One of the most common questions we get from small and medium-sized businesses is how much they should spend on their marketing program. We also hear complaints that they don’t know if their current spending is effective. This leaves business owners frustrated, often resulting in either under-allocating resources or investing in the wrong activities altogether. Ultimately, this can lead to underinvestment in valuable marketing tactics.

Many people in the marketing industry, as well as entrepreneurs, follow the guidance of spending a percentage of top-line revenue on marketing, typically between 4% and 15%. They determine their percentage based on available budget flexibility on their P&L (Profit & Loss Statement) and then make a bet in the interest of moving the needle across key business KPIs. But there’s a better way!

I’m a big believer in performance marketing and achieving a measurable return on investment (ROI) from your spend. I like knowing that every dollar invested has the potential to yield a return for my business. Most business owners would say the same—they’d be more willing to spend if they were assured returns. Of course, there are no guarantees in marketing or any other aspect of business, but making pragmatic choices about where to invest can provide more certainty and confidence in allocating precious resources to a critical function like marketing. So, what’s the best way to approach marketing budget development?

Start with goals

Every business should set clear, measurable goals across all its functional areas. We wrote a comprehensive document on goal setting to help with this, but let’s start with two of the most important goals for most businesses: top-line revenue and net profit.

• Top-Line Revenue ($) = Total revenue from all channels
• Net Margin (%) or EBIT ($) = Profit remaining after all costs, including the cost of goods, sales, and fixed expenses.

For marketing purposes, it’s best to start with goals directly tied to the business’s top line, typically represented by new customers. Virtually every marketing initiative will align with one of three core objectives:

                  1.             Acquiring new customers

                  2.             Retaining existing customers

                  3.             Growing revenue from existing customers

For some companies less focused on revenue, goals might include increasing daily active users (for SaaS) or expanding brand reach. However, we’ll focus on revenue-oriented goals, which are commonly used by growth-driven businesses.

Understanding customer value

It’s essential to understand the value of a customer to the business to determine what each of these objectives is worth. The most universal measure of this is Lifetime Value (LTV), which represents the total potential value of a customer. This calculation is usually based on historical data and accounts for customer revenue, cost of goods, and repeat purchases.

How to calculate lifetime value (LTV)

LTV represents the total potential spend of a customer in your business. It varies widely depending on the type of business and should account for loyalty and repeat purchases using average performance indicators from the past three years. Here’s a basic example:

LTV is the foundation of your budget. Next, consider your growth goal. If you’re aiming to grow revenue from $2M to $2.5M over the next 12 months, you’ll need new customers to meet this $500K target. With an average of $50K per customer, you’ll need approximately 10 new customers ($500K / $50K = 10), in addition to retaining your current 50 customers.

If your business relies on subscriptions or retainers, you may also need to replace any lost customers due to churn to reach your goal. Check out our Marketing Budget calculator, which accounts for both new wins and retention. For this example, let’s say we need to replace 50 churned customers in addition to acquiring 10 new ones, totaling 60 new customers.

Calculating customer acquisition cost (CAC)

In a perfect scenario, we’d establish a Customer Acquisition Cost (CAC), a measure commonly used by software and tech companies but valuable for any business. CAC is often calculated as a percentage of LTV. For example, if you decide to spend 15% of LTV on acquiring a customer, in our example, that would be $2,880 ($19,200 * 0.15) per customer.

CAC may include all acquisition costs, such as sales and marketing expenses. Many companies use a mix of sales and marketing costs with varying weights. We recommend factoring sales costs into your top-line calculations so that gross revenue and LTV account for these expenses.

The bottom line

To reach your stretch goal, your business needs to acquire 60 new customers. With a CAC target of $2,880, you should plan to spend up to $172,800. This represents the maximum budget, and if you can acquire customers at a lower cost, that extra efficiency will drive more profit to your bottom line. The next question, of course, is how to allocate these marketing resources. Check out our article on developing a killer marketing plan – and subscribe to keep getting this content in your inbox!