Percentage-of-Sales Method: Advertising Budget Allocation

A comprehensive guide to the percentage-of-sales method, which is a procedure used to set advertising budgets based on a predetermined percentage of past or forecasted future sales.

The percentage-of-sales method is a procedure used to set advertising budgets, based on a predetermined percentage of past sales or a forecast of future sales. This method of budget allocation is popular with advertisers due to its simplicity and its ability to relate advertising expenditures directly to sales.

Understanding the Percentage-of-Sales Method

Definition and Characteristics

The percentage-of-sales method involves allocating a portion of a company’s sales revenue to its advertising budget. The percentage figure is typically determined by management, based on the industry’s average or the company’s historical or previous year’s advertising spending.

Types of Sales Considered

There are two primary types of sales figures considered for this method:

• Past Sales: Budget is set as a percentage of past sales, often the previous year’s sales figures.
• Future Sales Forecast: Budget is predicted as a percentage of expected future sales, often projected from market trends or company growth estimates.

Calculation Formula

The basic formula for the percentage-of-sales method is:

$$ \text{Advertising Budget} = \text{Sales Revenue} \times \text{Specified Percentage} $$

For instance, if a company has sales revenue of $1,000,000 and decides to allocate 5% of sales to advertising, the budget would be:

$$ \$1,000,000 \times 0.05 = \$50,000 $$

Setting the Percentage

The percentage allocated to advertising can be determined in several ways:

• Industry Benchmarking: Comparing to the average advertising expenditure ratio within the industry.
• Historical Data: Using the company’s previous advertising-to-sales ratio.
• Competitive Analysis: Analyzing and matching competitors’ advertising spends.

Advantages of the Percentage-of-Sales Method

Simplicity and Ease of Use

The percentage-of-sales method is straightforward and easy to implement. It does not require complex calculations or extensive data analysis.

Direct Relation to Sales

This method ties advertising expenditure directly to sales, making it easier to justify the budget in terms of revenue generation.

Limitations and Considerations

Variability with Sales Fluctuations

Since this method bases the budget on sales figures, a decline in sales may lead to reduced advertising in times when aggressive marketing might be needed the most.

Lack of Market Dynamics Consideration

The percentage-of-sales method does not account for changes in market conditions or the competitive landscape. It may result in underinvestment in advertising when market conditions demand more aggressive marketing.

Examples and Applications

Example Calculation

Consider a company with past annual sales of $2,000,000. If the management decides to allocate 6% of sales towards advertising:

$$ \$2,000,000 \times 0.06 = \$120,000 $$

Thus, the advertising budget will be $120,000.

Historical Context

The percentage-of-sales method has been widely used since at least the early 20th century, mainly due to its straightforward approach and ease of implementation in both large and small enterprises.

Comparisons with Other Methods

Objective-and-Task Method

Unlike the percentage-of-sales method, the objective-and-task method determines the budget based on the cost of achieving specified marketing objectives. This method is more precise but also more complex and time-consuming.

Competitive Parity Method

This method involves setting advertising budgets to match competitors’ spending. While it ensures competitive spending, it does not necessarily align with a company’s unique marketing needs and sales objectives.

Related Terms

• Advertising Elasticity of Demand: The responsiveness of sales to changes in advertising expenditure. Understanding this concept can complement the percentage-of-sales method by providing insights into the potential impact of advertising changes.
• Marginal Utility: The additional satisfaction gained from an extra unit of spending on advertising. Evaluating marginal utility helps in optimizing the percentage-of-sales by understanding diminishing returns.

FAQs

What is the ideal percentage to allocate to advertising?

There is no one-size-fits-all percentage. The ideal figure depends on industry norms, competitive positioning, and company-specific factors.

Can the percentage-of-sales method be used for other budget allocations?

Yes, this approach can be applied to other areas such as research and development, marketing, and production budgets.

References

1. Belch, G. E., & Belch, M. A. (2003). Advertising and Promotion: An Integrated Marketing Communications Perspective.
2. Kotler, P., & Keller, K. L. (2015). Marketing Management. Pearson.
3. Aaker, D. A., Kumar, V., & Day, G. S. (2000). Marketing Research.

Summary

The percentage-of-sales method offers a simple, straightforward way to allocate advertising budgets based on sales figures. While it ensures a direct correlation between sales and marketing expenditure, it also comes with limitations such as lack of market consideration and dependency on sales fluctuations. Understanding its pros and cons, as well as comparing it to other budgeting methods, can help companies make balanced decisions to optimize their advertising strategies.