Misconceptions of Lower Cost

When it comes to Search Engine Marketing, there are a few basic metrics that advertisers tend to gravitate towards:  Impressions, Clicks, CTR, and Cost (Cost per click/lead/sale/etc.).

Today we are talking about costs and few of the common misconceptions:

The lower the cost per click, lead, or sale the better right? 

No, in fact, advertisers that approach SEM with this kind of mentality could essentially be paying so little that they are optimizing themselves out of a job!  How can this be?  Well, let’s take a look…

A few basic formulas:

Profit = Total Revenue – Total Cost

Total Revenue = Price per unit X Quantity

Total Cost = Cost per unit X Quantity

Imagine we have a shoe  advertiser who measures their success by looking at their Cost Per Sale metric or the cost of selling each pair of shoes.  We’ll call them advertiser A.  Currently they have a cost per sale of $10.

At a $10 CPS (cost per sale)  they were able to generate 100 shoe sales at a price of $30.

What does their current profit look like?
Profit = Total Revenue – Total Cost

Profit = (Price per unit X Quantity) – (Cost per unit X Quantity)

Profit = (30 X 100) – (10 X 100) = 3000 – 1000 = $2,000

The Director of Marketing at Advertiser A tells his staff “Let’s lower our Cost Per Sale, if we can cut it in half, our profits will double!”

Is the above statement True or False?

It depends.  In general, when it comes to SEM, you are able to lower your costs a few different ways (bid lower, use less keywords, increase your relevancy).  In most cases, advertisers will opt into the the first 2 options (bid lower and use less keywords).  This is the quickest and simplest approach, but not necessarily the best approach.  By doing this, essentially what you are doing is decreasing the amount of overall traffic that you are receiving because you are ranking lower on your ads (bidding lower) and not showing up for certain searches (use less keywords).

So let’s say advertiser A went ahead and lowered their cost per sale down to $5.  The effect of the them lowering their cost per sale decreased overall traffic to their website and in turn decreased the total sales down from 100 to 40.  But at least they cut their costs in half right?  Yes, but in doing so they also cut their profits in half!  Woah, how did profits get cut in half?

This is what their new profit looks like:

Profit = Total Revenue – Total Cost

Profit = (Price per unit X Quantity) – (Cost per unit X Quantity)

Profit = (30 X 40) – (5 X 40) = $1,000

So does this mean that you should be increasing your cost per sale?  Again, it depends.  If increasing your cost per sale will generate more revenue than cost, then yes.  If increasing your cost per sale won’t generate more revenue than cost, then no.  You have to find the cost per sale that will generate the most profit for your company.

So how do you maximize profits?

You maximize your profit when the growth rate of total cost equals the growth rate of total revenue.  In economic terms:  Max Profit is when MC=MR (Marginal Cost is equal to Marginal Revenue)

 

 

 

 

 

 

 

 

 

 

 

How can Advertiser A Maximize Profits?

Current Profit:

Profit = (30 X 100) – (10 X 100) = 3000 – 1000 = $2,000

Option 1: Leave it as is

Option 2: Increase cost per sale to $15 which generates 50 extra sales

Option 3: Increase cost per sale to $20 which generates 75 extra sales

Answer: Option 2

Let’s look at the profit for all 3 scenarios:

Option 1:

Profit = (30 X 100) – (10 X 100) = 3000 – 1000 = $2,000

Option 2:

Profit = (30 X 150) – (15 X 150) = $2,250

Option 3:

Profit = (30 X 175) – (20 X 175) = $1,750

In conclusion, every single advertiser needs to figure out their optimal cost per sale.  They need to ask themselves will the increase or decrease in cost per sale increase or decrease my overall profits?  Is it worth losing or gaining that traffic?  Once you figure out your optimal cost per sale, you are ready to start reaping the full benefits of your Search Engine Marketing campaigns (through creativity and optimizations of course, but I’ll save that for another post!).

Happy Searching!

Alexander Dao


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