Question

Critics of the percentage-of-sales method of budget setting contend that this method “reverses the advertising and sales relationship” and that it “treats advertising as an expense rather than an investment.” Explain what these arguments mean and discuss their merits

Answer 1

The Percentage of Sales Method is a Financial Forecasting approach which is based on the premise that most Balance Sheet and Income Statement Accounts vary with sales. Therefore, the key driver of this method is the Sales Forecast and based upon this, Pro-Forma Financial Statements (i.e., forecasted) can be constructed and the firms needs for external financing can be identified.

The percentage-of-sales method is used to develop a budgeted set of financial statements. Each historical expense is converted into a percentage of net sales, and these percentages are then applied to the forecasted sales level in the budget period. For example, if the historical cost of good sold as a percentage of sales have been 42%, then the same percentage is applied to the forecasted sales level. The approach can also be used to forecast some balance sheet items, such as accounts receivable, accounts payable, and inventory.

The basic steps to follow for this method are:

1. Determine whether there is a historical correlation between sales and the item to be forecasted.
2. Estimate sales for the forecast period.
3. Apply the applicable percentage of sales to the item to arrive at the forecasted amount.

The advantages of the percentage-of-sales method are as follows:

• It is the quickest way to develop a forecast.
• It can yield high-quality forecasts for those items that closely correlate with sales.

Disadvantages

• Many expenses are fixed or have a fixed component, and so do not correlate with sales. For example, rent expense does not vary with sales. Many balance sheet items also do not correlate with sales, such as fixed assets and debt.
• Step costing may apply, where a cost is variable but will change to a different percentage of sales when the sales level changes to a different volume level.

Now if we talk about one of the simplest yet most effective ways to find out what role advertising played in a purchasing decision is to ask the customer who made the purchase. Advertisers may also use promotions that contain a unique identifier to help business owners compare the effectiveness of two or more ads. The advertiser places a print ad that contains a coupon with a specific discount code in one publication and a different discount code in another. By tracking the codes as customers redeem their coupons, the advertiser can determine which advertisement generated the most sales.

Hereby I don’t agree with this “treats advertising as an expense rather than an investment”.

The term investment implies that you are going to earn money back while expense is something where you are going to loose something. We can’t measure the true return on everything we spend money on. You pay the electric bill in your business because you need power to light up your store or office. You need power to operate your computer. Those expenses are really impossible to measure your return on because you need power, right. But advertising and marketing, those are also important. Those are the tools to invite people to spend money with you. Unless people spend money with you, you are not likely to last very long. Companies that view Advertising as a necessary business investment generally tie budgets to goals. For instance, a new business looks at goals like creating awareness and building a brand image, and then budgets an amount necessary to accomplish this objective. This typically leads to higher allocations to advertising than companies less proactive in this area.

To justify Advertising as an investment, you need a way to measure your return. The challenge is that you can't always use financial methods as you would with other investments. You have to compare results to tangible marketing goals. For instance, if your goal is to increase company or brand awareness by 20 percent in one year, you can use awareness surveys and studies to gauge the results after a marketing campaign. With sales growth objectives, you can actually track increases in sales resulting during and after promotional periods.

So basically in a short run you may consider Advertising as an expense but ideally Advertising play a crucial role in marketing which create Brand image, product awareness and make the best impact on buyer and that return as increment in sales figure. In today’s scenario where buyer have so many options to choose advertising become very important and it helped back of the mind of buyer and when they make decision to buy the goods it helps in decision making.