In this third post in the Economics of PPC Pricing series, we consider the profit sharing model (you might also like to refer back to the previous Economics of PPC pricing posts on the markup model and the cost-per-sale model). By looking at the cost and revenue structures for both client and PPC agency, we discover that under the profit sharing model client and agency motivations are perfectly aligned, making profit sharing a highly efficient method of PPC compensation.

Although we infer that profit sharing is sound from an economic sense, we find it does have problems of its own in terms of implementation and conversion attribution, and conclude that profit sharing should only be considered once a strong and tested relationship has already been established between client and agency.

So let’s get started.

With a profit share deal, instead of paying the client paying the agency a percentage of PPC spend fee, or a set fee for each sale, the PPC agency receives a share of all profits they help to deliver for the client through PPC activity.

If the PPC agency helps make the client $50,000 in profit from PPC, and the agreed profit share percentage is 10%, the client will pay the PPC agency $5,000 for their troubles.

Since the more profit the agency makes for the client, the higher their fees, it is therefore in the agency’s best interests to make the client as much profit as possible. Unlike the percentage of spend (markup) model, there is no monetary incentive for the agency to spend money haphazardly on clicks to increase their commission. With a profit share model, it’s the other way around. There is an incentive for the PPC agency to reduce wastage and increase spend in areas which generate a return.

The profit share model is the only PPC pricing model which is perfectly efficient from an economics point of view. Unlike the management fee model, the percentage of spend model and the cost-per-sale model, with a profit share model both client and agency have the same common goal: to maximise client profit. As pointed out by Andreas Reiffen in his analysis on paid search profit sharing, it allows a win-win situation in which both the client and PPC agency are better off.

So the profit share model is economically sound. The point of maximum agency profit is also the point of maximum client profit. There is no other click volume which will deliver a higher profit. It provides the necessary incentives to help both client and agency maximise their bottom line.

What’s more, since a common goal is being chased by both parties, the profit share model provides a solid foundation for a long-lasting, open relationship between client and agency. It creates a platform for innovation, makes testing worthwhile and encourages the sharing of ideas to reduce clicks costs and increase click revenue. It’s in the agency’s interest to make recommendations to improve website conversion rates; and it’s in the client’s interest to share knowledge of their business with the agency to improve keyword targeting and ad copy. It’s a mutually beneficial agreement that can’t go wrong.

Or can it?

Perhaps. A client’s profit figures are sensitive information. If leaked into the hands of competitors, it could be disastrous for the client. A significant level of trust between both parties is therefore required for a profit sharing model to work.

Conversion Attribution

There’s also the issue of conversion attribution. Since the PPC agency’s fees are bases on profit generated from PPC activity only, how much the agency receives is entirely based on tracking capabilities.

Tracking generally uses cookies to measure customers who buy online within a certain time period (say 30 days), and generally ignores revenue through offline methods such as phone calls and store walk-ins. If someone clicks on a PPC ad while at work, then makes an order when at home on a different computer, or perhaps picks up the phone, that revenue is not attributed to PPC. Nor is revenue from users who have high browser privacy settings or reject cookies.

As pointed out by Econsultancy, PPC marketers are currently missing out on credit for half of the revenue their campaigns are driving, which is a huge amount. With a profit share model, agency fees are based entirely on trackable revenue, so the agency will be under-rewarded for the value they deliver. This can significantly compromise the level of investment in the client’s PPC campaigns, and the level of testing and innovation.

This bias in conversion attribution can also lead to the PPC agency reducing bids on generic ‘research’ keywords from customers earlier in the buying cycle. These keywords might not convert profitably online (according to the under-reported tracking), but may be essential for the client’s walk-in orders, branding or long-term growth. Again – not very efficient.

So although the profit share model performs exceptionally well at aligning the motivations of client and agency, it is far from a perfect PPC pricing model. A high level of trust is essential for it to work – as is accurate (and fair) revenue tracking. Until conversion attribution improves considerably, any business with strong brand or numerous different marketing touch points should use the profit share model with caution.

Are you a fan of the profit share model? Have you made it work for both client and agency? Or is it one for the future when conversion attribution improves? Share your thoughts in the comments section below.

Choosing a Pay-Per-Click (PPC) pricing model which works efficiently for both client and agency is a difficult process. A good pricing model should be simple, should create incentives for the agency to perform and should be a fair measure of the work and expertise involved.

