## The Pareto Ad Spend Rules

Posted on Thursday, July 8th, 2010 by Bradd Libby Print This Post

### Categories - Featured, SEM

Many people are familiar with the ‘Pareto Principle’, also called the ’80/20 Rule’. In the early 1900’s Vilfredo Pareto, an Italian economist, noticed that about 20% of his country’s population owned about 80% of the land. This relationship has since been noted in many other examples: about 20% of customers (or salespeople, or products) being responsible for about 80% of sales; about 80% of crimes being committed by about 20% of criminals. Even the UN has noted that about 20% of the world’s population are responsible for 80% of combined GDP.

This relationship frequently pops up in situations dominated by a ‘power law distribution’, that is, when many entities have (or contribute) little individually, a moderate number have moderate impact, and very few entities are highly important. This is what search marketers typically see in their ‘head’, ‘body’ and ‘long tail’ keywords.

If 20% of ad spend generates 80% of conversions, then it’s reasonable to ask if it’s possible to get 80% of *that* result (about 64% of conversions) from only 20% of that level of spend (about 4%). Similarly, perhaps it’s possible to get 80% of *those* results (about 50% of conversions) from only about 1% of the spend. Which equation yields 80% when the input is 20%, yields 64% when the input is 4%, and so forth? Mathematically, it is written Conversions = Spend^n and it’s straightforward to show that this equation describes Pareto’s relationship when ‘n’ is the base-p logarithm of (1-p), where p = 0.20:

In case the presence of a logarithm in an equation is giving you the cold shakes, remember that it’s just a decimal number. For the 80/20 case, it is about 0.13.

All this says is that, if Pareto is right for digital marketing, then the best-performing keywords that account for 50% of our spending should yield about 91% (0.5^0.13) of our conversions. To check this, I generated for various accounts a list of the keywords (treating each keyword’s matchtype as a separate entity) that have gotten at least 1 click in the 3-month period between March and May 2010. (I considered only words in Google’s Search network, not the Content network nor other search engines.) I sorted the list from those that got the most conversions per dollar to the least. I also calculated the total amount spent by all of the keywords and the total number of conversions that they produced. I was then able to calculate, for each entity, the cumulative fraction of money spent by that entity (and all the entities above it on the list) versus the cumulative fraction of conversions generated by that entity (and all the entities above it on the list).

First I considered a company that manages high-end rental real estate in major markets in the US. It turns out that, for this account, the ’80/20′ Rule is actually much closer to the ’70/30′ Rule (where p=0.30 and 1-p = 0.70):

For this account, 97.5% of all the spend was in words that generated at least 1 conversion. Considering only the conversion-generating keywords, we see that the ’70/30′ Rule (actually, to be more precise, the ’71/29′ Rule) is a very good representation of the relationship between Conversions and Spend. That is, the most efficient words generated about 1% of the total spending and 25% of the total number of conversions. About 10% of the spend generated about 50% of the conversions. And about 30% of the spend generated about 70% of the conversions.

An almost identical relationship was seen for a builder of new homes and for a seller of international calling cards in the US. Overall, 30% of the spending accounted for 70% of the conversions. However, among non-brand-related terms, the relationship for both of these accounts followed the 60/40 Rule, 40% of spending accounted for 60% of conversions.

The 60/40 Rule is commonly seen among non-brand terms, especially in very competitive industries with thin margins and little brand loyalty, such as was seen with an online retailer of movie tickets and a seller of gold bullion. Perhaps one measure of the strength of a company’s online brand is how much deviation brand-related terms introduce compared to when they are omitted from this sort of analysis.

The fraction of conversions generated by the best-performing non-brand keywords often follows the ’60/40′ Rule, equalling about the square root of the fraction of money spent on them. (This relationship has been noted before by Alan Rimm-Kaufman who in turn was quoting others.) Deviations from this rule might be due to budget limits artificially curtailing the performance of best-performing terms. If the performance is closer to the 80/20 rule, this sometimes signals an overdependence on brand-related terms.

As another guideline, you should generally see about 90+% of your spend in words that have generated at least 1 conversion in past 3 months. If more than 10% of your spend is in words that have not generated a conversion in the past 3 months, there might be a problem with the structure of your account, your bidding, or your data tracking. Whether you call it the ‘Pareto Rule’, the ’60/40 Rule’, or the ‘Square Root Rule’, though, the underlying principle is the same.

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Tags | 80/20 Rule, Pareto Principle, square root rule

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