I'm convinced that half of what I spend on advertising is wasted. I just don't know which half.

This comment, often attributed to George Washington Hill, the mercurial former CEO of the American Tobacco Company in its early years, pretty well summarizes the dilemma most advertisers find themselves in when it comes to budgeting.

"How much should budget for marketing?" is a question Spiro & Waites frequently encounters when counseling prospective clients. There is no one simple answer. Fortunately, there are some rules of thumb to determine the right budget level for you and your organization.

The three fundamental methods of budget setting are:

The Percentage Method. You determine your current or projected gross sales and dedicate a percentage to marketing.

The Task Method. You set your communication goals and determine how much it will cost to accomplish them.

The Lifetime Value Method. You determine the average lifetime value of a new customer and dedicate a portion of that amount to winning the new customer.

The Lifetime Value Method

Let's start with the third method. It usually is used in direct marketing but can be modified for general marketing. You apply a formula that combines the profitability of a customer over the period of time that he or she can be expected to do business with you, the anticipated response rates from your advertising or mailings, and the anticipated rate at which responders can converted into customers. This tells you how much you can afford to invest in creating a new customer and what it will take to make that happen.

For example, assume the average new customer will spend $600 with you each year she is a customer and that the average length of time a customer stays with your company is five years. This tells us that that the average lifetime value of a customer is $3000. If the average profitability is 30%, the total amount of profit that customer generates is $900. Let's assume you want to put $150 of that in your retained earnings. That leaves $750 available to invest in acquiring that new customer.

It would be nice if you could send someone $750 and that would guarantee they would do $3000 worth of business with you. Since it doesn't happen that way, we need to look at what it takes to get a new customer. You start this end of the equation with your average conversion ratio. What percentage of people who respond to your advertising typically become customers? Let's say it's 33 percent. (Depending on your business, it could significantly higher or lower.) Now we calculate that you must get three inquiries to get one customer. You can afford to invest $250 to get an inquiry.

Next, let's figure out what it costs to get an inquiry. Do this by calculating how many inquiries a dollar of advertising can generate. As indicated earlier, usually this formula is used in conjunction with direct mail efforts, so printing and postage costs play a role. Figure out what your creative, production, printing, postage and premium costs will be and divide by the total number of pieces you will mail. Let's say your cost is $1 per piece in the mail. If you mail a test of 2000 pieces at a cost of $2000, you must get three new customers (3 x $750=$2250) to pay off your investment. At a 33 percent conversion rate, you must get nine inquiries, or a response rate of 45 percent (.0045).

So, you mail your 2000-piece test to a list of names you believe will be responsive to your offer. If you meet your response and conversion targets, you know you have a success. Since you know every dollar you invest will return more than a dollar in new business, you can set your budget based on how much business you want to generate. Of course, you have to be able to acquire a larger list of people with the same characteristics of your test group. This approach also works in print and electronic advertising, based on the audience the medium reaches, but only if the medium focuses tightly on a productive target group, and only after testing.

Some marketers will say that you also gain awareness and residual business from the exposure of the public to the advertising. But the real test of this budgeting method is hard sales that can be tracked directly back to the direct marketing effort.

William Dueease of Aspen Business Group in Fort Myers offers a variation on this method that he calls Customer Acquisition Cost. He points out that a new business doesn't necessarily know what the lifetime value of a customer will be. In this case, the business owner must base the value of the customer on the average invoice amount. The number of additional sales the business wants to make times the amount the business is willing to pay to make each sale, based on the gross profit of the sale, then determines the budget.

The Percentage Method

Now let's return to the more common approach of setting a percentage of gross sales as your advertising budget. Typically, this percentage ranges from 2 to 10 percent depending on the product or service category and the position of the company in its business cycle.

According to Ned Barnett, senior vice president and partner of Notch/Bradley in Las Vegas, "I've used a rule of thumb ... of 2.5 percent to 7.5 percent of gross revenue collected, for established businesses, and 10 percent of desired gross collections for start-up businesses. The range roughly follows the life-cycle curve."

I recommend that start-up companies or companies that are introducing new products and services use a higher percentage of projected sales in order to establish some momentum, and to take advantage of news and growth. Cash cows, on the other hand, who are on the down side of their business cycle, should coast on a lower, maintenance percentage. This recognizes that most of the growth has happened and makes the most of the profitability that remains in the product or service.

Barnett, whose company specializes in healthcare communications, adds, "Like all rules of thumb, this leaves 8 or 9 fingers waving around ready to muck up the calculations ... lots of variables." Some of these variable are the different requirements of different business categories.

Grocery stores tend to spend a lower percentage of gross than do jewelry stores, as a function of their dollar volumes and their average mark-ups. Companies with extremely large gross sales tend to spend a lower percentage because the base is so high. A smaller percentage gives them a budget with enough critical mass to make a competitive impact. Companies with lower gross sales have to plan on a larger percentage, or their efforts may disappear in the competitive stew.

The Task Method

The remaining method is based on the communication objectives of the business. You simply decide the audience you want to reach and what media and message it will require to reach them. That determines how