Is Advertising Worth it? How To Calculate the ROI of Advertising. avatar
Is Advertising Worth it? How To Calculate the ROI of Advertising.

The short answers is: Yes, advertising is worth it! BUT…

For most small and medium sized businesses (SMB), advertising is a knee jerk reaction, not something well planned out, and much of it is wasteful and ineffective for a number of different reasons. First let me say that I define a successful ad campaign as one that generates more cash for a business than it consumes. If you run an ad in the paper that costs $500 but only 1 new person called you and they only spent $200 on your products or services, that’s ineffective advertising that consumed more cash than it generated for your business –that serves nobody well! Cash is the lifeblood of any business and running advertising campaigns that are cash flow drains will put you in the poor house!

Some might argue that even if it wasn’t successful financially you still created brand awareness and you can’t really measure that. There are times when you do want to create awareness, but the majority of SMBs need the phone to ring, they need cash flow, not brand awareness.

The goal of advertising is to support sales and contribute positively to the financial results of a business. It’s important to hold your advertising accountable (see our call tracking post for measuring leads) and make it pay for itself. You wouldn’t keep an employee around that wasn’t contributing, so don’t keep advertising around that isn’t contributing either. So to answer is advertising worth it, we start the accountability process by building a simple financial model to help us better understand how advertising affects our business.

The goal of this post is to provide a simple financial model with which you can use to measure the financial success of any ad campaign and decide for yourself if the advertising you’re doing is worth it? You can build this model using Excel.

Although the majority of my work these days is in Internet marketing, the case example I present below is with two direct mail campaigns. One is a relatively inexpensive postcard campaign, and the other a more expensive direct mail piece. However, you can use this model for any advertising you do to understand whether it’s positively contributing to the financial success of your business, whether that is Internet advertising through Google Adwords, or Yelp advertising, or any advertising where your goal is to drive sales.

Build a Financial Advertising Model

So let’s compare a postcard campaign where each postcard costs $0.35 each, and a more expensive direct mail piece that costs $1 each. Here’s the hypothetical total campaign cost:

Is Advertising Worth It?
Example cost of two different advertising campaigns.

So you can see the postcard is much less expensive but the hope is that the more expensive direct mail pieces will produce better results. Postcards are relatively inexpensive at a per unit cost. The question you should be asking is, will either of these produce positive financial results? And will the more expensive direct mail piece garner that much more of a response to make the extra cost worthwhile?

The more expensive direct mail piece could be variable data direct marketing letters printed on more expensive paper, for example. In the direct response marketing world personal letters generally have better response rates. So let’s continue the analysis.

Advertising Response Rate
For direct mail typical response rates are in the 1% – 3% range.

A response rate between 1% – 3% is reasonable, but this will obviously vary depending on the components of the piece, i.e. your offer, the CTA (call to action), a sense of urgency, effective headlines, your mail list etc. In our hypothetical example the Expensive Direct Mail Piece has produced twice as many leads or phone calls versus the postcard (this is not necessarily the case, just an example).

So next lets calculate hypothetical sales of each advertising campaign.

Average Order Direct Marketing Piece
Hypothetical average order.

If our average order size is $50 then we’ve achieved double the sales with the more expensive direct mail piece. The question is, is adverting worth it? Lets drill down further and calculate our net sales which is where we make the campaign pay for itself.

Net Sales of Advertising Campaign
Make the advertising pay for itself by subtracting the cost of the campaign.

So we can see right away in this particular case the net sales of the postcard were better, $750 versus $0. But was it still worth it to run the postcard campaign with net sales of $750? How did this affect the financials of our business?

To answer that question we need to take into account what it cost to produce those goods and services that were sold. Let’s assume we have a 50% profit on what is sold, then the cost of goods sold (COGS) would be half of sales. So back to our example, assuming we now have 50% gross margin:

Net profit from advertising campaign.
Subtract your Cost of Goods Sold (COGS) from your Net Sales

In the postcard example, our total revenue was $2,500 and if COGS was 50% our gross profit would be $1,250. So our net sales are $750 after we paid for the campaign, but then subtracting the COGS (in the postcard example, 50%*$2,500) we are actually negative $500 ($750 – $1,250). It’s even worse with the Expensive Direct Mail Piece which has put us in the hole $2,500!

These data are important. If you stopped the analysis at the forth chart which was calculating just your net sales you would have incorrectly concluded yes to the question, is advertising worth it? You may have assumed, the campaign paid for itself and generated positive cash flow but the COGS expense makes this not such an attractive campaign.

Build a model like this for yourself. It won’t take you much time at all and if you submit a comment here I’ll email the Excel spreadsheet to you. Play around with the numbers to understand what milestones you need to hit to make an advertising campaign successful.

So is advertising worth it? In our example neither case was, but yes advertising is worth it. The key is to understand which advertising campaigns are positively adding to the financial success of your company, and making them accountable.

Questions? Have you tried this or something similar before?

Is Advertising Worth It?
Is advertising worth it? What is the ROI of advertising? Build your financial model.