EcommerceBytes-Update, Number 171 - July 23, 2006 - ISSN 1528-6703     4 of 8

Google AdWords and Other Pay Per Click Programs, Part 2

By Peter Kent and Jill Finlayson

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Part 1 of this 3-part series can be read online: http://auctionbytes.com/cab/abu/y206/m07/abu0171/s03

Understanding Conversion Ratio, Click Value, and ROI
There's one huge disadvantage to PPC ads, though . . . they cost money. Sometimes a lot of money. Often, in fact, so much money that you will lose money if you buy PPC ads! In order to use PPC, you really must understand Conversion Ratio, Breakeven Click Value, and Return on Investment (ROI):

  • Conversion Ratio The proportion of visitors to your site who buy from you. This is the foundation of any click-value or ROI calculation.
  • Breakeven Click Value The "breakeven" value of a click is the maximum sum you can pay for a click and not lose money. Of course, you want to pay as little as possible, but there's a point at which a click doesn't make you money and doesn't lose you money. If you go over the price, however, you start losing.
  • Return on Investment The amount of money you make after investing in advertising, typically expressed in terms of the sum returned for every dollar invested. If you pay $1,000 for ads, and make a profit of $10,000, your ROI is $10 per $1 invested.

You need to consider these things three times:

  • When you have no background information When you first begin considering PPC ads, you may not know what your conversion ratio is. That is, you don't know how many people coming to your site will buy from you. You can, however, do a simple "guesstimate" to figure out whether PPC will work for you. At this point, you can decide if PPC is worth doing.
  • When you know your conversion ratio Once you understand what your conversion ratio really is, you can calculate more accurately whether PPC will work for you. At this point, you'll have a much better idea of the likelihood of success.
  • When you're running a PPC campaign Once you're buying PPC ads, and people are coming to your site, you can calculate ROI exactly. It's then that you'll know exactly whether (under current conditions) PPC works for you.

In order to calculate click value and ROI, you must first know - or estimate - your conversion ratio. The conversion ratio is the relationship between the number of people carrying out some process and the number of those people who move on to the "next step." For instance:

  • If 100 people see an ad, and three click the ad, the "conversion" is 3:100, or three percent.
  • If 100 people come to your web site, and ten sign up for a newsletter, the "conversion" is 10:100, or 10 percent.
  • If 100 people come to your web site, and one buys a product, the "conversion" is 1:100, or 1 percent.

Of course, it's the last of these that we're most interested in. Of all the people who come to your site, how many will buy? This conversion ratio is the core of any ROI calculation.

Calculating Click Value and ROI with No Background
Unfortunately, you're probably in a situation in which you simply don't have the information to accurately calculate click value and ROI. You have to guess. Here's what most people do: they think, "For every 100 people I can get to the site, I'll sell to, say, 20 of them." Based on that, they look at the cost of clicks, and get excited . . . there's a lot of money to be made! So let's look at more realistic numbers.

Assume that for every 200 people who visit your site, one will buy. If you're lucky, it will be more. If you're unlucky, it will be less. But a conversion ratio of 1:200 is not an unreasonable number.

Many people are shocked when they see this number. 1 in 200 . . . half a percent! How can that be right? You must understand that conversion ratios are very low. If you own a retail store and sell to 20 percent of all the people who walk into your store, you shouldn't use that as an online-store conversion-ratio estimate! Online conversion ratios are much lower than offline ratios.

NOTE: We're not saying that online stores never have better conversion ratios than 1 in 200 or 1 in 100-many have much higher conversion ratios. The world's top retail stores average perhaps 4 percent and sometimes, very rarely, reach over 20 percent. But such stores are in the minority. In general, online retail conversion ratios are small fractions.

Calculating Gross Profit
In order to calculate these important numbers, you need to know your gross profit per sale. We're talking gross profit, not revenues. If you sell a product for $50, your gross profit is not $50-after all, you first have to buy or create the product. Here's how to calculate gross profit:

+ The order total
+ The shipping and handling fee
= Revenues
- The credit-card transaction costs or other transaction costs (such as PayPal transaction cost)
- The e-commerce system transaction costs (some e-commerce systems, such as Yahoo! Merchant Solutions, charge a fee for every sale)
- The sum you paid for the products you sold
- The price you paid to ship the products to you, including shipping insurance
- The cost of the packaging used to ship the products
- The cost of the labor to pack and ship the products
- The shipping fee
- Any other per-product costs you had to pay
= Gross Profit

In other words, gross profit is what is left over from the sum you received for the products you sold after subtracting all the costs directly related to selling the products.

The calculation above doesn't include click costs, though; we're assuming that you're trying to calculate the gross profit of a sale, before you have begun your PPC-advertising campaign. Of course, if you are paying for clicks to generate the sale, you must also subtract the cost of those clicks.

Calculating Breakeven Click Value
So, here's how to calculate breakeven click value. Let's use some sample data:

  • Click conversion rate: out of every 200 people clicking a PPC ad and arriving at your site, one will buy.
  • Average profit per sale, before advertising costs: every sale brings $150 in gross profit.

    The calculation is very simple. Divide the average profit by 200 (in order to make one sale, you must get 200 clicks): $150/200 = 75 cents.