One common model that many agencies use is the ‘markup’ model (also commonly known as the ‘percentage of spend’ model). If the agreed markup is 10%, and the client spends $30,000 on clicks, the client pays $33,000, of which the agency receives $3,000.

Nice and simple.

But does it create incentives for the agency to maximise profit for the client? Does it fairly reflect the work and expertise involved at all spend levels?

No.

Conflict of Interest

In short, the percentage of spend model is a highly inefficient pricing model for paid search management, and should be avoided. As pointed out by George Michie in his recent post on SEM Pricing Models, since the agency receives a commission on every dollar spent, there is an incentive for the agency to spend as much as possible, which can be far in excess of the point of diminishing marginal returns.

To find out exactly what George means by diminishing marginal returns, and how it creates a conflict of interest for client and agency and renders the markup model pretty much useless, let’s consider the cost and revenue structure of the client.

Look at the line CPC (marginal) in the diagram below (Cost Per Click). It shows what happens to the Cost of each subsequent Click as the volume of clicks increase. It is upward-sloping, so each extra click costs progressively more than each previous click. Makes sense – since the first few clicks are usually very cheap, and raising bids and showing for more expensive keywords is generally needed to increase click volume.

Now have a look at the line RPC (marginal). It stands for Revenue Per Click, and shows how much Revenue is generated from each subsequent Click. It is downward-sloping, which again makes sense, since each additional click is likely to be less relevant and have a lower conversion rate than each previous click (this is known as diminishing marginal returns). A rational advertiser would always go for the low hanging fruit first (the most relevant keywords), which will naturally convert better than the high hanging fruit (less relevant generic keywords).

(If this all sounds very confusing, you may like to check out Wikipedia’s articles on marginal cost and diminishing marginal returns first).

So we have an upward-sloping marginal CPC line and a download-sloping marginal RPC line.

Now, assume the client has no other costs other than paid search click costs. If the client spends $1,000 on clicks and generates $1,500 in revenue, the client makes $500 in profit (this is of course very unrealistic – but just bear with me for the sake of argument).

Look at where the two lines cross. This is the level (2,000 clicks) where the client will make the most profit.

Why?

Well suppose click volume increased to 2,100 clicks. The 2,100th click is now costing $0.85, but is only bringing in $0.55 of revenue! The client is losing money on these extra 100 clicks, so reducing click volume would increase the client’s total profit.

What about reducing click volume?

Well, at 1,900 clicks, the 1,900th click is costing only $0.65 but generating $0.85 of revenue. The client is making $0.20 profit from their 1,900th click, so why not increase click volume further, and make $0.19, $0.18 and $0.17 profit from additional clicks? It makes sense to increase click volume until no additional profit is being made – until the cost of an extra click equals the revenue of that click.

It is where the marginal CPC and marginal RPC lines meet that no additional profit would be made, and it is at this point which makes the client the most profit. It is this level of click volume that the client should aim to target with their PPC activity.

Now let’s complicate things a little. The graphs above were only concerned with marginal costs and marginal revenues – costs and revenue at the margin. They show what happens to the next click or the previous click, but they don’t show what happens on average – to the average cost per click or the average revenue per click. Average CPC and average RPC lines are therefore needed for this purpose.

Have a look at the red CPC (average) line and see if it makes sense. Like the green CPC (marginal) line, it’s upward-sloping, but flatter. Why?

Think about it for a second.

If you just spent $1,000 on 2,000 clicks, each click costed you $0.50 each on average, right? If you then decided to go crazy and purchase a few extra clicks on some expensive keywords for a hefty $4.00 each, what will happen to your average CPC price? It will increase, but not by very much, maybe to $0.41? Adding some expensive clicks will pull up the average, but only by a relatively small amount. Hence the flatness of the average Cost Per Click line.

The same is true with the average Revenue Per Click line. If a few extra keywords bring in only a small amount of revenue, it will pull down your average revenue, but only slightly, hence it’s flatness.

Still following?

Great. So we now have 4 lines which represent the cost and revenue structure of a client:

1. Marginal CPC – shows how much each extra click costs
2. Marginal RPC – shows how much each extra clicks generates in revenue
3. Average CPC – shows how much clicks cost on average
4. Average RPC – shows how much clicks generate in revenue on average

These 4 lines are all that’s needed to assess the client’s profitability.

