How should we set our advertising budget?

The Advertising to Sales ratio is a measure of the proportion of a company's sales revenue that is spent on advertising. It is calculated by dividing the amount spent on advertising by the company's total sales revenue.

For example, if a company has total sales revenue of $1,000,000 and spends $100,000 on advertising, its Advertising to Sales ratio would be calculated as follows:

Advertising to Sales ratio = $100,000 / $1,000,000 = 0.10 or 10%

In this example, the company's Advertising to Sales ratio is 10%, which means that 10% of its sales revenue is being spent on advertising.

The Advertising to Sales ratio is a useful measure for companies, as it helps them understand how much they are spending on advertising relative to their sales revenue. It can also be useful for investors, as it can provide insight into a company's marketing strategy and how it is investing in advertising to drive growth. It’s also helpful when attribution is hard to measure, for example if the company is doing a lot of brand advertising, or if user-level tracking data is unavailable or unreliable.

The majority of companies use Advertising-to-Sales ratios to set marketing budgets because it’s a relatively easy and simple method which can be fully controlled by finance, requiring no domain expertise in marketing.

It allows companies to allocate a consistent portion of their sales revenue to advertising, which can help ensure that they are investing enough in marketing to drive growth. It also ensures companies avoid over- or under-spending on advertising relative to their competitors, as well as allowing straightforward comparisons between the advertising budgets of different companies, which can be useful for investors and analysts.

An alternative might be setting marketing strategy first, building a tactical plan based on that strategy, and using probabilistic modeling such as Econometrics (Marketing Mix Modeling) to estimate the potential future impact of each marketing channel. Based on the tradeoffs between volume and efficiency, marketers can choose the point in which they maximise the effectiveness of their marketing campaigns and advise finance on where that level is.

This strategy-first technique however requires advanced attribution and marketing domain expertise, and is open to bias given marketers are expected to justify their own costs using a technique finance might not fully understand. This is why the uncomplicated Advertising-to-Sales technique dominates marketing budget setting, with an estimated 90% or more companies using it, according to marketing professor Mark Ritson.

To use Advertising to Sales determine what marketing budget to set for next year, you first need to estimate what next year’s sales will be. To do this it’s common to use the CAGR, or the Compound Annual Growth Rate of the company, and extrapolate to apply the Advertising-to-Sales ratio to next year’s estimated Sales, assuming growth continues at the same pace.

CAGR is a measure of the average annual growth rate of an investment over a specified period of time. It is regularly used to measure the growth of investments such as stocks, mutual funds, and index funds, as well as company revenue.

CAGR is calculated by dividing the value of an investment at the end of the period by its value at the beginning of the period, and then taking the nth root of the result, where n is the number of years in the period. The resulting value is then subtracted from 1 to give the CAGR as a percentage.

For example, if the value of an investment starts at $1,000,000 and grows to $1,500,000 over the course of 3 years, the CAGR would be calculated as follows:

CAGR = (1,500,000 / 1,000,000)^(1 / 3) - 1 = 0.14 or 14%

In this example, the CAGR of the investment over 3 years would be 14%. Put another way, the value of the investment grew by an average of 14% per year, every year for 3 years.

CAGR is a useful measure because it helps investors compare the growth of different investments over time, regardless of their starting and ending values. It is often used in conjunction with other measures such as return on investment (ROI) to evaluate the performance of an investment.

As is common with startups, if you haven't completed a full year and need to estimate your CAGR run rate, you can use the following formula:

CAGR run rate = (current value / beginning value)^(1 / (number of months / 12)) - 1

Here's an example to illustrate how this formula works:

Let's say you have an investment that starts at $1,000,000 and grows to $1,100,000 over the course of 9 months, with the growth occurring evenly each month. To calculate the CAGR run rate of this investment, you would first need to divide the current value by the beginning value, which in this case would be $1,100,000 / $1,000,000 = 1.1.

Next, you would need to divide the number of months, which in this case is 9, by 12 months in a year, so the next step would be 9 / 12 = 0.75. Divide 1 by this number to get 1 / 0.75 = 1.33.

Finally, you would need to raise the result of the first step (1.1) to the power of the result of the second step (1.33), and then subtract 1 from the result. This would give you the following:

CAGR run rate = (1.1)^(1.33) - 1 = 0.14 or 14%.

Therefore, in this example, the CAGR run rate of the investment over 9 months would be 14%.

If the company has grown for several years and a partial year, the formula remains the same, other than adding the years to the partial year calculation. For example if you grew for 1 year plus 9 months, and arrived at $1,250,000, then you would add 1 year to the partial year of 9 months, which is 1 + 9 / 12 = 1.75, which you would divide into 1 as 1 / 1.75 = 0.57, and the rest of the formula is the same, for example you would divide 1,250,000 by 1,000,000, which equals 1.25, then take that to the power of 0.57, then subtract 1.

CAGR run rate = (1.25)^(0.57) - 1 = 0.14 or 14%.

Once you have the CAGR for your company, just take this year’s Sales and apply that growth rate, to get next year’s Sales. From there you can apply the Advertising-to-Sales Ratio to that figure, to determine next year’s marketing budget.

So for example if our CAGR was 14%, and last year’s Sales were $1,000,000, we would expect to hit 1,000,000 * (1 + 0.14) = $1,400,000 in Sales by the end of this year. That means we expect to reach 1,400,000 * (1 + 0.14) = $1,596,000 in Sales by the end of next year. If we look at the Advertising-to-Sales Ratios for our industry and find they are 10%, we would multiply 0.10 * 1,596,000 = $159,600 which we would allocate as the marketing budget for next year. Note that no marketing budget is set in stone: budgets are liable to be cut part way through the year if you aren’t hitting your growth targets, or can be negotiated upwards if you can convince finance that you have an opportunity for outsized returns.

The downsides of using Advertising-to-Sales Ratios to set marketing budgets is that it enables poor marketing practices, due to a lack of accountability for performance. If advertising budgets are always tied to total Sales, marketing budgets automatically increase even if it wasn’t marketing that was responsible for driving sales up. It also doesn’t take into account competitive moves in the market, for example if you use an outdated or category level Advertising-to-Sales benchmark, and your primary competitor doubles their budget this year without warning, you could be left with a much lower share of voice in the market. The recommendation is to use a combination of Advertising-to-Sales Ratios as well as Share of Voice benchmarking and bottoms up Tactical budget setting to triangulate a final budget.