What does this mean? If you spend 75 cents for every click - that is, 75 cents each time you use a PPC ad to bring a visitor to your site - and you sell to one person in 200, you'll break even. You won't make money on the sales, but you won't lose money on the products sold, either.

What's the ROI?
What's the ROI on an advertising campaign in which you pay the maximum click value? Nothing. You have no return. The profit you make on the sales goes to paying the investment in the advertising. Here's how to calculate ROI:

Gross profit derived from the advertising divided by the sum spent on advertising

In the previous example, the advertising cost was $150 (200 clicks at 75 cents), and the profit, after subtracting the cost of the advertising, was $150.

$150/$150 = $0

Consider another scenario. This time you spend 40 cents per click; you still need 200 people to come to the site for each sale (so you spend $80 on clicks), and the gross profit, before click costs, is $150.

$150 - $80 = $70

$70/$80 = $0.875

In other words, for every dollar you spend, your ROI is $0.875.

Calculating Click Value and ROI Later
If you're already in business and selling through your online store, you should have a closer estimate of your conversion ratio. From there, you should be able to figure out the real conversion ratio. It won't necessarily be the same as the conversion ratio you'll get from your PPC campaign; for many reasons the PPC conversion ratio could be higher or lower. But at least you'll have a real number to work with, rather than a pure guess.

How do you figure out your conversion ratio? Look at your web site statistics and find out how many people visited your store over a particular period. For instance, choose your last month of operations, and look for a statistic such as:

  • Unique Visits
  • Unique Visitors
  • Customers (an ambiguous term, but unfortunately the one used by Yahoo! Merchant Solutions)

TIP: If you're using Yahoo! Merchant Solutions, click the Reports link in the Statistics column and look for the Customers statistic.

Once you know how many people have visited your store during that period, you need to find out two more things:

  • The number of orders taken through the store
  • The average gross profit on each order

Now you can calculate your conversion ratio. To do so, divide the Number of Visitors by the Number of Orders. For instance, if you had 1,538 visitors one month, and you processed 12 orders, your conversion ratio is 1:128. That is, you need 128 visitors in order to make one sale.

The average gross profit number, of course, allows you to figure out your breakeven click value. For instance, let's say:

  • The average gross profit on the orders is $35.
  • For every order you needed 128 visitors.
  • Thus, your breakeven click value is 27.34 cents. If you pay more than this for every click, you'll lose money.

This is still just an estimate, of course, because until you run a PPC campaign, you don't know if the conversion will be worse, the same, or better.

Once you actually run the PPC campaign, you can get exact numbers. You won't care so much about breakeven click value anymore because you'll be able to see your ROI and determine whether you're making money. You'll know just how much you're spending for each click, and you'll also know your conversion ratio, under two conditions:

  • If you're sure you're getting all your site visits from PPC campaigns, then you know all your sales are derived from PPC advertising and you can accurately calculate your ROI. If you get traffic from various sources, though, you can't do this, unless . . .
  • You install software that tracks sales from your PPC campaigns. We'll look at this in Chapter 24.

So, Can You Make Money?
Many readers, after thinking about the last few pages, are probably now in shock, especially if they've run a few numbers through their heads. They remember that

  • A click costs at least 5 or 10 cents through the major PPC systems, and often much more.
  • Conversion rates are often 1:100 or 1:200.

How on earth can I possibly make money with PPC? The simple answer is, in many cases, you can't. Here's an example. Let's say your product will give you a gross profit of $10, before paying for the PPC costs. Not an unusual sum-many products are in this ballpark, such as books, music, small gifts, and so on. Let's give you a fighting chance, and assume you'll have a conversion ratio of 1:50. And we'll assume that you can buy clicks for 10 cents:

  • 50 clicks are needed for one sale.
  • 50 clicks cost $5 (50 × 10 cents).
  • Thus one sale costs $5, so your ROI is $1 for every $1 spent on advertising ($10 pre-advertising profit = $5 profit after advertising; $5/$5 = $1).

You're making money, but unless you sell a lot of whatever this is, you're not getting rich. So let's see what happens when you change just one thing in the calculation. Let's try separately altering the conversion ratio, the click cost, and the gross profit per sale and see how each affects the equation.

  • Your conversion ratio is 1:100 - you just broke even.
  • Your conversion ratio is 1:200 - you just lost $10.
  • Your click cost is actually 30 cents a click - you just lost $5.
  • Your click cost is actually 50 cents a click - you just lost $15.
  • Your gross profit is actually $6 - you just made $1.

The fact is, PPC doesn't work for everyone! In particular, you'll have trouble making PPC work if:

  • Your products have low gross profits.
  • Your web site has a low conversion ratio.
  • Click costs are very high for the keywords you want to use.

Remember:

  • High Gross Profits + High Conversion Ratios + Low Click Costs = Good!
  • Low Gross Profits + Low Conversions Ratios + High Click Costs = Bad!

Any one of these elements can cause a problem. If all three are bad, you're in real trouble!


About the author:

Peter Kent and Jill Finlayson are co-authors of "How to Make Money Online with eBay, Yahoo! & Google." This article is reprinted from Chapter 22, "Google AdWords and Other Pay Per Click Programs," with permission from the publisher. (c) Copyright 2006 by The McGraw-Hill Companies. You can find the book on Amazon (http://digbig.com/4mbgx).


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