To determine what you should be willing to spend on marketing, you need to consider:
- Lifetime value of the customer
- Fixed Costs
- Variable Costs
- Marketing Costs
Here’s an example of an existing company that manufactures widgets.
Each month you sell 1,000 widgets at $15 each for total revenue of $15,000.
Your variable costs – sales commissions, utilities, costs of goods, and manufacturing labor – are $6/widget.
Your fixed costs – insurance, rent, administrative staff, salaried employees, benefits – are $7/widget.
So your total costs are $13/widget and profit $2/widget for a total profit of $2,000/month.
Let’s say Walmart comes along and says – we love your widgets and would like to buy 500/month from you for $12/widget.
Should you do it?
At first glance, it looks like your cost/widget is $13 so you would lose money on the deal.
However, if you don’t need a bigger facility (i.e. rent doesn’t increase) or more office staff or more insurance, then you should absolutely do the deal!
Here’s why.
Your fixed costs haven’t changed so even though you paid $7/widget in fixed costs for the first 1,000, every additional widget pays $0 in fixed costs until you reach full capacity.
In other words, your cost to sell your 1,001st widget is only $6. If you sell that widget for $12, your profit is now $6/widget up until you reach capacity and need larger facilities and more office staff.
If we look at the big picture, you sell 1,000 widgets per month at $15 and 500 per month at $12. Your revenue is now $21,000/month and your profit is $2,000 on the first 1000 widgets and $3000 on the next 500 widgets for a total of $5,000/month.
Your profit just jumped 250% even though your sales only went up 40%.
So if you’re looking to invest in new marketing, any marketing that costs you less than $4/widget will allow you $2/widget in profit and is a good investment since you’ll still be able to maintain your net margins.
Keep in mind that $4/widget is now 1/3rd the cost of the widget which sounds like a big investment. However, if your marketing is generating a return it’s like handing someone $4 and them giving you $6 back. Who wouldn’t do that!?
Though many accountants consider marketing as a Fixed expense, we believe it should be Variable since the more you invest in marketing the higher your sales should be.
For a service business, like cleaning and restoration, simply replace widget with your service and the labor costs to deliver it. (Keep in mind your vehicle lease payments are a fixed cost but your vehicle maintenance and fuel are variable.)
Finally, you need to consider the Lifetime Value of the customer. If you spend $100 in marketing to get a customer that spends $50/month with your business and, on average, remains a customer for 2 years, your $100 in marketing generated $1200 in sales. As long as your net profit margins are at least 10% ($120/customer), then keep doing that marketing forever!
In summary, if you understand your Lifetime Value, Fixed Costs, Variable Costs and the Sales generated by each of your marketing campaigns, you can quickly determine how much to invest in marketing to keep growing your business.
