In my last post, we talked about different strategies used to calculate your marketing budget. Today, I’d like to focus in more depth on your marketing budget using sensitivity analysis.
Sensitivity analysis is a tool using the contribution margin to play “what-if” games to optimize market performance. Sure, sensitivity analysis is used for lots of business tasks, but I’m focusing on using sensitivity analysis to predict the marketing tactics likely to generate the highest market performance.
First, let’s take a look at contribution and break-even analysis.
Break-even reflects the point at which your business neither makes a profit or loses money. Commonly, you look at break-even on a product by product basis (or service by service).
Break-even has the general formula of:
FC / (SP – VC)
FC = Fixed Costs like salaries, insurance, rent that don’t change based on how much product you make
SP = the price charged for the product (or the average selling price if the product sells for various prices over the time period of interest.
VC = Variable Costs that go into the product such as material, shipping, production labor that change directly with the number of products you make
It’s important to know that the denominator (SP-VC) is also called the contribution and is critical for sensitivity analysis.
So, let’s say you collect the following monthly expenses for a business that makes shoes. We’re interested in finding the break-even for a particular women’s flat shoe that sells for $125:
leather: $5.25 / shoe
ornaments: $2.63 / shoe
miscellaneous materials (thread, glue) $.63 / shoe
assembly labor: $9.24 / shoe
Licensing: $10,000 (per month)
Marketing budget: $2,000 (per month)
Supervisor salary: $3,685 (per month)
Now, let’s calculate break-even:
($10,000 + $2,000 + $3,685)/ ($125 – ($5.25 + $2.63 + $.63 + $9.24))
$15,683/ ($125 – $17.75)
$15, 683 / 107.25 = 146.2 or 147 shoes/ month is the break-even point.
Sensitivity analysis example
We can play all kinds of “what if” games now to test how changes affect our profitability using the contribution (denominator). For instance, we can see what happens if we decide to increase our marketing budget to $3000/ month. We can either calculate a new break-even number or use the contribution of $107.25 as a shortcut. Simply divide the extra marketing budget ($1000) by the contribution ($107.25) to get your new break-even.
The analysis shows we need to sell 10 (9.32) pairs of shoes to cover our additional marketing expenses. If we know, from past experience, that increasing our marketing budget by $1000 results in 12 more pairs of shoes sold, we’re ahead of the game to go ahead and increase our marketing budget. We’ll make 2 (the additional # of shoes sold over break-even) * $107.25 (our contribution) extra or $214.50 more by increasing our marketing budget.
Sensitivity analysis using Excel
Commonly, marketers use Microsoft Excel to conduct more sophisticated sensitivity analyses. Here’s what it might look like if we continued testing different optional strategies for our women’s flat shoe:
||Leather||Ornaments||Direct labor||Misc||Marketing||Licensing||Supervisor||Sales to BE||Profit if 200 sold|
|Increase leather price||125||5.75||2.63||9.24||0.63||2,000.00||10,000.00||3,685.00||147||5665|
|Increase labor expense||125||5.25||2.63||10.24||0.63||2,000.00||10,000.00||3,685.00||148||5565|
|Add 1000 marketing||125||5.25||2.63||9.24||0.63||3,000.00||10,000.00||3,685.00||156||4765|
You’ll notice, I sorted the spreadsheet based on the highest profits, assuming 200 pairs of shoes are sold. Of course, the assumption of how many shoes you’ll sell is based on your STRATEGY. For instance, increasing the price has the highest profitability, but you might not be able to sell 200 pairs at a higher price. Meanwhile, increasing your marketing budget might result in MORE than 200 pairs being sold. Hence, you’d have to adjust the profit column on a case-by-case basis using an estimate of likely sales under each strategic option.
Setting your marketing budget using sensitivity analysis
Using sensitivity analysis, you can set your marketing budget to correspond to the highest profitability. Now, you might assume profits continue to climb as long as you’re spending more money on marketing products, but that’s likely inaccurate. Likely, what you’ll find is that your profitability begins to level off (and may even decline) as your spending goes up — you’ll have to test this assumption using actual results at different spending points (alternatively, you can create a predictive model) to help calculate the optimal marketing budget.
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