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Optimal Bidding, Part 1: Behind the Scenes of ‘Google AdWords Bidding Tutorial’

There’s a subculture of movie fans that likes to pick apart special effects scenes frame-by-frame, particularly in action, horror and science fiction films, to see and speculate about how each amazing stunt was done. And though Dr. Hal Varian’s new video ‘Google AdWords Bidding Tutorial [1]‘ certainly doesn’t fall into any of those genres, it is equally worthy of a minute-level analysis, both for the immense amount Dr. Varian reveals about optimal bidding on AdWords and for the large areas he leaves open.

In the film, Dr. Varian describes a 4-step process for finding an optimal bid:

1. determine your maximum profitable CPA,

2. determine your conversion rate,

3. calculate your value per click, and

4. adjust your bid so that the value per click equals the incremental cost per click.

The specific example he gives is of an online retailer of digital cameras where each camera sells for $300 and costs the retailer $200 (for a profit to the retailer of $100) and where each click has a 5% chance of converting into a sale. The basic question he addresses is: What is the retailer’s optimal bid (per click)?

Since the retailer can afford to spend up to $100 to acquire each new conversion and there’s a 5% chance any click will convert, he should be willing to spend up to $5.00 for each click, at the absolute most. At time 2:40 Dr. Varian says: “If you were to pay $5.00 for each click you would expect to just break-even on your marketing investment.” Obviously, then, having a cost-per-click (CPC) more than $5.00, which corresponds to a cost-per-acquisition (CPA) greater than $100, results in a loss to the retailer.

Since we now know that a $5.00 CPC results in no profit, Dr. Varian then begins to consider which bid does maximize profit. “While bidding at your value per click would generally lead to profitable results,” he says at time 3:20, “it may not produce the maximum possible profit for your marketing investment.”

He demonstrates this with a specific example, using sample values similar to the information that Google’s new Bid Simulator feature provides. For several reasonable bid values, we see the number of clicks expected per week, the total expected cost per week and the average CPC. Dr. Varian suggests calculating the expected revenue by taking the number of clicks and multiplying by the value per click and also calculating the expected profit by subtracting the ad cost from the revenue.


Figure 1. A screenshot from time 4:58 in 'Google AdWords Bidding Tutorial'

Doing this, we can see that a bid of $5.00 truly does not maximize the expected profit, since there is a higher expected profit if the bid is $4.00. At time 7:26, he says: “Actually, in this example, you probably want to bid a little bit more than $4.00 so you can get your ICC [incremental cost-per-click] as close as possible to the $5.00 value per click.”

The incremental cost-per-click from one bid to the next is simply the additional cost incurred divided by the additional number of clicks you receive. (Often, the ICC can be a large number, Dr. Varian explains, because raising a bid raises the CPC of all the clicks you’ll receive, not just the incremental ones.) To bid optimally, it is important to know the ICC, Dr. Varian says. “Whenever your value per click is less than the incremental cost per click, it will pay you to lower your bid in order to reduce your cost. Conversely, if your value per click is higher than your incremental cost per click, you should increase your bid.”

Even though Dr. Varian’s video is jam-packed with useful information about optimal bidding, it must be pointed out that he has also left out a great deal and made numerous simplifications and assumptions. Naturally, some simplifications are necessary for the purpose of maintaining comprehensibility (As the British writer Hector Hugh Munro once said, “A little inaccuracy sometimes saves tons of explanations”). However, some of the concepts that Dr. Varian skimmed over are so critical to determining optimal bids that they simply cannot be ignored when actually bidding on Google AdWords. I liken Dr. Varian’s remarkable new video to a power table saw – useful in skilled hands, but dangerous to unskilled ones. And it is only by knowing the limits of Dr. Varian’s description of optimal bidding, and how to make the most use of what he does describe, that search engine marketing managers can get the best performance out of their accounts at the lowest risk of causing themselves grievous financial harm.

