Breakdown Methods. There are a number of breakdown methods that can be helpful in determining promotion expenditures. Under the percentage-of-sales approach, promotion expenditure is a specified percentage of the previous year’s or predicted future sales. Initially, this percentage is arrived at by hunch. Later, historical information is used to decide what percentage of sales should be allocated for promotion expenditure. The rationale behind the use of this approach is that expenditure on promotion must be justified by sales. This approach is followed by many companies because it is simple, it is easy to understand, and it gives managers the flexibility to cut corners during periods of economic slowdown.
Among its flaws is the fact that basing promotion appropriation on sales puts the cart before the horse. Further, the logic of this approach fails to consider the cumulative effect of promotion. In brief, this approach considers promotion a necessary expenditure that must be apportioned from sales revenue without considering the relationship of promotion to competitor’s activities or its influence on sales revenues.
Another approach for allocating promotion expenditure is to spend as much as can be afforded. In this approach, the availability of funds or liquid resources is the main consideration in making a decision about promotion expenditure. In other words, even if a company’s sales expectations are high, the level of promotion is kept low if its cash position is tight. This approach can be questioned on several grounds. It makes promotion expenditures dependent on a company’s liquid resources when the best move for a cash-short company may be to spend more on promotion with the hope of improving sales. Further, this approach involves an element of risk. At a time when the market is tight and sales are slow, a company may spend more on promotion if it happens to have resources available.
This approach does, however, consider the fact that promotion outlays have long-term value; that is, advertising has a cumulative effect.
Also, under conditions
of complete uncertainty, this approach is a cautious one. Under the return-on-investment approach, promotion expenditures are considered as an investment, the benefits of which are derived over the years. Thus, as in the case of any other investment, the appropriate level of promotion expenditure
is determined by comparing the expected return with the desired return. The expected return on promotion may be computed by using present values of future returns. Inasmuch as some promotion is likely to produce immediate results, the total promotion expenditure may be partitioned between current expense and investment. Alternatively, the entire promotion expenditure can be considered an investment, in which case the immediate effect of promotion can
be conceived as a return in period zero. The basic validity and soundness of the return-on-investment approach cannot be disputed. But there are several problems in its application. First, it may be difficult to determine the outcomes of different forms of promotion over time. Second, what is the appropriate return to be expected from an advertising investment? These limitations put severe constraints on the practical use of this approach.
The competitive-parity approach assumes that promotion expenditure is directly related to market share. The promotion expenditure of a firm should, therefore, be in proportion to that of competitors in order to maintain its position in the market.
Thus, if the leader in the industry allocates two percent of its sales revenue for advertising, other members of the industry should spend about the same percentage of their sales on advertising. Considering the competitive nature of our economy, this seems a reasonable approach. It has, however, a number of limitations.
First, the approach requires a knowledge of competitors’ perspectives on promotion, and this information may not always be available. For example, the market leader may have decided to put its emphasis not on promotion per se but on reducing prices. Following this firm’s lead in advertising expenditures without reference to its prices would be an unreliable guide. Second, one firm may get
more for its promotion dollar through judicious selection of media, timing of advertising, skillful preparation of ads, a good sales supervision program, and so on. Thus, it could realize the same results as another firm that has twice as much to spend. Because promotion is just one of the variables affecting market performance, simply maintaining promotional parity with competitors may not be enough for a firm to preserve its market share.