Working from your P&L to your AdWords budget is a complicated process. Pie isn't complicated, it's delicious. So, we use one to fix the other!
There's a common mistake made when reading a P&L for figuring out how much to spend on a paid channel like AdWords but, to demonstrate the error, I'm going to have to buy some pie, which I'm heading to do right now. With our pie safely acquired, we're ready to take a look at how this is usually done. Imagine this pie represents the entirety of your revenue and from this, we're going to start subtracting all of our known costs. We're just going to look at fixed overhead.
This includes rent on your office, salaries for your employees and other costs like software and IT expenses. Next, the big one; cost of goods sold. In order to sell something, you have to buy it originally or have it manufactured and that's going to make up a large portion of this pie. Then there's always going to be additional fees such as; merchant fees or credit card processing fees that are going to be taken out as well, at the end.
Now, we are looking at that slice and that slice represents two major things that are left. That is profit and our marketing budget and so, when you're slicing up the pie like this, you end up looking at those two as adversarial. You're considering, "Well, the more I spend on marketing, the less I'm going to keep in profit." That's totally misunderstanding how marketing budgets work and what they do. They're intended to drive top line sales and therefore, you have to treat marketing budgets as an input, whereas, this entire approach treats it as an output.
Now, a P&L is totally an accounting tool and is very important and critical to understanding how your business is turning a profit but it's not a predictive tool. It really should be used forensically against months that have already closed and you can use it to sort of get an idea of what's coming if you assume that the future will be like the past but if you're actually planning budgets, it's much better to work the other way around.
Take the same ratios that might be in your P&L but treat them as a way of assessing any piece of given revenue. To start off with, we're going to need to start with a new pie. Now, this time, instead of taking the pie, which still represents all of our revenue, and trying to extract out costs, we're going to assume that some of those costs are just baked into every single dollar that is this pie so things like fixed overhead aren't a slice, they are the crust and so, it's present throughout the entire pie, no matter how you slice it.
Now, we're going to simplify things a bit and pretend that there are just two types of traffic and therefore, two types of revenue. Those are paid, such as PPC, email or social and then unpaid, such as, organic, direct or phone sales, depending on how your attribution works. The first thing we're going to do is separate this pie into those paid and unpaid segments. For simplicity, we'll assume that you have 50% of your revenue coming from paid channels and 50% coming from these non-paid channels.
Because you have to pay for products before you can sell them, regardless of what channel may generate the traffic originally, we're going to remove cogs from both sides. Finally, we still need to take care of those transactional fees like credit card processing and potentially shipping if it wasn't part of the cog slice. These two slices combined, represent your gross margin. That puts an obvious ceiling on how much you should possibly spend on any marketing activity because, if you spend more than your gross margin, you will lose money by definition.
However, you also don't want either of these two slices to go entirely to marketing spend and the reason is, within just the paid slice for example, if you spent more than just this sub slice, then you are going to lose money on that segment and would have been better off not running those channels at all and so, we end up with a pretty good, hard, fast ceiling on the maximum amount we would ever want to potentially spend on paid channels.
We know we don't want to spend more than that because it doesn't produce any profit. We also don't want to spend too little because then we won't generate enough revenue in the first place and so, there's an economy of scale that we're aiming to balance, obviously. Spend too little, you don't generate enough revenue. Spend too much, you don't generate enough profit. I'd love to tell you that there's a magic formula that finds that point of diminishing returns for your business but it varies so much.
Ranging from what your margins are, to your conversion rate, to what your competitors are doing in the space. Within retail, I generally see about 30% of the gross margin allocated as marketing budget. That's a great number because it's less than 50%, half of the margin was what our little paid slice was. We knew we didn't want to go beyond that. Now obviously, because 30% of the gross margin is less than 50% of gross margin. That's where our profit comes from that channel.
Then we look at a potential gross margin after advertising cost, of the remaining slice of the paid, plus the unpaid side. That's all well and good, assuming that your paid and your non-paid channels are about equal, which is a nice, healthy ratio but, if your organics are smaller than that, then all of a sudden, your overall profitability goes down because that organic gross margin slice is gone. What do you do? You don't have as much organic as our little pie example had. Then, 30% of your overall gross margin is going to be much, much smaller because it's going to be 30% of a slice that's mostly that paid channel.
There are two paths from here. One aggressive, one more conservative and finding the right one for you is going to depend heavily on your business context. The more aggressive position is to spend a larger percentage of your gross margin, perhaps something that's comparable to what you would have been spending if you had had the organic there to pad your total gross margin number. Instead of just 30% of your gross margin, you might need to use 60% of your gross margin in order to bolster the budget based on the fact that you don't have that organic revenue coming in.
The more conservative approach is to continue to stick to that 30% number, knowing it's going to be much smaller, knowing that's going to limit your top line revenue growth but if you're spending that time to short the defenses on your unpaid and organic side, then it can be worth the trade off because once you get down to whatever that slice is, if you then compare that slice that represents your advertising budget against the size of the total pie, you get a percent of revenue that you're willing to spend on ads.
We refer to this as a cost of sale number but, it's effectively the reciprocal on the return on ad spend and is represented, as I mentioned, as a percent. This makes it very easy to compare it to a margin percentage and it communicates much more effectively than a row-as number, exactly how much you're spending of your revenue. Now, if you look at this pie, you see that it has both organic and paid mixed in. If we're just looking at a paid target for example, in an AdWords account, you need to take into account, the full context.
If you can target 8% of revenue overall, that can be subsidized by that organic slice, to double it, effectively. Right? Because if half of it is not paying for the traffic and half of it is, and you can pay 8% overall, then that means you can pay 16% and still come out spending the correct amount overall. Another way to go about it, instead of doubling your paid target is to treat your organic channel as if it were a paid channel and instead of allocating dollars to an ad spend for it, you allocate those dollars to content generation to, technical SEO work on the site.
Basically, anything that goes back into trying to make that segment grow and, while that might be limiting what you could have potentially spent on AdWords, it can result in a more interesting and healthy marketing mix. If you're ready to get started on the next step, which is applying this to your actual business with something a little bit more precise than me badly cutting a pie, we have a COS worksheet that's just a spreadsheet, that you can actually work through and identify what different changes to your marketing spend would have on your overall profitability, not just revenue. It's a little bit speculative but we found it to be very, very predictive for most mid-market retail accounts. I will include the link in the description and I hope you take a look. It's quite a handy tool. Now, if you'll excuse me, I have about six pounds of pie to eat.