Now remember how we decided that 2,000 clicks was the most profitable click volume for the client? Let’s see exactly how much profit the client is making from 2,000 clicks.

Well, at 2,000 clicks, the average cost per click (CPC average) is $0.30. The client is spending $600 on clicks ($0.30 x 2,000).

At 2,000 clicks, the average revenue per click (RPC average) is $1.50. The client is generating $3,000 in revenue ($1.50 x 2,000).

Minus one from the other ($3,000 – $600) and we have a healthy client profit of $2,400.

Fantastic.

Now this is where the inefficiency with the percentage of spend (markup) model comes in. Since the agency is paid a commission on every click, the agency will always want to increase click volume and spend as much as possible. As we’ll see from the following examples, this is often in excess of the point of maximum client profit.

Suppose the agency increased click volume to 3,000. The average Cost Per Click (CPC) increases from £0.30 to $0.45, and the average Revenue Per Click (RPC) falls from $1.50 to $1.20. The client is still making a healthy profit of $2,250 (revenue of $3,600 ($1.20 x 3,000) minus cost of $1,350 ($0.45 x 3,000)), although their profit of $2,250 is less the previous level of $2,400.

The agency, however, has increased their profit, since they now receive a cut of a bigger spend ($1,350 instead of $600). Assuming the markup is 10%, the agency’s profit has increased from $60 to $135, at the expense of the client’s profit.

But here’s the thing. The client is unlikely to complain – the agency is making them $2,250 of profit, after all! How is the client to know that they could be making $2,400 of profit, should the agency decide to reduce click volume? The client is none the wiser and would most likely praise the agency for their ‘efficient’ work in making them such as tidy profit of $2,250!

But why stop there?

The agency makes a cut of every click spent, so why not increase click volume further? Why not increase it to – wait for it – 4,000 clicks!

Here, at 4,000 clicks, click spend will be $3,000 ($0.75 x 4,000) so the agency’s profit will be $300 (10% of $3,000) – much better than the measly $60 or $135 from the previous click volumes of 2,000 and 3,000.

But look at what’s happened to the client’s profit at this new click volume of 4,000. Their costs are now $3,000 ($0.75 x 4,000) and so is their revenue! The client is making no profit at all! Any more spend, and the client’s average revenue will fall below their average cost, and they will make a loss. If the client is losing money, they will most likely leave the agency, or at least apply massive pressure on the agency to increase performance (reduce click volume), so any click volume in excess of 4,000 is not sustainable in the long-run.

So it’s in the agency’s interest to maximise their commission by getting the click volume as close to the point of 4,000 click where the red lines cross (where average costs equals average revenue) – but without going over, so as to keep the client happy (the client will still be making some profit).

What happens is a negotiation of pushing and pulling between the client and agency until a compromise is found – say 3,000 clicks. Exactly how close to the point of maximum client profit or the point of maximum agency profit is settled upon depends on the relative bargaining strengths of client and agency, access to cost and revenue information and countless external influences to name just a few factors at play.

What is clear though, is that whatever click volume is reached as a compromise, it will not be efficient. It is impossible to maximise the profit of both client and agency using a percentage of spend model. At every click volume, there will always be a way to increase agency or client profit by adjusting click volume.

With a percentage of spend model, there is no working together of client and agency, no common goal, no shared vision. It’s a constant pushing and pulling and conflict of interest. Time and effort is wastefully diverted into politics in an attempt to move click volume closer to one party’s optimum, not to mention the reluctance of each party to be open and transparent and share useful information with each other. Doesn’t sound like the foundations of a successful and lasting business relationship to me. Perhaps it’s why some agency churn rates are so high?

Of course, no PPC pricing model is perfect – every method will have its weaknesses. The key is to find one that works best for your goals and objectives as a business, and one which appropriately compensates the agency for their efforts in helping you develop your paid search marketing strategy. But in terms of aligning the agency’s monetary motivations with that of your business, and creating incentives encouraging them to maximise your profit from paid search, the percentage of spend model fails miserably.

My advice: use the percentage of spend model with caution.

Are you a fan of the percentage of spend model? Have you made it work for client and agency? Or does it create more problems than it’s worth? Share your thoughts in the comments section below.