The first limit is probably also the most obvious: to use Google’s Bid Simulator (GBS) for a given keyword requires it to be active for that keyword. Presently, the GBS only returns Click and Cost estimates for keywords that have gotten about 25 or more clicks in the past 7 days. For words that have gotten fewer clicks (which typically constitute the vast majority of the words in an account) you get an estimate only of the number of Impressions. And if a word recently was receiving Click and Cost estimates, but then fell below the minimum click traffic level, the Click and Cost estimates will be terminated, leaving you without a way to intelligently change the bid after that. In other words, Google’s Bid Simulator can be a helpful supplement to your primary means of calculating optimal bids, but you can’t rely on it to always return estimates when you need them.

In the video, Dr. Varian suggests performing tests of higher and lower bids on your own to see how Clicks and Cost change with the bid, but this too is problematic, since testing high bids is often expensive (with higher bids incurring greater total ad cost and lower bids forgoing potential conversions) and typically involves collecting data for more than 7 days (and those days shouldn’t be weekends or holidays or days when your tracking crashes etc., etc.)

The second point where careless bidders could harm themselves comes about by confusing your ‘maximum profitable CPA’ with your ‘target CPA’. Early in the video, when Dr. Varian introduces the example where the retailer sells a digital camera for $300 which has a wholesale cost of $200, he says, “Therefore a conversion for a user who buys a camera on your site generates $100 worth of revenue for you.” This $100 figure is labeled ‘max profitable CPA’. Just afterwards, at time 1:05, he says, “That $100 is your maximum profitable cost per acquisition, or ‘CPA’. You can pay up to $100 per conversion and still make a profit on the sale.”  Dr. Varian’s calculation is 100% correct – your maximum profitable CPA is your profit per conversion multiplied by your conversion rate (conversions per click).

However, please pause for a moment to ponder the difference in meaning between the phrases “maximum profitable CPA” and “CPA of maximum profitability”. The first refers to the CPA at which you just barely break even. To have even a slightly higher CPA means to lose money. The second phrase, ‘CPA of maximum profitability’ means the CPA at which you make the most profit per click, not just barely break even. This is your target CPA. Your target CPA (not your maximum profitable CPA) multiplied by the keyword’s conversion rate gives you your target cost-per-click (CPC), the amount you should attempt to pay per click.  Pay above this amount and you will spend more per click than you receive in additional profit. Pay less than this amount and you will refuse clicks whose value to you exceeds the amount you expect to receive from them.

A third area where viewers might encounter some confusion comes from the atypical way Dr. Varian describes the financial goals of the fictitious retailer in his example. Search engine marketers tend to classify their accounts as either ‘CPA-targeted’ or ‘ROI-targeted’ (return on investment) and CPA-targeted and ROI-targeted accounts, though generally very similar, are not identical. In Dr. Varian’s example, the retailer sells products online and apparently is able to track the number of items sold in each purchase, the price of the products, the cost of the goods sold (COGS) and, therefore, the profit per conversion, and so forth. Such accounts are typically classified as ‘ROI-targeted’, since their explicit objective is to maximize the total net margin (that is, profit after COGS, ad costs and all other costs have been accounted for) that they receive per day. In an abstract sense, the goal of all economic activity is to maximize the profit generated, but in cases where an account cannot track the number of items sold, value per item, etc. at a very granular level, the account manager is forced to resort to a proxy measure of profitability. With these accounts, called ‘CPA-targeted’ accounts, account managers often select a single type of event to call a conversion (as Dr. Varian lists, “the sale of a product, a new lead, a sign-up, or getting users to download or view some material on your site”) and then attempt to maximize the number of conversions received for each amount of spending.

It’s strange that Dr. Varian gives an example where the retailer has the ability to track conversions, revenue per conversion, COGS per conversion, profit and so forth, but then chooses to attempt to optimize to a target CPA, rather than to the target ROI that maximizes profit.

