Paid Search: Bidding Based on ROI

Nico Brooks

April 26, 2010

Paid Search: Bidding Based on ROI

Bidding for ROI

This article explains some basic concepts related to bidding on paid search keywords based on return on investment (ROI). Using ROI to make bidding decisions helps ensure that you are spending your advertising dollars in the most effective ways possible.

To explain these concepts, we will use paid search marketers Jane and Lisa as examples.

  • Jane’s goal is to generate as much revenue as possible, but she doesn’t want to spend more than a dollar in advertising for every $5 in sales.
  • Lisa’s goal is to drive as many leads possible at a cost per acquisition (CPA) of $10.

A few definitions to start things off:

  • Click – a paid search click bought on Google, Yahoo or Bing
  • Conversion – a click-to-sale conversion. A conversion is when someone clicks through to your site, then completes a purchase. This could also be a click-to-lead conversion if your goal is to drive leads
  • Conversion Rate – the percentage of time clicks convert to sales. For example, a conversion rate of 5% means that 5 out of every 100 clicks result in sales.
  • Average Sale – the average value of a sale
  • ROAS – return on ad spend: the return in sales you are getting on your paid search investment. I will calculate this as $X in sales for every dollar spent
  • CPC – cost per click: what you are paying per click in Google, Yahoo or Bing
  • Target CPC – the cost per click you should be paying to achieve your target ROAS

Here’s an example scenario: Jane is paying $0.10 per click, 10% of clicks are converting to sales, and her average sale is $5. This means that on average she generates $5 in revenue for every $1 she spends to buy clicks. Therefore, her ROAS is $5.

If Jane is ok with a lower ROAS, she can generate more sales. Spending more per click will lower her ROAS, but the higher CPC will also drive more traffic. For example, if she can achieve her profit goals at a $2.50 ROAS, she can afford to pay $0.20 per click. Here is the math:

ROAS = Sales / Ad Spend
= (Average Sale X Conversion Rate X Clicks) / (Clicks X CPC)
= (Average Sale X Conversion Rate) / CPC

Solving for CPC, we get:

Target CPC = (Average Sale X Conversion Rate) / Target ROAS

Substituting Jane’s goal for ROAS, we get:

Target CPC = ($5 X 10% / $2.50) = $0.20

The process is similar for Lisa. Cost per acquisition is total cost divided by the number of acquisitions, or:

CPA = Ad Spend / Conversions
= (Clicks X CPC) / (Clicks X Conversion Rate)
= CPC / Conversion Rate

Solving for CPC, we get:

Target CPC = Target CPA X Conversion Rate

Substituting Lisa’s goal for CPA and assuming a conversion rate of 10%, we get:

Target CPC = $10 X 10% = $1.00

These calculations are pretty straightforward, and many paid search marketers use some variation of these methods. There are also a number of automated bidding systems that have formulas like these somewhere under the hood.

One assumption we’ve made is that we know Jane and Lisa’s conversion rates, but that is not necessarily a safe assumption. To learn more about the challenges of estimating conversion rates, have a look at this article: Paid Search: Bidding with Confidence.

And if you do not currently have the ability to track leads or sales to a keyword ad, Google Analytics is free and will do the job. If you would like help tracking performance or optimizing your paid search campaigns contact us.