Paid ads are generally a great way to generate leads, traffic and sales but as the saying goes, the dose makes the poison. How much should you be spending?

Here’s the TL;DR: If you’ve an ecommerce business doing paid ads for the first time, plan for roughly a 10% cost of sale. Eg: if you are doing $500k per year, look to spend about $50k/ per year in ads.

Now that’s a gross oversimplification and there are plenty of examples of businesses that spend $0 or close to $0 (Apple, Tesla) on advertising and there’s plenty of examples of businesses that seem like they’re entirely advertising (RedBull, Liquid Death). Our experience typically comes from direct to consumer (DTC) brands and eCommerce retailers so if your business is something that looks/smells closer to a dtc ecommerce brand, it’ll probably be closer to that figure.

This is somewhat of a spin on the previous blog that we wrote on “What is a good ROI” and there’s not really a formulaic answer, but here are the ways to think about it.

Variable Costs, Margin & Profitability

There’s some pretty simple math that you can use to make sure that you’re evaluating costs so that, at bare minimum, you’re not delving into unprofitability, or losing money for every sale you make.

Variable Costs

Cost of Goods Sold
Shipping/Order Fulfillment Costs
Shrink

Revenue Generated

Product Revenue
Shipping Revenue
Tax Collected

So the simple version of this formula is:

Variable Costs + Advertising Cost <= Revenue

Otherwise, you’re losing money for each sale you’re making.

If you want to get even more complex about how you want to consider profitability and make your accountant happy, you can also consider other annual fixed costs, spread across the year. Payroll, asset depreciation, contractor fees, etc… all factor in. Get familiar with your Profit & Loss statement and what level of profitability you’re targeting.

Considerations for Information and App Based Businesses

Are you in the business of selling 1’s and 0’s rather than atoms? Apps, eBooks and Digital Education products are great examples where you’ve in the unique situation where there’s effectively 0 variable cost of sale. This allows you to be very aggressive with your ad dollars as you’re basically running a 100% margin product. You can factor this into your marketing spend accordingly.

Considerations for Inventory

If you’re not so lucky as to have infinite and intangible inventory, you’ve got to consider your inventory position. We’ve worked with a lot of seasonal businesses and if you’ve got a buy-and-hold style inventory that’s got to last you the whole season, you might want to consider reducing your ad budgets at times when you’ve got great sales velocity and limited inventory. Paid ads accelerate sales, but if your inventory is moving along and you’re on schedule to run out of product to sell early, it’s probably not likely that you’ll need to lean harder into paid ads.

“Weeks of Supply” is something to consider and it’s always a good idea for your paid ads team to be in coordination with your merchandising and inventory teams to make sure you’re not over-selling.

Growth Goals

Let’s revisit the chart from the previous blog post on determining a “Good” ROI:

As you reach saturation of your messaging in a given market, the efficiency of that message is likely to decline. Now, profitability isn’t necessarily the correct short term goal for every organization. Infamously, there are plenty of startups that reach billion dollar valuations who’ve never been profitable - they’re in the market capture phase of their business growth. A small business or new DTC brand or VC funded organization is looking to invest in an organization’s future may be looking at more aggressive goals than a small mom & pop operation that’s not looking to scale beyond the 4 walls of their current business.

Strength of Brand & Product, Competitive Moats

It may be odd coming from a paid ads agency, but brand strength is something that also affects the need to do paid advertising. As you can imagine, there are some staple brands that everyone knows about: Ferrari, Gucci, Apple. While they may need to accelerate messaging around specific events or product launches, paid digital ads are not likely to be a big part of their sales process.

In a similar fashion, if your product or service is new, unique or the absolute best, you probably have customers lined up around the block to pay for your doodad. If you’re the only plumber in town, everyone with a leak already knows your phone number.

Brand and Product-market-fit are both examples of competitive moats that make it easier to retain and acquire customers. Facebook’s network effects is a great example of a competitive moat that reduces their need for advertising. There’s only one Facebook or Instagram (although TikTok and possibly Nostr are nipping at their heels) so you don’t have an option but to use the social media that everyone else is using.

Considerations for New Businesses

So this all sounds great, but you’ve never run any paid ads before - how do I know how much to spend? What we typically recommend is to set an experimental budget and backwards engineer your test budget based on conversion rate. You can use a model like this to estimate how much you’d need to spend to get a few conversions and understand what your unit economics are going to look like:

link to this sheet here - feel free to make a copy and adjust

Play with the blue highlighted rows to see what 1000 clicks will cost you and how many conversions and conversion rate you can expect.

Conclusion

Generally speaking, you’re wanting to spend as many ad dollars as possible while maintaining strong return, profitability and acceleration of inventory. There’s a lot of levers and toggles to play with to get the right mix, so feel free to reach out if you need some help.

Small Business Series #8 - Developing a Marketing Budget