A fourth issue that Dr. Varian simply glosses over, most likely for the purpose of saving “tons of explanations”, is the fact that in his example he talks about a digital camera that brings in $100 in gross margin per sale, but that on Google AdWords, advertisers don’t bid on products, they bid on keywords. Dr. Varian admits this himself when he says, “In general, however, you don’t bid by CPA on Google; you bid by CPC, or ‘cost per click’.” So, the advertiser would not bid on each sale of that particular digital camera, but rather, each click on the ad associated with, say, the keyword “digital camera retailer” / exact match. A searcher might purchase the $300 camera after typing in that search query, giving the retailer a $100 gross margin (before ad cost). But the next person to search for that term might just purchase a $10 carrying case for a digital camera. Or, the searcher might be a professional photographer whose studio was recently robbed and spends $10,000 on a wide variety of equipment in one order.  Therefore, the advertiser has no way to know a priori when setting the bid whether the next click will bring in $10 in business or $10,000.  So, a profit-maximizing advertiser must estimate the expected Revenue per Conversion (RPC) and the expected Cost of Goods Sold per Conversion (COGSPC), two numbers that Dr. Varian discusses as if they are easy to calculate, but which in the real world are often known only to a certain level of accuracy.

A fifth factor with which the online advertiser must contend, but which Dr. Varian also assumes to be obvious, is the conversion rate for any given keyword is usually not known precisely.  At time 1:44, he says, “Your conversion rate is the number of conversions completed on your site, divided by the total number of ad clicks to your site.”   It is true that this quantity is your observed account-wide conversion rate.  However, advertisers bid at the keyword/matchtype level, not at the account level. Knowing the total number of conversions divided by the total number of clicks for your entire account is simply not good enough – you need this information for every individual keyword on which you intend to bid.  For very high traffic keywords (and only for very high traffic keywords) simply dividing the number of conversions by the number of clicks can give you a fairly decent estimate of the conversion rate.  But as any experienced online marketer can tell you, most keywords fall into ‘long tail’ traffic-levels, where there are simply not enough clicks and conversions per keyword to be able to pin a nice simple number like ‘5%’ to the conversion rate.

And, finally, a sixth issue which Dr. Varian glosses over is really an entire collection of related problems: keywords don’t exist in a vacuum.  He only talks about optimally picking one bid for one ad as if all the information necessary to set that bid is contained within the performance data of that keyword and that keyword only.  But optimally picking a set of bids for a set of ads requires considering account-level and campaign-level budget limits, cross-keyword attribution (that is, the fact that a non-converting click on an ad might prompt a later search on a different term which then does convert), conversion latency (which Dr. Varian addresses briefly at time 2:50 when he says that “you might want to bump this value [your assessed value per click] to reflect the fact the visitor might not convert on this particular visit but may return in the future to buy something”), cross-channel and cross-media influences, data errors, holidays, hour-of-day and day-of-week periodicity, seasonality and a gamut of other issues that would run the length of your arm.

The short point is, the topics Dr. Varian does not talk about in his new video are at least as important to optimal bidding as the ones he does, and if you take his advice at direct face value, you might get hurt.  Fortunately, The Search Agency [2] (and AdMax, our online marketing platform) are here to maximize the return on all of your online marketing efforts, regardless of your level of expertise.

This post is continued in ‘Behind the Scenes of ‘Google AdWords Bidding Tutorial’, Part 2 [3]‘.

About Bradd Libby

Bradd easily becomes obsessed with small details. He can barely make it through a conversation without drawing a graph of something. He lives in the woods on the side of a hill in Norway. Bradd doesn't willingly wear shoes. He makes maps of places that don't exist. He picks up small shiny things he finds on the ground. He devolves into violent shouting matches with himself. He takes things apart to find out how they work but then can't figure out how to put them back together again. He also writes at Search Engine Land [8], Search Engine Journal [9] and his personal blog [10].