Advertising - Where Does It Generate the Profit

By: Michael Gallagher
Former District Director
North Dakota District Office

In our last newsletter we showed the effect of price increases on the bottom line – profit. Many small businesses believe that the quickest way to a profit increase is increased sales. They also believe that the fastest way to increase sales is to advertise.

In this article we will look at an example where we are going to invest a few dollars in advertising and see what can actually happen. What do we advertise and why? If you were going to spend money to make money - profit, it would seem that you would want to try to sell those items that make you the most money - profit. In our example Profit Off Sale Inc., a bottle shop, we can look at two situations. In the first one we increase our spending on advertising and show an increase in sales. Although sales increased, we show less profit.

Profit Off Sale, Inc. (Figures 1 and 2) - We increase advertising from 3% of sales to 4% of sales with a resultant increase of 5.9% in sales, but we lost money. Why? The cost to advertise exceeded our contribution margin. In other words, we sold the wrong things.

Figure 1
Sales   $450,000
Cost of Goods Sold 79% $357,390
Gross Profit   $92,610
     
Operating Expenses    
Rent 4.0% $18,000
Utilities/Phone 1.3% $6,000
Salaries 5.6% $25,000
Payroll Taxes/Benefits 1.1% $5,000
Advertising 4.0% $18,000
Professional Services 0.9% $4,200
Supplies 0.7% $2,940
Depreciation 0.8% $3,700
Repairs/Maintenance 0.7% $3,200
Insurance 1.2% $5,400
Misc. 0.2% $1,000
Total Expenses 20.5% $92,440
     
Net Profit   $170

 

Figure 2
New Sales $450,000
Original Sales $424,800
Increase in Sales $25,200
   
New Advertising Costs $18,000
Old Advertising Costs $12,744
Increase in Advertising $5,256
   
New Profit $170
Old Profit $240
Increase in Profit -$70

In this first example (Figures 1 and 2), we increased our sales in the same proportion as they were before we advertised. In other words, we used a general marketing and advertising approach which sold more products. All products sold - beer, wine, liquor and misc. - increased, but the margin or amount that each sale contributed to the bottom line was not sufficient to pay for the advertising.

In our second example (Figures 3, 4, 5 and 6) we spent the same amount of money, but targeted our advertising to the areas where we would achieve the greatest result, wine sales. This resulted in an increased profit.

Profit Off Sale, Inc. (Figures 3, 4, 5 and 6) - We spent the same amount on advertising and ended up with the same level of sales. But look at the profit. What was the difference? In this case the advertising was targeted to wine sales and the increase in sales came from that department. With the higher margin for wine, we not only paid for the additional advertising costs, but also increased our profits by about $3,000.

Figure 3

Department % Sales Beginning Inventory Purchases Ending Inventory Cost of Goods Sold CGS% Inventory Turnover
Beer 48%  $216,000 $12,240 $183,100 $11,740 $183,600 85% 15
Wine 18% $81,000 $6,075 $49,350 $6,825 $48,600 60% 8
Liquor 29% $130,500 $13,539 $107,965 $13,189 $108,315 83% 8
Misc. 5% $22,500 $3,375 $16,975 $3,475 $16,875 75% 5
Totals   $450,000 $35,229 $357,390 $35,229 $357,390 79%  

 

Figure 4
Sales   $450,000
Cost of Good Sold 79% $354,105
Gross Profit   $95,895
     
Operating Expenses    
Rent 4.0% $18,000
Utilities/Phone 1.3% $6,000
Salaries 5.6% $25,000
Payroll Taxes/Benefits 1.1% $5,000
Advertising 4.0% $18,000
Professional Services 0.9% $4,200
Supplies 0.7% $2,940
Depreciation 0.8% $3,700
Repairs/Maintenance 0.7% $3,200
Insurance 1.2% $5,400
Misc. $0.2% $1,000
Total Expenses 20.5% $92,440
     
Net Profit   $3,455
     

 

Figure 5

Department % Sales Beginning Inventory Purchases Ending Inventory Cost of Goods Sold CGS%
Beer 46%  $207,000 $11,730 $175,450 $11,230 $175,950 85%
Wine 21% $94,500 $7,088 $57,450 $7,838 $56,700 60%
Liquor 28% $126,000 $13,073 $104,230 $12,723 $104,580 83%
Misc. 5% $22,500 $3,375 $16,975 $3,475 $16,875 75%
Totals   $450,000 $35,265 $354,105 $35,265 $354,105 79%

 

Figure 6
New Sales $450,000
Original Sales $424,800
Increase in Sales $25,200
   
New Advertising Costs $18,000
Old Advertising Costs $12,744
Increase in Advertising $5,256
   
New Profit $3,455
Old Profit $240
Increase in Profit $3,215

This example (Figures 3, 4, 5 and 6) has a lot of numbers. I offer the calculation of Cost of Goods Sold (CGS) so that you can follow the step by step approach to how your contribution margin is calculated. Beer sales offer only $0.15 from every dollar of sales to your contribution margin. In other words, for every dollar of beer that is sold you only have $0.15 to use for advertising, labor, overhead costs and all the other expenses including you profit. Wine sales offer $0.40 for each dollar. Contribution margins vary a great deal from business to business and product to product within a business. It is important to understand the dynamics in your business. The numbers are meant only to illustrate the fact that increased profit in a business is a result of better management and analysis of how your business functions. Profit results when you know your business and know what effects your decisions will have on the bottom line. As the business owner, it is your responsibility to know the business and make informed decisions. Profit is generally not an accident.


Mike GallagherMike Gallagher joined the U.S. Small Business Administration in 1984 as a Business Development Specialist.  He was chosen as the Deputy District Director in 2005 and was the District Director from November 2013 to January 2017.  A graduate of the University of North Dakota, Mike is a Certified Public Accountant and a former business owner.  The SBA North Dakota District Office can be reached at north.dakota@sba.gov.