September 4, 2013
SEM is unlike other marketing channels because you have the luxury of choosing your profit margins (by setting how much you are willing to pay for a sale) and you are effectively locked into the resulting customer volume. This is a very powerful aspect of SEM but one that requires some sensitivity analysis to ensure you are maximizing total profit.
Let’s say you sell premium WordPress themes online, and you sell each one for $30. Let’s assume you own the themes outright and there is no other direct cost involved with each incremental sale. So you can spend up to $30 to acquire each customer, but what should you be paying to ensure you make the most money? A lot of marketers fall into the trap of being complacent with an arbitrary profit margin, not knowing how much they might be leaving on the table. You could come to the conclusion that you want a 50% profit margin and so you are willing to pay a $15 CPA (cost per acquisition, a common term used in online marketing). Let’s say that at a $15 CPA you can acquire 500 customers each month. So each month you spend $7,500 to generate $15,000 in revenue and you are left with $7,500 in profit. This might sound great but you are ignoring many other combinations of profit margin and total profit, some of which will likely result in more total profit.
The Total Profit Curve
It requires just a little bit of math to understand how to maximize profit when using SEM. Total profit is simply total revenue minus total cost. If you were to graph total profit, it would be a concave parabola that has some “peak” which corresponds to the sales volume where profit is maximized. Not to dive too deeply into economics, but the reasoning for the shape of the total profit curve is because as you seek more sales volume your costs will increase because you need to “work harder” to find more customers and that causes an increase in cost and thus a decrease in profitability. This could be hiring more expensive employees, using more expensive marketing channels, etc. For the purpose of SEM, the reason for the increase in costs as volume increases is due to keyword pricing. To get more volume you have to bid more for keywords (which is equivalent to lowering your profit margin) in order for your ad to show up more frequently or in a higher position for those keywords. Below is an example of what the total profit curve might look like for our hypothetical WordPress theme business.
Graph of Total Revenue, Total Cost, and Total Profit
Profit Margin vs. Total Profit
Our total profit formula [Total Profit = Total Revenue – Total Cost] can be further written out as [Total Profit = Sales Volume * Revenue Per Sale * Profit Margin]. If you notice, you have complete control over all of the variables except sales volume, which is partially determined by you from your desired profit margin (effectively your keyword bids) and partially determined by Google’s keyword auction system that allocates you traffic based on your desired profit margin. And that’s the point of leverage. You can experiment with different profit margins and discover the associated sales volumes and resulting total profit.
From above, we know that when revenue per sale is $30 and profit margin is 50%, sales volume is 500 customers per month and total revenue is $7500. What we don’t know is how customer volume changes when we adjust profit margin. So what we have to do is adjust profit margin and take note of the effect on volume. For example, if we hold revenue per sale constant and changed the profit margin to 66.67% (we change our target CPA to $10), let’s say sales volume becomes 200 customers per month and so total profit becomes $4000 per month. That’s clearly undesirable because you just lost $3500 per month in profit. Let’s move the other way and reduce profit margin to 33.33% (target CPA now becomes $20) and let’s say this results in sales volume of 1000 customers per month and so you make $10000 in total profit. Note that this is better than our initial total profit, even though the margins are smaller. After you test various CPA targets, you will have a gauge of what kind of volume to expect and you can build a model like the simple one I’ve laid out below. You can see that of the five CPA targets, $20 is the one that results in the most total profit.
Easier Said Than Done
Testing profit margin and volume combinations is important because it helps you understand the total profit curve and where you should be positioning yourself, but like anything, this is easier said than done. While it won’t be better than your own observations from testing, Google AdWords has a really helpful tool called Bid Simulator that predicts click volume for a given keyword and bid input. So if you have solid conversion history you should be able to extrapolate what kind of sales volume you can expect at various bid levels.
Google AdWords Bid Simulator
It takes a lot of time, patience, and money to get the necessary data to understand how your target CPA will affect your sales volume, but it’s well worth it if your goal is to maximize profit. You might ask why anyone would not want to maximize profit, but you’d be surprised how many companies (big ones, particularly) don’t look at total profit as the most important metric when utilizing SEM for customer acquisition. That’s a topic for another post
Clarifying note: Desired profit margins determine CPA targets: [Target CPA = (1-profit margin) * Revenue Per Sale] which determine keyword bids: [Keyword Bid = Target CPA * Keyword Conversion Rate].