Why You Need to Understand Market Elasticity to Master Paid Search

By Shane Murphy

Recently, I sat in a meeting with a retail marketing manager who was presenting on the performance of his paid search campaigns. With a wide grin, he proclaimed that in the last month his team had delivered a 20 percent increase in sales conversions while still remaining within the targeted CPA (cost per acquisition), which was agreed upon by the finance department. He and his colleagues looked across the room, seemingly lapping up the applause they were hearing in their head.

I was thinking something very different: “This person has just cost the company $50,000.”

So how can it be that a finance exec agreed to the CPA target — a positive return on investment for the customer — but the company still lost cash?

Let me first walk you through the concept of the marginal CPA.

The Marginal CPA Calculation

This post assumes that you've figured out what dollar amount you can afford to acquire a customer — i.e., that you have taken measure of your CPA. For example, if you know a customer will be worth $150 over the course of one year and you decide you're happy to break even during that span of time, then your CPA target is $150. If you spend $165, you're now outside the ROI threshold. Anything less than $150 and you're good to go, right? Well, it’s not really that simple.

Most digital marketing campaigns have a certain degree of price elasticity. If you increase your bids, you get more sales conversions. If you decrease them, you get fewer. In order to appropriately set your bids, you need to understand the dynamics of the elasticity in the paid search market you're operating in.

For example, if you're already appearing in the top position on Google and increase your bids, you're burning cash. There's no elasticity there. You can’t get more profit out of the situation even if you pony up. Luckily, Google protects us from ourselves and won’t let marketers bid more than necessary to get into the top position, but you get my broader point. You need to map the elasticity curve for the various markets you're operating in. Pretty much all digital marketing operates on the basis of bidding against other companies for ad space, therefore this is an important concept. Consider the below for example.

The Money Trap

You’ve worked with finance and agreed that your CPA target is $200.
You first bid $100 and get 750 sales conversions. You’ve spent $75,000.
You then increase your bids to $150 and achieve 2,000 conversions. You’ve now spent an incremental $225,000 to get an incremental 1,250 conversions. In this case, the CPA on the incremental sales conversions is $180. The “marginal CPA” here is $180; in other words, you’ve spent $180 per incremental person. Since this figure is within your CPA target, you've done a good thing. So now you’re feeling confident. You up your bids again.
You bid $200 because finance has said you can do that. And you get 3,500 sales conversions. You feel bloody great about yourself. You’ve delivered an incremental 1,500 conversions. You walk around the office like a gunslinger … look at me, I just increased our customer acquisition by 66 percent!

But hold your horses, cowboy. In this scenario you’ve spent an incremental $400,000 to get an incremental 1,500 sales conversions. That’s $267 per conversion, which is higher than the CPA you can afford. You’ve just lost the business money. Not good. You can leave your saddle at the door, thanks.

Conclusion

Here’s what you should have done: Raise your bids only to the point at which you were still making a positive return on a marginal basis. So you needed to halt increasing the bids when the marginal CPA hit $200. If the marginal CPA goes above that figure, then you’re paying more than you can afford for every incremental customer.

Indeed, when working on digital retail marketing campaigns — for search or display — where you can easily vary your bids, you need to understand the elasticity of your campaigns. You need to comprehend how much your sales conversions fluctuate based upon changes in bids, and then calculate the marginal CPA.

This best practice will ensure it doesn’t break your CPA target set by finance.

Shane Murphy is the vice president of marketing at AdRoll, a retargeting and prospecting platform.