Feb 152010

Maximizing ROI: The Wrong Game

My SEL piece from this morning in case you missed it.

How could anyone oppose ROI maximization? Don’t all advertisers want better ROI?

Well, no.

Volume and Efficiency are always at tension and how that tension is balanced is highly revealing.

There are two fundamental approaches to this problem:

  1. Spend the budget and “maximize the ROI”; and
  2. Hit the efficiency target and maximize the budget within that constraint.

RKG has always believed that the ROI target should take precedence.

Let’s say Acme has a budget of $100,000 and an ROI target of 4 to 1.

The first approach: Spend the $100K and maximize the ROI.

Scenario 1: Spending $100K leads to significantly lower than 4 to 1 ROI:

Does it make sense to keep spending when the ROI turns south? The law of diminishing marginal returns tells us that next dollar of additional advertising wisely spent will always return less than the previous dollar. When we hit the point that the next dollar returns less than the target efficiency, or less than break even, why would we keep spending? If the returns are poor it’s like feeding money into a shredder simply because the goal was to “get rid of” some fixed amount of money.

Scenario 2: Spending $100K leads to significantly higher than 4 to 1 ROI:

Does it make sense to stop spending money if the ROI is great?

When the delay between investment and return is long or uncertain, budgets are essential. For advertisers taking direct sales the paid search returns happen before the media expense is billed, so the cash flow argument doesn’t carry much weight. And, when the returns are cash rather than leads, there isn’t even uncertainty as to the value of those returns.

It’s like having a commissioned sales force but telling them to go home when they’ve hit some salary cap. If the commission rates make sense, why would anyone apply the brakes?

“Maximizing ROI” implies exactly this kind of budget first mentality.

When client prospects approach us with budgets that are inconsistent with their ROI objectives we tell them that up front. Imagine a company selling all varieties of bungee cords and hoping to spend $250K a month at a 5 to 1 ROI. We’d tell them that given the market opportunity we can only do one or the other, and would recommend pursuing the 5 to 1 ROI as far as the market will allow.

Most other agencies would say: “Those are aggressive goals, but we’re up for the challenge. We’ll spend the budget and see what we can do about the ROI.” Next month, the discussion will center on how they can “Maximize the ROI”…while still spending like a drunken sailor. That’s good for the agency’s revenue, and good for the engines, but I’m not sure it’s in the advertiser’s best interest.

Maximizing ROI isn’t necessarily even the most profitable approach. By definition ROI is a ratio. A 5 to 1 ratio seems better than a 4 to 1, but looks can be deceiving. Let’s say the advertiser has 40 points of margin on a sale. On $10K in advertising the advertiser generates $50K in sales. $50K in sales yields $20K in margin, less the advertising means $10K in marketing income. Cool.

But if the additional aggressiveness of a 4 to 1 target gets them significantly higher on the page and hence more top line, the extra volume may generate more marketing income. Depending on the bidding landscape, perhaps $20K in advertising well-spent generates $80K. That 4 to 1 ratio, generates $32K in margin and $12K in marking income. A smaller ratio, but more money, and as every banker knows, you don’t put percentages in the bank.

According to the square root rule, profit is maximized when the ratio of margin generated to advertising spend is 2 to 1. In practice we find running that lean cuts the top line too much for $ maximization. At RKG, we’ve found that a ratio of margin to advertising of 1.4 – 1.7 tends to maximize marketing income.

The “Spend the budget first” mentality does make sense in some contexts. When the return on investment is uncertain (brand building) or delayed (lead generation), budgeting is wise. Too often, though, budgets are used simply because they are customary.

For this channel, any company with measured, immediate ROI goals should place those goals first and let the ad spend rise and fall with the market opportunities.

Language matters in paid search. The language agencies use in describing themselves can reveal a great deal. “We’ll maximize your ROI” screams: “We think about spending your budget first and hitting your efficiency targets last.”

Next week, I will take on baseball, motherhood and apple pie :-)


8 Responses to "Maximizing ROI: The Wrong Game"
Great post, as always :) The ratio of margin to advertising is particularly interesting to me. I’m curious to know how you put forward and manage the idea of flexible budgets to clients?
And if you can demnostrate that Paid Search yields new customers that pay back over a year or two years ... or fundamentally increases the LTV of existing customers, you can optimize long-term ROI at margin-to-advertising ratios of 1:1 or worse. Folks tend to under-invest in Paid Search ... you can go to 1:1 or even worse if you factor in that new customers and increased value from existing customers will generate enough profit in a year to more than cover the lost profit in the Paid Search campaign.
Thank you, Louis-Dominic! We pretty much lay out the argument to our clients above and hope they buy into it. It can be a tough sell, because in most advertising/marketing initiatives budgets are the norm. Accounting departments don't like hearing that marketing doesn't know how big the Google invoice is going to be next month, because it's harder for them to plan the cash management. That said, almost all of our clients "drink the cool-aid" eventually and abandon budgets. If you can convince the CFO that the PPC spend is like pick-pack and ship charges-- they vary directly with sales and higher is GOOD -- then you're half way there! Say hello to Pinny for me, he's one person I always look forward to seeing at the shows! George
Absolutely Kevin, and to be clear, I'm not an advocate of the "measurable cash in the bank" maximization approach. LTV is one important consideration, but also cookie breakage -- shopping on one machine, buying on another, or calling the call center. We see every penny of expense, but some of the sales are impossible to track. Many folks are understandably leery of lifetime value measurements, fearing that LTV is a thing of the past, but clearly a good customer experience is tremendously valuable in creating a long-term revenue stream.
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