There are a few simple ways to calculate how much you should spend on marketing, and I’m going to share with you how we do it for our own business today.
First, the typical method is by researching what other businesses are doing. The average recommendation is that 7-8% of your gross revenue should be spent on marketing and advertising, and for small businesses, the recommendation is actually a little bit higher than that. Therefore, now that we know the average recommendation, we can forget about it and move on 🙂
It’s not bad to know the general assertion because it can provide an idea of what’s going on in the market, but it’s not that accurate because your ambitions, goals, and products are different than someone else’s, which means you have to analyze a couple of factors regarding your business before you can identify how much to invest in marketing.
What Is Marketing?
Marketing and advertising are almost always considered to be the same thing. I’m not going to go on a whole rant about why that is and why it’s wrong. However, I’ll say this: Marketing pretty much IS your business. Advertising is only one part of many that are considered within your marketing/business plan.
I make this point because it’s important we know what we are referring to when we say “marketing.” Moreover, for most small businesses, what we are really asking is: “How much money should I spend to get one lead or to acquire one new customer?” And that is precisely the answer we seek, which we are going to answer today.
(For purposes of this article, marketing is defined as: the sum of the deliberate and unintentional choices the people who work in and on the business make every day.)
Answering The Better Question
We cannot talk about the cost of customer acquisition without mentioning pricing. There is a whole science behind pricing and how to do it well. However, we will only discuss your personal analysis that will determine the cost of your being and staying in business.
You either already have a business, you sell products/services and you want to determine if you should spend more or less on lead generation, or you are starting out and trying to decide how much to spend on your next marketing move.
Let’s begin with established businesses
First, identify the Lifetime Value (LTV) of the product/service you want to promote. For example, if you are an IT company that sells a service for $100 a month and the average client stays with your company for 18 months, then for that specific service, the lifetime value of the customer is $1,800.
On the other hand, you may be selling a vacuum cleaner for $600 and then never see the same customer again (very unlikely, but let’s assume this is the case for the sake of the example). Hence, the lifetime value for a customer, for that specific product is only $600.
(It is very likely that a client will purchase multiple products/services from you due to the virtue of already doing business with you. Therefore, there are cross-overs between products, and you should consider that in your calculation. Our example is intentionally simplified, so that anyone can easily understand.)
Since you are already in business and are selling, it means you are already spending money on acquiring customers, and your goal is to determine how much that is. This determination is not difficult to do, but it may just take a little bit of time to calculate all of the expenses. Things you should consider as expenses for delivering one of your products/services are the costs of employees (including yourself), the cost of goods, the cost of delivering the goods or services, and your overhead costs. A lot of businesses don’t know their numbers accurately. Therefore, consider taking time to self-analyze all of your expenses for a specific product/service and then add at least 10-20% profit for the business.
Considering our first example of the IT services company, in a perfect world, you will be able to calculate that all of your expenses and operational costs are $1,300, your business generates $300 profit from each customer, and the $200 is what you currently spend to acquire a new customer.
The truth is that as you go through the calculations, trying to attach a dollar value to each aspect of your business’ product/service, as you should, you will find that in the end, there would be factors that are difficult to account for. Therefore, you will have to estimate a few numbers and test them with your efforts to validate that they are correct, and/or you may need to make some adjustments accordingly.
Also, you want to consider including a 5-10% buffer for factors that can go wrong unexpectedly with a specific customer. Depending on the product/service and deal value, a 2% buffer may be enough, while in other deals you will need your buffer to increase it to 15%. This is when you should use your knowledge and expertise relating to that specific business to make that determination.
Now that you know your numbers, you can clearly see whether you are pricing your products/services well enough, and how much you should spend on lead generation and customer acquisition.
Consider that you can spend and profit as much as the market is willing to pay, which means that increasing your price by 20%, for example, is perfect if people are still buying and you are not engaging in any type of unethical price gauging behavior. On the other hand, increasing prices too much can actually prove to be counterproductive if it makes consumers stop purchasing. That’s when you want to test price levels in practice in the specific market and with the target audience you seek to serve. You can experiment with various prices, as well as with different pricing techniques.
Scaling costs you. Remember that!
There is one more variable you have to consider: the cost of scaling. It’s a myth that the more customers you serve, the more money you make. While in some cases it may be true, most of the time you will find that the more customers you serve, the more money you need to invest in people (i.e., employees) and systems. As you scale your business, this doesn’t necessarily mean that your overall dollar value in profits decreases, but it could cause your percentage of profit to decrease.
For new products or businesses
If you are starting as a solopreneur, or launching a new product/service, then the calculation of your optimal marketing costs is very easy. However, you will have to make a lot more agile adjustments as you engage with the market.
First, decide how much money you want to make for each hour you work. If your goal is to produce a $100k income every year, and on average there are 255 working days in a given year, then assuming you work 8 hours a day, you should make $50 an hour. This amount is what your business pays you for your hard work.
Keep in mind that, realistically, when you start a new business, you won’t be making what you ideally anticipated (or $100K, in this example) as an income in your first year (in most businesses, at least). However, you want to keep your hourly rate in mind, so you can price your products/services correctly.
Therefore, calculating the price for a product/service should be as follows: your hourly rate times the number of hours it will require you to complete the job, then add your overhead costs, costs of goods and of employees (if any), and remember to include a 10-20% profit for the business and a reasonable buffer to deal with the unexpected when it happens.
Considering all of the above, add on top of it a reasonable amount to invest in acquiring new customers. Since you are just starting out, it all may feel very abstract, which it is. So as you engage with the market, be willing to make major adjustments quickly until you find your sweet spot.
The Benefits Of Knowing Your CPA
I’m not referring to your accountant; I’m talking about your Cost Per Acquisition.
The benefit of understanding how much it costs you to acquire a customer means you can potentially scale much faster.
Let’s consider our first example, a $1,800 LTV (lifetime value), after all of the expenses, the business is left with $200 to acquire new customers. This really means that the business can allow itself to offer up to a $200 discount or referral fee. Also, the business can spend as much money on advertising or other lead generation transaction, as long as the Coat Per Acquisition (CPA) does not exceed $200.
If It’s That Easy, Then Why Is It So Hard?
It may look like a dream: theoretically, you can spend $200K to acquire 1,000 new customers that will bring the business $1.8 million dollars in revenue and will result in a $250K profit (on average, considering our first example).
The problem is that it’s not that easy to discover a lead generation mechanism that can consistently and predictably keep on producing the same results. You also need to consider your market size, and how many people are ready and willing to buy your product/service now if they knew about it. It takes time to build trust in the marketplace. It takes time to achieve product-market fit, and the more you scale, the less money your business makes from a percentage perspective.
What To Do Next In 2 Steps
If you know your numbers or are just starting out, then congratulations: you have accomplished Step 1!
Now on to Step 2: take a certain dollar amount, make the calculated bet of how many customers that money can buy you, and begin growing your business. As you proceed with caution, learn to recognize opportunities. If you find a customer acquisition tactic that works predictably, then go full in. You never know when it will stop working, and like everything in life, you must be willing to constantly adapt, innovate, and change.
Good luck! We hope this article provided you with some clarity on the issue of how to calculate your marketing budget. Feel free to ask a question or reach out.