One of the most focused ways to reach who have an interest in your offering is by purchasing Adwords. Adwords are offered by Google on an auction basis and the following description applies specifically to Google. But there are a number of other similar alternative venues and pricing schemes. The way the Adwords auction market works is as follows. First, when a user enters search terms into Google, Google identifies ad words, terms that advertisers have placed bids on that match the searchers topic. This step is not trivial from a computing point of view. For example, Google may match a user search on emergency pet care to the key words veterinary hospital and animal hospital. Advertisers bid on their keywords by setting a maximum cost per click-through, or Max CPC for each keyword they are interested in. CPC bidding is also sometimes called pay per click, or PPC. Typically, winning adword bids are sold for less than the maximum CPC. The actual CPC is typically 1 to $2. The formula for how actual CPC is calculated is a little complicated and we'll leave that for another day. Currently, the most expensive adwords that you can buy are per-click through prices for insurance, attorney, and mortgage, $54, $47, and $47 respectively. Note that Google gets paid only when someone clicks through a sponsored link to the advertiser's landing page. Google ranks the links that it shows. Higher ranked links get more attention and more clicks. Google could maximize its revenues by ranking highest, links that maximize actual CPC multiplied by the expected click-through rate. In fact, Google does almost exactly this calculation. But instead of multiplying the CPC by the expected click-through rate alone, they multiply CPC by a metric called a Quality Score that includes the expected click-through rate and two other factors. The other weighting factors are ad relevance and landing page experience. In Google's words what this means is the quality of your ad text and landing page in the context of what a user is searching for. This may sound mysterious, but the purpose of the two additional waiting factors is to prevent exploitative misdirection that would hurt the Google brand. For example, imagine if a liquor store decided to buy adwords related to emergency pet care, the example we used before, on the theory that people with a sick pet could probably use a drink. Google automatically parses the text of the sponsored link, and of the web page the sponsored link points to, the so-called landing page. If either text does not contained primarily language directly related to the medical care of animals, the liquor store would get a very low quality score for that bid. Google aims to offer sponsored links to landing pages that are as similar as possible in subject matter, quality, and click-through rates to the webpages that Google ranks highest in its unsponsored or organic search results. To avoid low quality scores the rule of thumb is be yourself. Keep your landing page text directly relevant to your adwords and vice versa. If we bid on adwords such as vegetarian pizza and frozen pizza, we should have a reasonably good quality score, so long as we make sure that our landing page contains substantive information about our product, like information on our ingredients, our vegetarian philosophy, etc. If we tried to sell ads on our homepage or direct people to links on other topics, that would also negatively impact our quality score. Once we develop some experience with bidding on adwords, we will have data on the typical actual cost per click through, actual CPC we are paying. We can track just the users who come to our website through a sponsored link and determine what percentage of them ultimately buy our product at least once. This percentage is our conversion rate for sponsored links. The actual CPC divided by the conversion rate is our acquisition cost for new customers through the sponsored link channel. Some customers will buy from us only once. Others become recurring revenue customers. Once we have enough conversions to develop an idea of what the average pattern of purchases over time is, from each conversion, we can estimate a lifetime value, or LTV, of each customer. This represents the present value of all future revenues from that customer. Lifetime value is calculated in a number of different ways. There's an excellent infographic produced by Kissmetrics, and we'll provide a link to that in the supplemental materials and we'll give some different formulas in the glossary as well. If we assume that the lifetime value for our pizza business for each customer is $500, then in theory with a conversion rate of $2, we could pay anything up to but not over $10 CPC and still be profitable. However, this standard calculation is a bit misleading in my opinion. Unless your company is already very cash flow positive, your goal should be a cost of customer acquisition less than the first year's average revenues per customer. So, if our pizza sales on average or $85 per new customer in the first year and we are paying $2 CPC with a conversion rate of 2%, we are paying $100 cash to acquire each customer with an expected revenue of only $85. That is potentially risky. This customer may be profitable over a lifetime, but don't forget what happened to Egger's Roast Coffee. Don't run out of cash on your way to riches. We need a CPC of under $1.70 to recover the cash outlay of our campaign within a year. Even then we will be cash flow negative because $85 is the average revenue total sales, not the positive cash flow from that customer's sales.
