Ontario business

Methods of Establishing a Budget

Each of the various ways in which to establish an advertising budget has its advantages and constraints. No method is perfect for all types of businesses, nor for that matter is any combination of methods.

Concepts from several traditional methods of budgeting have been combined into three basic methods: percentage-of-sales or profits; unit-of-sales; and objective and task. You will need to use judgment and caution in choosing your method or methods.

Percentage of Sales or Profits

The most widely used method of establishing an advertising budget is to base it on a percentage of sales. Advertising is as much a business expense as, say, the cost of labor and, thus, should be related to the quantity of goods sold.

The percentage-of-sales method avoids some of the problems that result from using profits as a base. For instance, if profits in a period are low, it might not be the fault of sales or advertising. But if you stick with the same percentage figure, you will automatically reduce your advertising allotment. There's no way around it: 2% of $10 000 is less than 2$ of $15 000.

Such a cut in the advertising budget, if profits are down for other reasons, may very well lead to further losses in sales and profits. This, in turn, will lead to further reductions in advertising investment, and so on.

In the short-term, a small business owner might increase profits by reducing advertising expenses, but such a policy could lead to a long-term deterioration of the bottom line. By using the percentage-of-sales method, you keep your advertising in a direct relation to your sales volume. Therefore, if sales increase your advertising should increase accordingly. Gross margin, especially over the long run, should also show an increase, of course, if your advertising outlays are being properly applied.

What percentage?
You can guide your choice of a percentage-of-sales figure by finding out what other businesses in your industry are doing. These percentages are fairly consistent within a given sector of business.

Knowing the advertising sales ratio for your industry will help you align your expenses with those of your competitors. You must be careful however, not to base your entire budget on these figures. Your particular situation may require you to advertise more or less than your competitors. You may feel that, at this point in your business life cycle, it is important to spend more than average on advertising. The decision is ultimately yours. After all, growth requires investment.

No business owner should let any method bind him or her. It may be helpful for you to use the percentage-of-sales method because it is quick and easy. Not only is it a sound method for stable markets, but it may also keep your advertising budget from getting way out of proportion. Note: if you are looking to expand your market share, you will probably have to use a larger percentage of sales toward advertising than the industry average.

What sales?
Your budget can be determined as a percentage of past sales, of estimated future sales, or as a combination of the two:

Past sales
Your base can be last year's sales or an average of a number of years in the immediate past. Consider, though, that changes in economic conditions may cause your figures to be too high or too low.

Estimated future sales
You can calculate your advertising budget as a percentage of your anticipated sales for next year. The most common pitfall of this method is an optimistic assumption that your business will continue to grow. You must always keep general business trends in mind, especially if there is the chance of a slump. Remember to assess the directions in both the industry and your own operation.

Past sales and estimated future sales
The middle ground between an often conservative appraisal based on last year's sales and an often overly optimistic assessment of next year's, is to combine both. This method is generally more realistic during periods of changing economic conditions. It allows you to analyze trends and results as well as predict future sales with a little more accuracy.

Unit-of-Sales

In the unit-of-sales method, you set aside a fixed sum for each unit of product to be sold, based on your experience and trade knowledge of how much advertising it takes to sell each unit. For example, if it takes two cents' worth of advertising to sell a case of canned vegetables and you want to move 100 000 cases, you will have to spend $2 000 on advertising. If it costs X dollars to sell a refrigerator, you will have to budget 1 000 times X to sell one thousand refrigerators. Using this method you are simply basing your budget on units of sale rather than dollar amounts of sale.

Some people consider this method just a variation of percentage-of-sales. However, since unit-of-sales is based on what experience tells rather than an overall percentage of your gross sales estimate, it is probably a more accurate estimate.

The unit-of-sales method is particularly useful in fields where the amount of product available is limited by outside factors, such as the weather's effect on crops. If that's the situation for your business, you must first estimate how many units or cases will be available to you. Then, you advertise only as much as experience tells you it takes to sell them. Thus, if you have a pretty good idea ahead of time how many units will be available, you should have minimal waste in your advertising costs.

This method is also suited for specialty goods, such as washing machines and automobiles; however, it's difficult to apply when you have many different kinds of products to advertise and must divide your advertising expenses among these products. The unit-of-sales method is not very useful in sporadic or irregular markets or for style merchandise.

Objective and Task

The most difficult (and least used) method for determining an advertising budget is the objective-and-task approach. Though it is more complex (and therefore less attractive) than other methods, this approach is the most accurate and therefore best method for determining your budget.

It relates the appropriation to the marketing task to be accomplished.

It relates the advertising appropriation under usual conditions and in the long run to the volume of sales, so that profits and reserves will not be drained.

To establish your budget using this method, you need a coordinated marketing program with specific objectives based on a thorough survey of your markets and their potential.

While the percentage-of-sales or profits method first determines how much you'll spend without much consideration of what you want to accomplish, the task method establishes what you must do in order to meet your objectives. Only then do you calculate its cost.

You should set specific objectives, not just "Increase sales" but, for example "Sell 25% more of product X or service Y by attracting the business of teenagers". Then determine what media best reaches your target market and estimate how much it will cost to run the number and types of advertisements to meet your sales target. You repeat this process for each of your objectives. When you total these costs, you have your projected budget.

You may find that you can't afford to advertise as you'd like to. It's a good idea, therefore, to rank your objectives. As with the other methods, be prepared to change your plan to reflect reality and to fit the resources you have available.