Summary: a bid-based per-per click advertising system like Google Adwords can suck all the profit out of your market. But there are things you can do to stop this happening to you.
Let’s imagine you’re called Acme Widgets, and you sell Widgets.
Say these widgets cost you £1 each to manufacture and deliver.
So long as you can sell the widgets for more than £1, you make a profit.
Now let’s say you want to start advertising.
You decide to run a Google pay-per-click campaign, and you bid at 10p per click. It turns out that you have a 10% conversion rate on these clicks – in other words, you sell one widget for every 10 people who click through to your site. Each person’s click is costing you 10p, so the 10 clicks you need (on average) to make a sale cost you £1.
So now your actual cost-of-sale price is £2 per widget: £1 in manufacturing and delivery costs, and £1 in advertising costs. So long as you can sell your widgets for more than £2, you are making a profit.
So you decide to sell your widgets at £2.50.
You’re happy. You’re making 50p profit on each widget.
Now along comes a competitor, Wacme Widgets. Wacme also sell widgets, and their manufacturing costs are the same as yours.
To compete with you, they try out-bidding you on Google so that their ads are more likely to appear at the top of the Google ad list.
They bid 11p per click (in other words, £1.10 per sale, assuming they have the same 10% conversion rate). So they get ranked higher up the Google ad list.
You aren’t going to sit back and let them knock you off our perch at the top of Google’s ad list, so you respond by bidding 12p per click. It’s now costing you £1.20 (12p x 10) in advertising per sale, on top of your £1 manufacturing costs. But that’s still OK, you’re selling our widgets for £2.50, so you’re still making 30p profit (£2.50 – £1.20 – £1) per widget.
But Wacme see what you’re doing, so they raise their bid to 13p. Profit margins are getting squeezed now, but there’s still 20p per widget to be made.
What do you do now? You raise our bid again, to 14p. Now your profit margin is wafer-thin, only 10p per widget.
Now Wacme are in trouble. To out-bid you, they need to raise their bid to 15p. But at that price, there is no profit left to be made: Widgets still sell for £2.50, manufacturing costs are still £1, and advertising costs would be £1.50 (15p x 10), meaning that Wacme would break even, but not make any profit at all.
So Wacme can’t out-bid you on Google now and still hope to make a profit. The best they can do is to match you by bidding 14p per click. So that’s what they do.
Where does that leave you?
Acme and Wacme have both just vaporised their profit margins, from a healthy 50p to a minuscule 10p per widget. All they’ve done is pushed up costs for each other, for no overall gain.
No overall gain? Surely someone has made money out of this?
Ah yes, I forgot. Why, it’s our old friend Mr Google, of course. Where they used to make 10p per click, now, thanks to the competition between Acme and Wacme, they’re making 14 per click.
Magic! It’s like making money out of thin air. Except that it isn’t thin air. It’s your profits.
So what can you do to stop Google taking all your profit? Here are a few ideas.
- Invest in appropriate search engine optimisation work. With SEO, you can keep your costs fixed – you’re not paying more each time somebody clicks.
- Target more specific keywords with less competition. Look for niche markets, where you can keep your advertising and SEO costs down. Although there is less volume in niche markets, you may be able to larget multiple niches (see our forthcoming post on The Long Tail), and you should be able to scoop a larger proportion of the business in each niche.
- Keep innovating, to make your widgets distinct from (and better than) those of your competitors.
- Work on your conversion rates. If you can double your conversion rate (to 20%, in the example above), then your advertising costs per sale halve. Now, if you bid 15p per click, you’re only paying 75p (15p x 5) in advertising per sale. That’s nice. That means you can make 75p profit per widget (£2.50 – £1 – 75p) even while out-bidding Wacme, who, because they’re stuck with a 10% conversion rate, can’t afford to match your 15p bid. Win.
- Work on your Google Ad targeting. The ranking of Google Ads is weighted by your bid. But your bid is not the only factor. Click-through rates matter too. So better-targeted ads, with lower pay-per-click bids but higher click-through rates, can leapfrog advertisers who are paying more. Used appropriately, this technique can improve your conversion rate too.
If all else fails, buying shares in Google might not be a bad back-up plan.
Oh, and one other thing. I’ve only picked on Google here because they run the dominant online advertising platform at the moment. But the same warnings – and the same solutions – apply to any competitive pay-per-click advertising system.