Choosing a Pay-Per-Click (PPC) pricing model which works efficiently for both client and agency is a difficult process. A good pricing model should be simple, should create incentives for the agency to perform and should be a fair measure of the work and expertise involved.

One common model that many agencies use is the ‘markup’ model (also commonly known as the ‘percentage of spend’ model). If the agreed markup is 10%, and the client spends $30,000 on clicks, the client pays $33,000, of which the agency receives $3,000.

Nice and simple.

But does it create incentives for the agency to maximise profit for the client? Does it fairly reflect the work and expertise involved at all spend levels?

No.

Conflict of Interest

In short, the percentage of spend model is a highly inefficient pricing model for paid search management, and should be avoided. As pointed out by George Michie in his recent post on SEM Pricing Models, since the agency receives a commission on every dollar spent, there is an incentive for the agency to spend as much as possible, which can be far in excess of the point of diminishing marginal returns.

To find out exactly what George means by diminishing marginal returns, and how it creates a conflict of interest for client and agency and renders the markup model pretty much useless, let’s consider the cost and revenue structure of the client.

Look at the line CPC (marginal) in the diagram below (Cost Per Click). It shows what happens to the Cost of each subsequent Click as the volume of clicks increase. It is upward-sloping, so each extra click costs progressively more than each previous click. Makes sense – since the first few clicks are usually very cheap, and raising bids and showing for more expensive keywords is generally needed to increase click volume.

Now have a look at the line RPC (marginal). It stands for Revenue Per Click, and shows how much Revenue is generated from each subsequent Click. It is downward-sloping, which again makes sense, since each additional click is likely to be less relevant and have a lower conversion rate than each previous click (this is known as diminishing marginal returns). A rational advertiser would always go for the low hanging fruit first (the most relevant keywords), which will naturally convert better than the high hanging fruit (less relevant generic keywords).

(If this all sounds very confusing, you may like to check out Wikipedia’s articles on marginal cost and diminishing marginal returns first).

So we have an upward-sloping marginal CPC line and a download-sloping marginal RPC line.

Now, assume the client has no other costs other than paid search click costs. If the client spends $1,000 on clicks and generates $1,500 in revenue, the client makes $500 in profit (this is of course very unrealistic – but just bear with me for the sake of argument).

Look at where the two lines cross. This is the level (2,000 clicks) where the client will make the most profit.

Upward Sloping Marginal Cost (MC) Curve

Why?

Well suppose click volume increased to 2,100 clicks. The 2,100th click is now costing $0.85, but is only bringing in $0.55 of revenue! The client is losing money on these extra 100 clicks, so reducing click volume would increase the client’s total profit.

Downward Sloping Marginal Revenue (MR) Curve

What about reducing click volume?

Well, at 1,900 clicks, the 1,900th click is costing only $0.65 but generating $0.85 of revenue. The client is making $0.20 profit from their 1,900th click, so why not increase click volume further, and make $0.19, $0.18 and $0.17 profit from additional clicks? It makes sense to increase click volume until no additional profit is being made – until the cost of an extra click equals the revenue of that click.

Profit Maximization Where MC=MRIt is where the marginal CPC and marginal RPC lines meet that no additional profit would be made, and it is at this point which makes the client the most profit. It is this level of click volume that the client should aim to target with their PPC activity.

Economics Maximum Client Profit

Now let’s complicate things a little. The graphs above were only concerned with marginal costs and marginal revenues – costs and revenue at the margin. They show what happens to the next click or the previous click, but they don’t show what happens on average – to the average cost per click or the average revenue per click. Average CPC and average RPC lines are therefore needed for this purpose.

Have a look at the red CPC (average) line and see if it makes sense. Like the green CPC (marginal) line, it’s upward-sloping, but flatter. Why?

Think about it for a second.

If you just spent $1,000 on 2,000 clicks, each click costed you $0.50 each on average, right? If you then decided to go crazy and purchase a few extra clicks on some expensive keywords for a hefty $4.00 each, what will happen to your average CPC price? It will increase, but not by very much, maybe to $0.41? Adding some expensive clicks will pull up the average, but only by a relatively small amount. Hence the flatness of the average Cost Per Click line.

The same is true with the average Revenue Per Click line. If a few extra keywords bring in only a small amount of revenue, it will pull down your average revenue, but only slightly, hence it’s flatness.

Average Cost Curves Are FlatterStill following?

Great. So we now have 4 lines which represent the cost and revenue structure of a client:

  1. Marginal CPC – shows how much each extra click costs
  2. Marginal RPC – shows how much each extra clicks generates in revenue
  3. Average CPC – shows how much clicks cost on average
  4. Average RPC – shows how much clicks generate in revenue on average

These 4 lines are all that’s needed to assess the client’s profitability.

