Every small business owner struggles with figuring out how to allocate their resources. Even if you’re profitable every year, you still need to balance your overhead against your desired profits.

With content marketing and social media use on the rise, it can be especially tricky to determine where your paid advertising budget should be. You want to make sure to spend enough to grow your business, but not so much that it ends up putting you in a financial hole.

We’re here to help. We’ll walk you through the process of determining the proper advertising budget for your business based on your sales and profit margins. The resulting number might end up surprising you.

Budget Calculation Basics

The first thing you need to do is figure out your total paid advertising budget. A lot of companies underspend or overspend on advertising. They may also be making unwise choices in terms of where to spend their budget, but that’s a separate topic.

The key to determining the amount of your budget is to factor your profit margins and mark-up into the calculation. Here’s a formula you can use to figure out your minimum and maximum allowable advertising budget.

  1. Calculate 10% and 12% of your gross annual sales. A company with a million dollars in sales would start with figures of $100,000 and $120,000.
  2. Divide your gross profits by the cost of the goods you sold to determine your mark-up. For example, if you paid $480,000 for products and made $520,000 in gross profit, you’d divide to figure out that mark-up is 93.7%.
  3. Multiply your two earlier figures (10% and 12% of gross annual sales) by 93.7% to determine your minimum and maximum budget for exposure. In this case, it would be $93,700 on the low end and $112,440 on the high end.
  4. From those two figures, subtract your annual rent. For example, say that your rent was $2,000 per month, or $24,000 per year. You’d end up with a low budget of $69,700 and a high budget of $88,440 on the high end.

These numbers can help you form the framework of your budget. You may decide that you want to stick to the low end of the budget, especially if it’s more than you’ve been spending. On the other hand, if you’ve been spending more than you should, it may be a challenge just to bring your spending down to the high end.

Return on Investment vs. Customer Acquisition Cost

It’s not enough just to set the proper amount for your paid advertising budget. You also need to crunch the number to ensure that the money you spend is getting the results you need.

Many small business owners focus on ROI (return on investment) as the number that determines whether an advertising campaign is a success. They figure if they end up making more than they spend, then they’re doing just fine.

We like to recommend a different strategy. Customer Acquisition Cost, or CAC, is an important number to keep in mind as you finalize your marketing budget.

You can determine the cost of acquiring a new customer by looking at your website’s conversion rate. Let’s use a simple example to illustrate the point.

Imagine a company that spends $50 for each visitor to its website. They might be paying for pay-per-click ads on Google or Bing, or even using Facebook advertising.

Once visitors land on their site, they’re converting 50% of those visitors to paying customers. That means that for every two customers who visit their site, they’re making a sale to one.

In this example, the CAC is $100. They spend $50 for each customer and convert one of every two. You can see why looking solely at the PPC rate is a mistake. This company is spending twice as much on CAC as they are on PPC. That’s a big difference.

Look at your current advertising budget and figure out what you’re actually spending to acquire a new customer. That can help you going forward.

Lifetime Customer Value

The last statistic you need to know to make the most of your advertising budget is the lifetime value of a customer.

Why does this number matter? Simply put, you need to make sure that the average customer’s lifetime value (LTV) is greater than the CAC. If it isn’t, you’re in big trouble.

Let’s continue with the example we provided in the previous section. If a company has a CAC of $100, they would need to have an LTV higher than that to justify the money they are spending on their PPC ad.

If their average sale is only $20, it means that a customer would have to make more than five purchases at that price to exceed the CAC.

To determine your average LTV, you’ll need to track customer behavior and figure out how many of your customers are buying from you more than once. You’ll also need to know how much they’re spending on your products or services over the course of their relationship with you.

Let’s say that the company in our example had an LTV of $150. Based on that number, they would know that their advertising dollars were being reasonably well spent. Every customer they acquire is spending, on average, more than it costs to acquire them.

On the other hand, if that same company had an LTV of only $75, it would demonstrate that they are not allocating their advertising budget wisely. They would need to take a hard look at their marketing strategy.

Regrouping and Strategizing

After you’ve crunched the numbers, the final step is to look at your advertising budget and determine what you need to do differently.

If you’re using Google AdWords, you should keep in mind that the top three paid options on the search results page get approximately 41% of the clicks. Instead of trying to compete for a top keyword, focus your attention on long-tail keywords that are less competitive.

You may also want to consider moving away from search engine advertising and reallocating your budget to social media advertising and other, more cost-effective options.

Conclusion

The key to making the most of your advertising budget is to make the most of each dollar you spend. Crunching the numbers can help you eliminate waste and maximize your profits.