Q: My CPA has advised me to budget 5 percent of gross sales for advertising, but this seems like a pretty generalized guideline. Is there a better way to calculate an ad budget?
A: You're a very perceptive business owner. Budgeting 5 to 6 percent of total sales for advertising and another 5 to 6 percent for rent is the traditional wisdom. But as you suspected, this old formula is more tradition than wisdom, and it often results in too much or too little spent on advertising.
The purpose of advertising is to increase the exposure of your business beyond what is provided by your physical location. Yes, advertising and rent are both paid from the same bank account, and they both contribute to your overall visibility. True wisdom adjusts the ad budget by both the markup and the rent. Here's how to do it:
Step 1: Calculate 10 percent and 12 percent of your projected annual gross sales and multiply each of these dollar amounts by the markup made on the average transaction. This will give you an adjusted budget range for total cost of exposure.
In this first "adjustment" step, it's important to remember that we're talking about markup, not margin. Markup is gross profit expressed as a percentage of cost. Margin is gross profit expressed as a percentage of the selling price. Sell an item for $150 that costs you $100, and your markup is 50 percent. Your margin, however, is only 33.3 percent. This is because the same $50 gross profit represents 50 percent of your cost (markup) but only 33.3 percent of the selling price (margin). Most retail stores in America (carpet, jewelry and so on) operate on an average markup of approximately 100 percent, though some stores operate on as little as 50 percent markup and others add as much as 200 percent. More expensive items, such as cars, recreational vehicles, houses and the like, carry a markup of only 10 to 15 percent.
Step 2: Deduct your annual cost of occupancy (rent) from the adjusted 10 percent of sales number and the adjusted 12 percent number.
Step 3: The remaining balance in the 10 percent column represents your minimum, and the balance in the 12 percent column represents your maximum, allowable ad budget for the upcoming year. At this point in the calculation, you may learn that your business is spending a large part of the allowable ad budget on rent, or you may learn that you should be doing a lot more advertising than you had previously suspected.
Now let's calculate an ad budget together. Assume that my business is projected to make $1 million in sales this year, I have a profit margin of 48 percent, and my rent is $36,000 per year. The first thing to do is to calculate 10 percent of sales and 12 percent of sales. In this case, that would be $100,000 and $120,000, respectively.
Second, we must convert my 48 percent profit margin into markup, because markup is what we've got to have to make this formula work. (Most business owners know their margin by heart, but never their markup.) To make the conversion from margin to markup, we simply divide gross profits by cost. Dividing $480,000 (gross profits) by $520,000 (hard cost) shows us that a 48 percent margin represents a markup of 92.3 percent. Bingo.
Now we multiply $100,000 by 92.3 percent to see that our adjusted low budget for total cost of exposure is $92,300. Likewise, we multiply $120,000 by 92.3 percent to get an adjusted high budget for total cost of exposure of $110,760. From each of these two budgets, we must now deduct our $36,000 rent. This leaves us with a correctly calculated ad budget ranging from $56,300 on the low side to a maximum of $74,760 on the high side.
Most organizations will tell you that 5 to 6 percent of gross sales is the correct amount to budget for advertising, but don't you believe it. It simply isn't possible to designate a percentage of gross sales for advertising without taking into consideration your average markup and your cost of occupancy. Yes, expensive rent for a high-visibility location is often the best advertising you can buy, since a business with a good sign in a high-visibility location needs to advertise significantly less than a similar business in an affordable location.
To prove this, just look at our example above and change the rent to $75,000 per year. The ad budget would now range from $17,300 to $35,760, representing only 1.7 to 3.5 percent of sales.
This formula works because it reconciles your ad budget with your rent budget and considers the profitability of your average sales; it adjusts your advertising by both your markup and rent.
Nicknamed "the Wizard of Ads" by an early client, Roy H. Williams and his staff have often been the unseen, pivotal force in amazing come-from-behind victories in the worlds of business, politics, and finance. Williams is the author of The Wizard of Ads, Secret Formulas of the Wizard of Ads, Magical Worlds of the Wizard of Ads, Accidental Magicand Free the Beagle.
The opinions expressed in this column are those of the author, not of Entrepreneur.com. All answers are intended to be general in nature, without regard to specific geographical areas or circumstances, and should only be relied upon after consulting an appropriate expert, such as an attorney or accountant.