Next: cost-per-sale performance models – rewarding agencies based on how they perform. Do they work? Are they efficient? Economics of PPC Pricing: Why Performance Deals Often Fail

 

Daily campaign budgets in Google AdWords are great. You simply enter the maximum you want to spend per campaign per day, then sit back and relax, safe in the knowledge that your monthly Google bill will not cause any nasty surprises.

But despite the reassuring nature of campaign budgets and the ease at which they can control your spending, they should not be used to control your spending. Instead, cost per click (CPC) bids should be your tool of choice for spend management.

More clicks, no extra spend

To understand why, suppose the daily budget for one of your campaigns is set to $100/day. Each click costs you $1.00 and your ads are showing in position 3.0. Your daily budget of $100 is being hit, so you receive 100 clicks/day.

Since your campaign is reaching its daily budget, your ads are not showing for all eligible searches. Depending on your campaign ad delivery settings, either your ads are not showing later in the day (accelerated delivery), or they are only showing intermittently (standard delivery). In either case, you are missing out on potential customers.

Now suppose you were to reduce your bids by 25%. Your average cost per click drops to $0.75 and your ads are now showing lower down in position 5.0. But since your ads are now appearing throughout the whole day for all eligible searches, you receive more clicks. Instead of 100 clicks, you now receive 120 clicks. Daily spend is now $90 (under your budget of $100).Ceteris paribus, reducing CPCs for campaigns which hit their daily budgets is likely to give you more clicks for no extra (or possibly less) spend. That’s more visitors, for no extra spend. Assuming that all clicks are of equal value to your business, and average position does not affect your conversion rate, these extra clicks are likely to mean more sales and a higher ROI.

More clicks, same CPCs

Alternatively, leaving CPCs constant and instead increasing your daily budget, will likely result in more clicks for the same average CPC. That’s more visitors, more potential customers, without paying a higher per-customer premium (CPC) for the privilege.The bottom line is this: campaigns which hit their daily budgets are inefficient.

For this reason, it is important to check on a regular basis that each of your campaigns are well within their daily budgets. If you notice any of your budgets are being reached, or ore close to being reached, alarm bells should start ringing.

Check your budgets

One simple way to keep on top of daily spending is to log in to Google AdWords, select ‘yesterday’ as the time period and compare the ‘cost’ and ‘daily budget’ columns for each of your campaigns. If any of your campaigns are hitting – or are close to or hitting – your daily budgets, either increase your budget (if extra spend is financially viable), or reduce your CPCs.

A more comprehensive approach, which looks at campaign costs a longer time period, gives you a better understanding of daily trends. By looking at a month’s worth of data (instead of just ‘yesterday’), you will be more informed and better equipped to make changes to your CPCs and budgets.

Download a campaign report

Log in to Google AdWords and create a new report. Select ‘campaign performance’ as the report type (since daily budgets are set at campaign level), select ‘daily’ as the unit of time and enter a date range such as ‘last 30 days’. In ‘add or remove columns’, ensure ‘daily budget’ is ticked. Leave all other options as default. Run the report, and export it to Excel.

Identify overspend

Once you have the report in front of you in Excel, create a new column to identify the percentage of budget spent by each of your campaigns each day, such as in the example below. Once you have done this, you will then be able to see how close each of your campaigns came to its daily budget.

Suppose you are a retailer of European holidays. You have two campaigns – one for Venice and one for Amsterdam. Both campaigns have a daily budget of $100.Looking at the % spent column, it is clear that the Venice campaign is regularly reaching its budget. Reducing CPCs for Venice keywords would likely result in more clicks for no extra (or possibly less) spend.

By all means continue to set daily budgets to protect against freak spikes in traffic which you cannot afford, but make sure CPCs – rather than budgets – are your primary tool for spend management.

Summary

When you notice any of your campaigns regularly hitting daily budgets, ask yourself a few questions:

1. Are you achieving less than satisfactory results from your current AdWords spending? If so, reduce your CPCs – you will likely see more clicks for no extra spend.
2. Are you achieving satisfactory or good results? Do you have extra funds available for AdWords? If so, increase your daily budgets – you will likely see more clicks for the same CPCs.

Either way, it’s a win-win. You will either get more clicks for the same budget, or more clicks for the same average CPC. Effective spend management is essential for a performing PPC campaign, so make regular budget checks a priority.