Now remember how we decided that 2,000 clicks was the most profitable click volume for the client? Let’s see exactly how much profit the client is making from 2,000 clicks.

Well, at 2,000 clicks, the average cost per click (CPC average) is $0.30. The client is spending $600 on clicks ($0.30 x 2,000).

At 2,000 clicks, the average revenue per click (RPC average) is $1.50. The client is generating $3,000 in revenue ($1.50 x 2,000).

PPC Pricing Markup Model

Minus one from the other ($3,000 – $600) and we have a healthy client profit of $2,400.

Fantastic.

Profit from Percentage of Spend PPC Model

Now this is where the inefficiency with the percentage of spend (markup) model comes in. Since the agency is paid a commission on every click, the agency will always want to increase click volume and spend as much as possible. As we’ll see from the following examples, this is often in excess of the point of maximum client profit.

Suppose the agency increased click volume to 3,000. The average Cost Per Click (CPC) increases from £0.30 to $0.45, and the average Revenue Per Click (RPC) falls from $1.50 to $1.20. The client is still making a healthy profit of $2,250 (revenue of $3,600 ($1.20 x 3,000) minus cost of $1,350 ($0.45 x 3,000)), although their profit of $2,250 is less the previous level of $2,400.

The agency, however, has increased their profit, since they now receive a cut of a bigger spend ($1,350 instead of $600). Assuming the markup is 10%, the agency’s profit has increased from $60 to $135, at the expense of the client’s profit.

But here’s the thing. The client is unlikely to complain – the agency is making them $2,250 of profit, after all! How is the client to know that they could be making $2,400 of profit, should the agency decide to reduce click volume? The client is none the wiser and would most likely praise the agency for their ‘efficient’ work in making them such as tidy profit of $2,250!

Why Marking up Click Costs is Inefficient

But why stop there?

The agency makes a cut of every click spent, so why not increase click volume further? Why not increase it to – wait for it – 4,000 clicks!

Here, at 4,000 clicks, click spend will be $3,000 ($0.75 x 4,000) so the agency’s profit will be $300 (10% of $3,000) – much better than the measly $60 or $135 from the previous click volumes of 2,000 and 3,000.

But look at what’s happened to the client’s profit at this new click volume of 4,000. Their costs are now $3,000 ($0.75 x 4,000) and so is their revenue! The client is making no profit at all! Any more spend, and the client’s average revenue will fall below their average cost, and they will make a loss. If the client is losing money, they will most likely leave the agency, or at least apply massive pressure on the agency to increase performance (reduce click volume), so any click volume in excess of 4,000 is not sustainable in the long-run.

AdWords agency has incentive to spend as much as possible

So it’s in the agency’s interest to maximise their commission by getting the click volume as close to the point of 4,000 click where the red lines cross (where average costs equals average revenue) – but without going over, so as to keep the client happy (the client will still be making some profit).

Confict of interest between SEM advertising agency and client

What happens is a negotiation of pushing and pulling between the client and agency until a compromise is found – say 3,000 clicks. Exactly how close to the point of maximum client profit or the point of maximum agency profit is settled upon depends on the relative bargaining strengths of client and agency, access to cost and revenue information and countless external influences to name just a few factors at play.

Paid search markup model is inefficient

What is clear though, is that whatever click volume is reached as a compromise, it will not be efficient. It is impossible to maximise the profit of both client and agency using a percentage of spend model. At every click volume, there will always be a way to increase agency or client profit by adjusting click volume.

With a percentage of spend model, there is no working together of client and agency, no common goal, no shared vision. It’s a constant pushing and pulling and conflict of interest. Time and effort is wastefully diverted into politics in an attempt to move click volume closer to one party’s optimum, not to mention the reluctance of each party to be open and transparent and share useful information with each other. Doesn’t sound like the foundations of a successful and lasting business relationship to me. Perhaps it’s why some agency churn rates are so high?

Of course, no PPC pricing model is perfect – every method will have its weaknesses. The key is to find one that works best for your goals and objectives as a business, and one which appropriately compensates the agency for their efforts in helping you develop your paid search marketing strategy. But in terms of aligning the agency’s monetary motivations with that of your business, and creating incentives encouraging them to maximise your profit from paid search, the percentage of spend model fails miserably.

My advice: use the percentage of spend model with caution.

Are you a fan of the percentage of spend model? Have you made it work for client and agency? Or does it create more problems than it’s worth? Share your thoughts in the comments section below.

Next: cost-per-sale performance models – rewarding agencies based on how they perform. Do they work? Are they efficient? Economics of PPC Pricing: Why Performance Deals Often Fail

Alan Mitchell

Alan Mitchell is a Google AdWords PPC specialist, based in Melbourne, Australia, with a proven track record at improving return on investment (ROI) from Google AdWords. Find out how Alan can help your business.