Pennywise, Pound Foolish in Paid Search

No one enters a business or personal relationship expecting to fail. However, individuals and businesses sometimes exhibit attitudes and behaviors that set them up for likely failure. Having a wife who is a behavioral psychologist gets you thinking about all the self-defeating behaviors and attitudes that exist. Failure is a powerful tool if you can learn from it. But setting oneself up for failure is idiocy.

Here’s a real-life example of setting oneself up for failure: a large multichannel retailer recently announced that it will choose an SEM (define) vendor using a process that truly boggles the mind. After a lengthy RFP (define) process — don’t get me started on RFPs again — this retailer is running a reverse auction in which the SEM provider willing to manage the retailer’s SEM at the lowest fee levels will be awarded the contract.

Choosing vendors based solely on management fees only makes sense if you believe you’re buying a pure commodity and the following factors have no role in success or failure:

  • Technology
  • Staff skill level and training
  • Staff hours allocated for production and strategy

If you spend several hundred thousand dollars a month on a highly complex campaign in a highly competitive marketplace where you aren’t the number-one player, failure of any important element within the search campaign can have highly material consequences.

But because the focus on cost versus overall profitability and business benefit can lead to a productive discussion, let’s do the math to see whether choosing a vendor this way makes sense. To simplify the model, we won’t cover all the aspects of a PPC (define) SEM campaign that are highly positive but more difficult to measure or manage. These factors might include offline conversions, the branding impact of search, and the benefits of acquiring an online customer with a high long-term lifetime customer value. We’ll do the calculations based purely on immediate, observable ROI (define). (Calculating the impact on true ROI, and therefore the opportunity costs of doing something in a suboptimal manner, will reveal much higher costs.) To make it interesting, we’ll also model the opportunity cost implications of selecting vendors that have better technology against those that may be more or less skilled at search or perhaps more or less willing to staff an account aggressively after bidding the lowest to win the business.

The first assumption is that not every vendor will do as well as its competition. After 13 years in the search business, I can attest to there being a wide diversity of performance levels in the marketplace, not only among my competition but even within some agencies. It can make a huge difference which team you get — making team headcount far less important than who your strategist or account manager happens to be. I’m not talking about 5 percent variation, either. It’s fairly common to see performance variation in excess of 25 percent, much more if one includes agencies of different pedigrees or capabilities.

Clearly, SEM isn’t a commodity service. But let’s assume the short list in this instance includes agencies of similar size, age, and technological capabilities. Let’s also assume that variation between the best and the worst performer is 20 percent (I’d bet that in a sample set of 10, there’d be a 20 percent variation from the mean in both directions).

Depending on the business category, the margin on retail products sold online ranges between 5 percent and 60 percent. Let’s assume a margin of 40 percent with a short-term, online-only, highly tracking-centric campaign, where it wouldn’t be unusual for a marketer to assign a net search profit of half the margin. That’s a ROAS (define) of 5, meaning you can spend up to $20 to generate $100 in revenue and still be left with a net search profit of $20. To look at this correctly, one would want to factor in the cost of the agency in the spending, not just the media cost.

Since this is an example of a fairly large search spender where some economies of scale are present, let’s assume the full-service SEM agencies are bidding a media management fee range of 5 percent to 15 percent of spending. The variation in fees as it relates to the spend under management for an ROAS of 5 and an assumed $20 spent to generate the $100 is from $1 on the low end to $3 on the high end.

Yet we are making the conservative assumption that the best and worst agencies are 20 percent apart in efficiency in spending money, because it’s very likely that there is a correlation between price paid and quality of service delivered (not a perfect correlation, perhaps). However, since we used a very conservative difference in agency performance, let’s assume the cheapest agency is the poorer performer. Could the media savings outweigh the performance loss?

Factoring in their own cost, the agencies don’t really get to spend $20 of each $100 because they aren’t counting their fees. The agency with a 5 percent fee spends $19 on search media, the one with the 10 percent spends $18, and the one charging 15 percent spends only $17 on clicks. Yet when you include a conservative performance variance (ability to extract revenue from the search spend) of 20 percent, you see that the low-performing agency generates $95 in revenue from its $19, whereas the top performer (which is also highly likely to be the most expensive or at least at the top of the range) generates $102 in revenue with a media spend of $17. In effect, this agency is able to achieve an ROAS of 6 (a 20 percent improvement), even though its invoice (or bid for the business) is three times more than the lowest bidder, making the more expensive vendor choice a far better business decision.

Measurement Formula Low-fee agency High-fee agency
Profit margin on all goods sold online (assumed) 40% 40%
Gross media spend (assumed) $20 $20
Agency fee (assumed) 5% 15%
ROAS (assumed) 5 6
Agency fee per $20 spent Gross media spend x agency fee $1 $3
Net media spend Gross media spend – agency fee $19 $17
Gross revenue Net media spend x ROAS $95 $102
Net search profit (Gross revenue x profit margin) – gross media spend $18 $21

While the example I gave is simplified and doesn’t take several less-material factors into account, the calculations should show that this multichannel merchant is very likely setting itself up to fail — or at least fail to achieve its true potential, even though someone’s going to get a pat on the back for saving the company money during tough economic times. One can only wonder whether this same company, if audited by the IRS, will be picking a tax audit specialist accounting firm in the same way it’s selecting an SEM agency! In both cases, millions of dollars are on the line.

While management fees are a consideration when choosing an SEM vendor, it’s more important to consider technology, staff skill level and training, and staff hours allocated for production and strategy, among other factors. Making money can be much more profitable than saving money.

What’s your favorite marketing tool or service? Which one made your campaign a success? We want to know! Nominate your choice in the 2008 ClickZ Marketing Excellence Awards. Nominations are open until August 14. Nominate now!

Meet Kevin at SES San Jose, August 18-22 at San Jose Convention Center.

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