There are many businesses who find themselves in the pay-per-click trap and at the end of the day most of their profits are paid to Google for the advertising they rely on to sustain their businesses. Getting to the bottom of this “pay-per-click trap” and how you could be working for Google will take a little explanation.

Media outlets and other sources of advertising have always charged based on the number of impressions/viewers/listeners/readers and set their pricing based on what the market will bear. So what’s wrong with that?  Well, traditional media is different from Internet advertising, specifically the pay-per-click model and how it affects pricing and competition, and this changes everything. (check out “Do We All Work for Google?“)

Let’s step back and explore the basic economics behind PPC advertising and its relationship to Internet commerce. PPC advertising is setup in a bid/auction model where the more you are willing to pay, the higher your ad will be placed in the sponsored results for your target keywords. Using free-market economic principals you would assume that over time competition for these keywords will naturally increase the cost per click. So again, what’s wrong with that? What’s wrong is that the very nature of the Internet permits hyper-competition, therefore creating sustainable profit in markets where significant barriers to entry or competitive advantage do not exist is virtually impossible.

Using a recent headline bankruptcy to illustrate the point, Circuit City for most of its life was a 100% traditional retailer, it had physical locations, sales people on the floor, and used lots of traditional advertising to bring customers in the door. If someone wanted to compete with them they had to also have a physical location, sales people, and use traditional advertising to bring customers in the door. So at least on the surface Circuit City and any competition that entered the market such as Best Buy would face similar challenges and would expect a reasonable profit margin to make the creation of the enterprise worthwhile. If there are already a couple of competitors in the market that aren’t making unreasonable profits or running inordinately sloppy operations, it’s unlikely that would-be competitors would jump into the fray lightly.

By contrast can you even count the number of online retailers who sell most or all of the products that Circuit City once carried in their stores? Searching for a particular model of LCD TV yields thousands of online retailers offering the product up for purchase. So what is the competitive advantage of one online retailer over another? For some shoppers it might be service or product information, however most shoppers will use whatever sources they can find to narrow down their selection but will make the purchase from whoever has the lowest price. So the only tangible advantage an online retailer has over another is cost and how readily they can be found on the Internet.

This brings us back to the PPC model and the underlying economic principals it relies on to generate staggering profit and growth for Google quarter after quarter. Anyone who wants to jump into online commerce can setup a Yahoo! store and a Google AdWords account and be ready to sell merchandise in a few days with very few barriers to entering the market. This new merchant has virtually no overhead outside of his or her basic living expenses such as food, rent, and advertising.

The cost per click will naturally increase as each new competitor enters the market and the only thing that will stop the increase in PPC bids is the inability for the market to bear anything higher. This happens in nearly real-time as advertisers adjust their bids based on sales conversions, and in the very back of their minds the profit they are making on those sales. Businesses with the best converting websites and the slimmest overhead and profit will ultimately prevail and at the end of the day Google very well might be making more profit from your business than you do. If Google is making more profit from your business than you, then like it or not you’re working for Google.

You might be thinking that Internet commerce is hopeless at this point, but that’s not the case. The key to competing on the Internet is that you MUST find ways to carve out competitive advantages or you will be doomed to work for Google and eke out whatever meager profits the market will bear.

Areas you might consider exploring for competitive advantage are search optimization, building a better Website, creating a very focused niche with exceptional knowledge within that area, increasing the value of each customer through repeat purchase programs, customer referral programs, or partnerships.

Traffic — traffic is certainly an element of online success, but is traffic the only thing that’s important? Certainly not. Lets consider a site that sells automotive parts. If the site has 100,000 unique visitors a day but the traffic isn’t targeted its unlikely the site will be very successful even with that much traffic. Ie. if the visitor reaches the site because they were searching for computer parts its doubtful whether they will decide to pick up a new alternator for their Taurus on a whim. Carefully targeted traffic is much more valuable then untargeted traffic and will be reflected in conversion rates.

Conversion — While targeted traffic is a factor in conversion its not the only important thing. Once you pass this stumbling block there are a host of things that next become important. In short, for the highest conversion rates you want to tailor the page or pages that you deliver to visitors based on what they searched for and making sure you give them all of the information they need to proceed to your goal (either a checkout, contact form, or other action) in the least amount of pages. Every opportunity you give them to go elsewhere, even other pages in your own site, give the visitor an opportunity to do something other than reaching the goal. If a visitor can reach the goal by visiting one page, often called a landing page, then conversion rates will typically increase. If your visitors must visit multiple pages throughout the site conversion rates will fall, almost no matter how good the site is. The trick is to channel visitors to a goal and offer them as few opportunities to exit the channel as possible.

Return on Investment — At the end of the day, ROI encompasses the whole ball of wax. No matter what’s going on with traffic and conversions if you are spending more on advertising then you make in net income then your ROI is upside down. Its very easy for clients to lose sight of ROI when sales volume is up, but we’ve seen many businesses with multi-million dollar gross revenues (or even billion dollar revenues such as GM, Enron, etc) work all year without making a true profit. ROI is a simple concept and just needs to be calculated with fairly easily obtained business numbers. If conversions are accurately tracked to their originating source then calculating ROI for any particular marketing source or channel is easy. Lets take this basic example. Company sells widgets for $5 each. These widgets are drop-shipped and the cost of goods sold is $3. We can assume there is also another $1 in general and administrative costs required for each sale. So this leaves $1 in simplified potential net profit per sale. If we have a conversion rate of 5% then we can’t afford to spend any more than $5 per 100 visitors to break even. With this simplified example you can quickly see how easy it is to be upside-down with ROI if you don’t take the time to calculate it.

What percentage of profit is allocated for online marketing?

A landscaping company charges their commercial clients $10,000 per season for a large account and is willing to dedicate 10% ($1,000) to acquire each new account. In this case $1,000 worth of online marketing is allocated to bring in $10,000 worth of new business.

What percentage of actions results in a sale?

Based on prior sales and conversion data gained from testing it is determined that 10% of contact forms or phone calls turn in to a commercial account valued at $10,000.

What percentage of visitors takes action (contact form, download, phone call, etc)?

Using web site statistical tracking like Google Analytics we can determine the ratio of visitors to contact form submissions. In this case 5% of all visitors to the site fill out a contact form requesting more information or a price quote. Based on the 5% contact form conversion ratio we determine the target cost per acquisition (CPA) is $50. How much should you pay for each visitor?

The target CPA for a contact form submission at $50 and it is determined that 5% of all visitors result in a contact form conversion. Based on this data we deduce that each new visitor to the website has a value of $2.50. This value really translates to the cost you can pay for each visitor and still remain profitable.

Knowing how much a visitor is worth to your business, conversion ratios, and potential profit from a sale allows you to determine if your marketing dollars are being spent effectively and how to allocate your marketing budget for the highest return.