What Should be My Company’s Marketing Budget?

Posted on May 9, 2011

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I get asked this question almost everyday; not just by startups but also by large established companies. When I ask them how indeed have they been deciding the marketing budget I get one of the two following answers:

  1. decide on the marketing tactic (search marketing, social marketing, event marketing, etc.) to use, determine (rather ad hocly) how much to spend on each tactic and thereby arrive at the marketing budget,
  2. decide (again rather adhocly) to spend a certain percentage of the revenue on marketing.

I find both these approaches rather unhelpful.

Suppose you are building a house. Would you simply commence construction having decided you want 2 bedrooms, 3 bathrooms, a kitchen and a living room or would you spend enormous time pouring over a number of plans, understand the relationship between the different rooms you need, discuss tradeoffs between smaller bedrooms & larger living room and a zillion other things? How then can you arrive at a marketing budget by merely throwing together a number of activities without any thought how these might help you achieve your business goals, how these activities would play off each other and what tradeoffs there would be of choosing one tactic over other.

The scond approach of marketing budget as a percentage of revenue is even more bizzare. Its like putting the cart before the horse. Is your marketing driving your revenue or is marketing simply a discretionary spend (like office parties) that needs to be reduced or eliminated when you are likely to miss the revenue target. I find it strange that business owners reduce marketing budget because they are likely to miss their revenue target. Shouldn’t they increase the marketing spend to help them reach their revenue target?

I recommend that business owners determine marketing budget much the same way they would determine budget for any capital expense. Business owners must assess the likely return on marketing investment to determine how much money should be allocated as marketing budget.

The size of your marketing budget is a function of

  • your previous year revenue,
  • the revenue growth rate you desire over the next 3-5 years, and
  • hurdle internal rate of return, i.e. the minimum rate of return on capital employed which a project must deliver for you to make the investment in that project.

Every business enjoys goodwill that allows it to earn certain revenue without making effort. This is variously called word-of-mouth, brand equity, reference sale, etc. I have found, depending on how unique its offering is, a business can generate between 50% to 70% of its previous year’s revenue without any additional effort. I call this goodwill revenue. However, since goodwill revenue delivers only a part of the current year’s target, the business has to earn the rest through its marketing program. If a business’ goal is to grow revenue by 30% over previous year, then a good marketing program is required to deliver 46% to 62% of current year’s revenue target. But a good marketing program does more than deliver current year’s revenue. It allows the business to replenish its goodwill reservoir so that it continues to earn an increasing amount of goodwill revenue in subsequent years. Another way of looking at it is that current year’s marketing budget impacts revenue beyond just the current year. In deciding the impact of current year’s marketing budget, businesses must value its impact on subsequent years’ goodwill revenue. This is usually done by discounting future goodwill revenue by the hurdle internal rate of return. The following table translates this discussion using some numbers:

Previous Year

Current Year

Subsequent Years

Year -1

Year 0

Year 1

Year 2

Year 3

Year 4

Year 5

Revenue(assumed growth rate of 30%)

100

130

170

220

290

380

490

Goodwill Revenue (assumed at 70% of previous year’s revenue)

70

90

120

150

200

270

Revenue impacted by Year 0 marketing budget

130 – 70 = 60

0.7*60 = 40

0.7*40 = 30

0.7*30 = 20

0.7*20 = 14

0.7*14 = 10

Discounted value of revenue impacted by Year 0 marketing budget (IRR assumed at 20%)

60

40/1.2 = 33

30/(1.2)^2 = 21

20/(1.2)^3 = 12

14/(1.2)^4 = 7

10/(1.2)^5 = 4

Total revenue impacted by Year 0 marketing budget

137

The final question that now needs to be answered is what is this total impacted revenue worth to the business i.e. how much are you willing to spend to earn the total impacted revenue. That is your marketing budget. The answer depends on the environment that the business finds itself in. For e.g. if you are in an environment where winning a large marketshare quickly is important then you might be willing to pay more than a unit for every unit of impacted revenue i.e. your marketing budget could be greater than 137.

I hope you find the approach I detailed more rational than just picking a number. I look forward to your comments and questions

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Posted in: On Marketing