New Math

How to calculate an effective bid

Remember when you sat in math class in high school and thought, “I’m never gonna use this.”? Turns out that your teacher may have been doing you a favor after all, because setting the right bids in search marketing does require some calculations. Last week we showed you the numbers you need to know to set your bids. This week, we’re going to show you how to fit them together.

Bidding calculations example: Cost-Per-Action
Cost-per-action measures how much advertising spend is required to get one action (in this case, one buyer). Most of the variables are fixed, but you control the cost per click and, therefore, the number of clicks you receive.

Advertising costs: 4,500 clicks x $.40 per click = $1,800
Number of visitors: 4,500
2% of visitors became buyers = 90 buyers
Spend on Yahoo! Search Marketing = $1,800
Number of buyers = 90

Result: $1,800/90 = $20 CPA

If your CPA is less than buyer value, congratulations, you are making money and may be able to increase your bids to gain a higher position in search results. If your CPA is greater than buyer value, you are losing money and may have to reduce your bids.

Another way to view the CPA calculation is, instead of starting with known advertising costs and bids, figure out where to set your company’s bids. If the value of a buyer is $60, how much are you willing to spend to acquire the buyer? It could be 5% or 95%; it depends on what other costs are involved and what your goals are.

For our example, let’s arbitrarily set the amount at 33%.
1. Value of a Buyer: $100 average purchase x 60% gross margin = $60 value of a buyer
2. Maximum CPA: 33% maximum acquisition x $60 value of a buyer = $20 maximum CPA
3. Target Bid: $20 maximum CPA x 2% conversion rate = $0.40 CPC target bid

Bidding calculations example: Profit
Profit is hard to maximize. You may have to experiment with moving bids up to see how much more revenue it creates, and whether it offsets the rise in advertising cost, but it’s essential that you look at the bottom line when you are setting your bids.

Revenue: 4,500 clicks x 2% conversion rate = 90 buyers x $100 average purchase amount = $9,000
Costs: $9,000 revenue x 40% product cost = $3,600 product cost + $1,800 advertising cost = $5,400
Profit: $9,000 revenue – $5,400 costs = $3,600 profit

Now, assess your profit. If your profit is above 0, you may be able to increase bids to get more buyers and increase profit. If your profit is less than 0, you may have to reduce your bids. In our example, the profit is $3,600, so there is room to increase bids.

Bidding calculations example: Return-on-Investment
ROI measures how effective your overall business spend, including advertising, is at generating profit.

Profit: $9,000 revenues – $5,400 costs = $3,600
Advertising Costs: 4,500 clicks x $0.40 CPC = $1,800
ROI: $3,600 profit divided by $1,800 advertising costs = 200%

Now, assess your ROI. (The scenarios for ROI are the same as for profit.) If your ROI is acceptable and profit is positive, you may be able to increase bids to get more buyers and increase profit. If your ROI is unacceptable or profit is negative, you may have to reduce bids. In our example, the ROI is very high and profit is positive, so there is room to increase bids.

Business model implications for bids
The calculations just reviewed apply particularly well to e-commerce sites, but the basic concepts apply to all types of sites. You should always strive to define at least one action that a visitor can take on your site that will denote that the visitor is worth more than average. Once you have defined one or more actions and monitor which visitors undertake the actions, your tracking system should tie it back to where the visitors came from. This will help you better gauge the value of particular keywords, for example, so you can set bids with better regard for the economics.

— The Team