The Economics of Online Marketing

From this article, you’ll learn how to determine the efficiency of your online advertising efforts and how to calculate the maximum cost per click for those campaigns.

The basic economics of online marketing are simple: Determine the advertising efficiency needed to make your profitability goals, then buy all the inventory you can get your hands on.

But how do you determine the advertising efficiency needed to achieve your profitability goals? This article offers some practical formulas and advice.

Defining Online Advertising Efficiency

Ad efficiency comes down to a cost vs. benefit ratio: “What did I spend on advertising?” vs. “What did I get in return?”

The “What did I spend on advertising?” side of the equation is straightforward. The ad venue sends invoices; your accounting department tallies the funds you paid during a period.

But make sure the cost figures you use to compute efficiency match actual invoices paid. Some agencies and advertisers estimate costs via their own in-house click counts and average cost-per-click (CPC). These click and CPC estimates can differ from the authoritative costs provided by the search venue. Conduct occasional audits to ensure that the cost side of your online reports ties to your online ad bills.

The “What did I get in return?” side of the equation is more complex. Most marketers seek profit as their ultimate online marketing goal. Yet accurate profit numbers may be too hard to obtain or may be generated too far in the future. When this is the case, employ meaningful proxies such as cost per lead, cost per registration, cost per order, cost per new buyer, advertising-to-sales ratio, and margin-to-cost ratio as surrogates for actual profit.

Establish an A/S Target

Let’s continue using the advertising-to-sales ratio (A/S) as our profit surrogate. What’s the right A/S efficiency for your online business? Rule of thumb: Catalogers typically spend 80 percent of sales on cost of goods and marketing combined. The profit and loss statement logic here is that if marketing and cost of goods sold consumes 80 percent of sales, and variable selling expense and overhead each consume another 7 percent or 8 percent, then about 5 percent is left as pretax profit.

So a gift cataloger with a 50 percent average margin may select a 30 percent A/S for its ad efficiency target. A retailer with slimmer margins — say computers or electronics — would choose a lower A/S target.

If you sell products with widely differing margin structures, you may be wasting an opportunity if you apply a single A/S target to all your advertising efforts. Setting a single target may lead you to over-advertise your lower-margin products, while under-advertising your higher-margin products. To combat this, either fold actual margin data into your online marketing management process or apply different A/S targets at the product-category level.

Measure Sales

The denominator of the A/S ratio is sales dollars. But there’s more than one way to measure sales:

- Web demand sales measures sales as seen by your Web site.

- Booked sales measures sales that actually make it into your bank account (demand sales less frauds and cancels).

- Net sales reflects sales that actually stick (i.e., booked sales less returns).

These sales measures come bundled with various time lags, as frauds and returns take days and weeks to unfold.

For simplicity, most online retailers use Web demand sales —that is, sales as reported by the Web site — as a reasonable proxy for true sales. If the ratio of Web demand sales to booked sales is relatively constant during a period of time, track demand sales and use this ratio to accordingly adjust your financial models.

Sometimes this ratio isn’t consistent over time. For example, some online jewelry merchants experience large fluctuations in fraud attempts week to week. As frauds are detected after orders come through the Web site, they’re included in Web demand sales, making this measure less than accurate. In such cases, back out frauds from your Web demand sales.

Channel Spillover

Just as many retailers deflate Web demand sales by a percentage to account for frauds and cancels, many then inflate the result to account for spillover into their call centers and retail stores.

While a few firms (e.g., Ingenio, Jambo, VoiceStar, eStara) and search engines offer technology to track online clicks at the ad level into the call center via distinct toll-free numbers, these solutions still are new and costly and have yet to gain significant traction. But they will. Web-to-phone tracking and pay-per-call advertising will become essential for all online direct marketers during the next few years.

In the meantime, many online marketers use monthly call center surveys to estimate call center spillover (“May I ask how you heard about us today, sir?”). A handful of sites display different toll-free numbers to track clicks into the contact center at the gross engine level (i.e., visitors to the site from Google see one toll-free number, while those from Yahoo! see another).

Even fewer online direct marketers track store spillover. There are two reasons for this. First, many online direct marketers have no (or quite small) retail store networks — think Amazon, Overstock and most catalogers. Second, many large, national store retailers with strong online direct divisions still suffer from internal political struggles regarding channel importance and sales allocation.

This will change. In 2006, expect to see more national retailers providing Web visitors with offers and discounts via PDF barcoded coupons redeemable at retail checkouts. During the next few years, if you have stores, expect to be tracking the impact of specific Web promotions on your retail store sales.

Maximum CPC

Suppose you’ve determined an appropriate A/S efficiency target for your business, either overall or by product category. And suppose you understand how to adjust reported Web demand sales to mirror actual booked revenue — some downward tweaks to account for frauds and cancels, some upward tweaks to account for contact center spillover. Given accurate click counts, you can divide adjusted sales by clicks to compute average sales per click.

The relationship between what you can pay (max cost per click, or CPC), how your Web site performs (sales per click, or SPC), and your target efficiency (A/S) is simple math:

max CPC = A/S x SPC

For example, consider a retailer seeking a 35 percent ad-to-sales efficiency with a Web site that sells $120,000 online to every 100,000 qualified visitors. After tweaking Web demand sales to account for frauds, cancels and contact center spillover, she estimates her adjusted SPC to be $1.30. To hit her efficiency target of 35 percent, she must pay on average no more than 45 cents per click for those 100,000 visits.

Warning: Don’t Drive PPC Campaigns by Averages

While averages are useful to describe portfolio economics overall, they’re not helpful for the actual management of your online pay-per-click (PPC) search efforts. Averages apply to populations, not individuals.

Your actual SPC estimates will vary widely across your keyword portfolio. Different terms will have different SPC measures. And when you delve into it, you’ll find these term-level SPCs will vary with the ad copy, destination URL, season, day of week and time of day.

Returning to the previous example, that retailer may be able to afford an average 45 cent CPC across her portfolio. But many of her ads wouldn’t meet her efficiency target even at a penny per click, and a handful of her best ads easily would beat her A/S target, even at several dollars per click.

With online PPC advertising, the devil (and the profits) are in the details. Make sure your programs are managed at the keyword level, with smart bidding adjustments for copy, landing page, seasonality, time of day and day of the week.

What Kind of Customers?

Traditional catalogers know that buyer response rates drive profits. Accordingly, many catalogers spend more aggressively acquiring new customers, often running acquisition efforts at breakeven (plowing all gross margin obtained from new customers into marketing to new customers).

Track what fraction of your online customers are new-to-file. If you’re not doing so already, flag these names in your merge/purge to see how they dupe out against your housefile. If your online marketing efforts bring in a satisfactory rate of new customers, and these new customers have solid, repeat purchase rates, you can grow your business more rapidly by granting your online programs a lower efficiency (that is, a higher A/S), which in turn raises your maximum allowable CPC, letting you buy more traffic.

Online advertisers come into the online ad marketplace with their own goals. Some seek to build brand; some want sales growth, others look for profit. Whatever the goal for your company, determine appropriate efficiency targets and track your results carefully.

Alan Rimm-Kaufman, Ph.D., leads the Rimm-Kaufman Group, a service and consulting firm providing search marketing management and Web usability services to leading direct marketers. He can be reached online at www.rimmkaufman.com.