Economics of Paid Search

For a change I’m going to give you food for thought right off the bat with this blog post. Have you ever wondered whether your competitors are actually out there to make money?
I know it sounds daft, but these are the economics of paid search and they will all make sense further down the line so just keep on reading.

What is Paid Search?

Paid Search is fundamentally different to any other type of marketing.

In no other point in history have retailers been able to put an ad for a product in front of somebody as they look for it.

In the early days of paid search sellers didn’t really have to pay attention to the economics of it because originally it all started with organic searches (essentially free in the early days) and whenever somebody searched for a product the listings would show up, they’d click on it and they would be taken directly to the product page and buy.

As time went by, things changed, competition grew and today’s advertising techniques and advertisers evolved too.

So we went from having to work at our traffic and nurturing our traffic organically, to someone realising that it would be far easier, scalable and quicker to just buy that traffic.

Once everyone else caught up with that, demand for traffic has grown and it has now become quite expensive.

The logic behind Paid Search it is that you list your products on a search engine and when someone types a product that matches what you are selling your ad shows up, once the person clicks on your ad you then pay the search engine a fee for that click, pay-per-click – PPC.

Now I understand that paying for every click you get may sound like you’re spending far too much money but the opposite is true. In a well designed campaign you may pay for every click but those clicks are so highly targeted that they’re almost certain to turn into conversions making you money in the end.

But before you even get into it, you need to understand the economics of paid search.

The first question you need to ask yourself is, are you offering products in one single purchase, in which case all the profit you can get is going to be obtained in a single transaction and no likelihood of repeat.

Unless you are someone like John Lewis that could get the customer email address and offer other products through email listings. However if you are like John Lewis then you can reach to the database and try to sell to them multiple times away from paid search. But this isn’t what we are focusing on today so let’s move on.

Now on the other hand you can look at the lifetime value of a customer. Let’s say we are in the business of selling VOIP phone systems, and we know that the average SME customer spends £150 per month on calls and line rental.

Now assuming that the average VOIP system customer stays active for 3 years our revenue is going to be £5400 over the next 36 months.

Out of the £5400, 30% of it is our gross profit, the question you need to ask now is, how much out of the 30% gross profit do we want to spend to get a new customer?

£5400 x 30% = £1620 Gross Profit

So by doing quick maths here, we know that our gross profit is £1620 and we are willing to spend 20% of that in advertising.

£1620 x 20% = £324 Marketing Budget per customer

At this point we have £324 to spend in advertising in order to get a new customer.

What this means is that we are willing to spend £324 for a new customer.

Now if we are competing against the guy that sells the VOIP phones only, because the people that purchase from him only do it once and he doesn’t get recurring income for any services, his whole order value is only £210 and his gross profit is 33% of that value.

So we know that he has £69.30 of gross profit and out of that gross profit he is willing to spend 20% in advertising as well.

So he only has £13.86 to get a new customer, versus me that can spend £324 for the same end goal.

This is the prime example of how people bid differently and how this allows for either more or less engagement with potential customers.

So understanding the economics of paid search is key. Lets dig even deeper, so lets say we both get one new customer out of every 50 clicks (2% conversion rate), therefore his maximum bid per click is £1.39 whereas I can spend £6.48 per click.

So this is why it’s so important to understand this before even setting up an adwords account.

Another thing to consider is that in 2015 people would look at least 15 pieces of content before committing to a purchase.

So now you also need to consider engaging in re-marketing and put budget aside to make sure the customer is aware you are there and to build that brand awareness.

So now we cover what I started this blog with, what if your competitors aren’t working on either single sales or lifetime value?

There are actually two other groups of advertisers to consider – investors and incompetent advertisers.

Incompetent advertiser is someone that goes out there blows a load of money on his adverts without fully understanding how this all works.

He doesn’t understand or know that nowadays nobody buys off the first click. People tend to shop around, so he spends £5 just to be the first one on his list.

But customers are savvy and they will click on the other results below and compare prices.

If this other advertiser is the first on the list and is paying £5 per click, but you are 3rd instead but spend £1.50 per click and therefore are able to sell your products cheaper guess who the customer is going to be buying from?

Then there are the investors.

What if I said to you that we have clients in the US that are funded by venture capitalists. I’m not going to get into value details but what they have done is they invested millions into a business and in two years they expect to have doubled that investment.

Then in two years time what they will do is sell the company for what it’s now worth and move on to another venture.

These are people that don’t care how much money they spend advertising, for all they care they can spend £1 to get £1 sale, they just want the figures there.

Now what this also means is that these guys have crazy amounts of money to invest in advertising and will spend it because all they want is turnover, so the guy next door that runs his family business selling exactly the same things stands no chance when competing against them.

So who’s the fool here? If you don’t understand the economics of paid search – it could be you.