” is an interesting and important factor that is often overlooked. As explained above, the “normal course” business has a rate of Marginal Profit that is 36%. The promotional rate of Marginal Profit is 29%. The promotional rate is seven (7) percentage points less than the normal course rate. Because switched sales would occur anyway without the campaign/promotion, it means that what is lost on those sales for exposing those sales to the promotion is seven (7) percentage points of Marginal Profit.

“Net MP$’s” is the sum of incremental and switched Marginal Profit dollars.

“Fixed Expense” is the fixed cost for the campaign/promotion.

“Campaign Profit/(Loss)” is “Net MP$’s” minus “Fixed Expense”.

It should be obvious that there is severe downward profit pressure on one-off campaigns and promotions and without proper consideration of the factors discussed in this paper the tendency is to lose money. Of course, there can be reasons to make this kind of investment (i.e. accept a loss), such as an investment in the acquisition of new customers and their lifetime value (a topic for another time).

In the end, based on the factors assumed in this business case and assuming the best rate of incremental sales (25%), the campaign/promotion would have to generate $5,000,000 in sales to breakeven. At a 25% increment (see above) the rate of Net Marginal Profit is 2% ($15,000 / $750,000 = 0.02). Therefore $100,000 divided by 2% = $5,000,000. This sales level is 6.6X the current estimate from Marketing. Clearly, this proposal needs to be analyzed further before it is executed.

Implementation/Conclusion

The method discussed here is a reliable way to evaluate the potential in marketing initiatives and to make good decisions about spending marketing dollars. In most, if not all cases, the sales required to justify incremental marketing expenditures are much larger than originally contemplated. The company’s marketing leadership should be asked to challenge their assumptions in the context of this tool and present this analysis when asking for additional spend. Additionally, the company’s financial leadership should be asked to determine the company’s normal rate of Marginal Profit and the promotional rate of Marginal Profit for marketing promotions.

Before marketing spend proposals are put forth both Marketing and Finance need to agree on the factors discussed in this paper.

This business case is an example for illustrative purposes only. FEOD is not responsible for company results or other actual results that could occur as a result of using the methods and observations discussed in this business case example.

Other Case Studies

Allowable Up-front Recruiting Expense

Analyzing/Planning the P&L Using Marginal Profit

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Make Good Decisions About
Spending Money On Marketing