What you need to know to make smart financial decisions on marketing costs
Not long ago, I counseled officers of a fast-growing information technology firm on how to create a marketing budget. The company was generating tremendous margins, and its officers had a good grasp of their operating expenses. The hurdle confronting them was an inability to determine how much the company should spend on marketing. An elegant solution was needed.
I worked out a formula for the company, based on profits per unit. The formula had two distinct advantages. It enabled leaders to understand what they could spend on marketing. And, they now could rein in company managers pushing to spend a lot more on marketing than was justifiable.
How-to calculate your annual marketing budget
There’s a cost associated with marketing efforts, but your dollars are finite. Your company must establish a ceiling on how much it will spend on marketing over the course of the year. While it’s not often easy for start-ups to identify a marketing budget, they can establish a hard stop on marketing costs.
In start-ups, the money for marketing will come from start-up funds. Those funds may be from your own savings, or from moneys obtained from family or financial backers. Because these are important funds, they must be spent wisely.
That means addressing key costs in areas from lead generation to use of social media, from lead conversion to content creation.
But ultimately, the crux of the matter is your sales volume and margins. The question upon which marketing spending decisions hinge for start-up companies is, very simply, “How fast will the company’s sales volume and margins grow?”
As important as it is for start-up companies to get a handle on marketing costs, it’s equally important they don’t spend a disproportionate amount of time on that task. The overriding aim is to begin attracting customers and sales.
For established businesses, financial models can make the challenge of determining a marketing budget for the coming year much easier.
They already have profit-and-loss statements, and those statements can provide information that can be used in models to determine optimal marketing spend.
We know now why it is important to identify the amount a company will spend on marketing in the next 12 months. In the next blog, I will present a simple way to determine how much you can spend in the coming year.
Misclassified expenses and un-segregated revenue streams result in poor financial reports that can halt a company’s progress in its tracks
It’s hard to make informed decisions about a company’s future based on poorly- structured financial reports. Yet many small to mid-sized companies rely on reports beset with serious problems. No wonder these firms aren’t growing.
One common problem with financial reports is that the reporting system is capturing a variety of product or service revenue streams in one account. Without those streams being segregated, the CEO doesn’t know what areas of the business are doing the best and worst jobs of generating critical revenues.
Another all-too-frequent issue is misclassification of expense categories into overhead, rather than cost of goods sold. As a result, companies get a read on gross profit and gross margin that is simply not accurate.
For example, if a company wants to launch a new marketing program, officers will attempt to determine how many additional sales the program will have to generate to justify its cost. If they don’t have an accurate read on gross margin, they will make a decision based on skewed sales numbers. That could result in the marketing program being over or under-funded.
These financial reporting issues are very prevalent, and are present in four out of every five companies I counsel. The problems exist for two reasons.
First, company officials don’t know how to distinguish between direct costs to produce sales and those line items that should go into the category called “overhead.” Second, despite their desire to place all transactions in the right categories, the companies do a poor job of coding, or classifying, transactions.
Unless the company addresses these reporting issues, the CEO will face the same problems month in and month out.
He or she must take a stance and rectify the reporting problems. If the CEO is smart, he’s going to say, “We have a direct cost of generating these sales dollars in overhead. They should be in cost of goods sold.”
The result of poor financial reporting is wasted time. The company wastes time pulling financial statements together, and again wastes time being forced to pull information out of the accounting system into a format that can be used. Precious hours and days that could be used to concentrate on building profitable sales growth go down the drain. In this case, wasted time truly is wasted money.
In the preceding paragraphs, I’ve discussed the surprising prevalence of poor financial reporting, and the negative outcomes that result. In my next blog, I will address steps chief executive officers can take to meet the problem head on.
Now is the time to get started on financial projections for the coming year, and these are the fail-safe steps that will help you do just that.
Remember the story I told in my last blog, the one about the CEO who doubled his sales as a result of projections? That CEO was focused on revenue streams. That’s where all projections have to start. You must determine what your revenue streams will be, either by service or product line.
Total revenue or total sales over the course of a year don’t just happen. Three ingredients go into generating those revenues. The first is the number of customers your company has. The second is the transaction frequency, or how often your company is expected to do business over the next year with each of those customers. And the third, of course, is the average transaction value. If you had a hundred customers and did business with each 10 times a year, with the average transaction $1,000, you’d have sales for the year of one million.
The other thing to focus upon is the velocity of these sales transactions. Velocity is likely to move up and down over the year, and you’ll have months or seasons where velocity is comparatively higher than at other times. Your company won’t record the same level of sales each month, so give thought to how that will vary.
The next step in the approach is to establish the gross margins of each revenue stream. The gross margin is a very, very important number in your financial statement, and a topic into which we’ll delve more deeply in a future newsletter.
In order to make informed future financial decisions, you must know the gross margin. That’s a combination of looking at the direct costs to produce each revenue stream, and adjusting your sales prices as needed to hit your targets.
Let’s define direct costs, as opposed to overhead costs. A direct cost is any expense related to generating that sale and delivering it to the customer, while overhead costs are not directly related to that sale.
The final step is studying overhead needed to generate revenue streams. Most businesses, I think, let overhead be where it is, realizing it will cost so much to generate those revenues. Some CEOs will take it a step further, saying, “No, let’s allocate a portion of overhead to each of those revenue streams.”
The result of projections is peace of mind for business owners, because they’ve laid out a plan. If you’d like a plan for the year ahead, get in touch with me.
I offer a 100 percent guarantee on my work. I take on only clients I can help. Call me and let’s talk about your business. My phone number is 630-269-7646.