Direct response advertising through AdWords probably has an ROI greater than any other investment opportunity available to an ecommerce merchant. It’s far greater than most people realize. The real return on investment is obscured by the way traditional cost accounting records the transactions and reports on them on a monthly basis. It’s easy to get distracted by tax accounting rules and forget the fundamentals of solid financial decision making.

### An Ecommerce Merchant Example

Let me start with a typical example. Let’s say we have an ecommerce merchant that runs a Magento store pulling in millions of dollars per year in revenue. The owner isn’t sure that a $20,000 per month PPC ad spend is truly worth it. This store’s average order value on these transactions is $80 and the AdWords account is generating around 600 of these sales per month, totaling $48,000 in revenue. The owner thinks this isn’t enough to warrant such a high advertising expense. After all, the normal cost of goods sold is around 50%, or $24,000 of this revenue, and the advertising expense reduces what could have been a $24,000 margin down to a mere $4,000. Ouch!

In this scenario, the contribution margin coming out of these transactions can be expressed like this:

\[ \begin{align} CM &= Revenue - (Cost_{COGS} + Cost_{Advertising}) \\ CM &= 48000 - (24000 + 20000) \\ CM &= 4000 \end{align}\]

The business owner is rightly concerned that a $4,000 gross profit margin is low, and doesn’t cover much overhead. I won’t address the issue of overhead in this post since we’re just focused on ROI here, but that’s an interesting question worthy of more discussion, which I will tackle soon.

A $4,000 GPM on $48,000 in revenue is only an 8.33% profit margin, which is pretty thin for most businesses. If the rest of the business is generating a 50% gross profit margin, this can make the marginal revenue coming from online advertising seem really expensive and potentially not worth it at that price. But there’s more to the story.

### Why We Should Think of Advertising as an Investment

I’m going to firmly state right here and now that thinking about online advertising from a cost accounting perspective leads you to some errors in judgment. There is certainly a place for cost accounting, but rational financial decisions need to be made differently. Expressed as a cost, AdWords is very expensive. But let’s flip this analysis around and think about it in terms of ROI to see it from another angle.

What are the characteristics of an investment? It requires committing some assets up front. We have some risk associated with the investment which could result in us not getting our money back. There’s some potential for a return that’s higher than the amount we invest, or an ongoing stream of cash coming out of the investment that compensates us for taking that risk.

In an AdWords account for an ecommerce company doing direct response advertising for immediate conversions, an alternate perspective is this:

We commit some money to our AdWords account as an initial investment. We get some conversions. As long as the conversion value is higher than our marginal costs of getting those conversions, including the advertising costs, we have gotten our original cash back and received a return on our investment. As long as we’re not losing money on transactions, we have an investment with a return.

In addition, we’re also building another valuable asset. An AdWords account is really an automated set of proprietary business rules that turns into a money-generating machine. A well-tuned AdWords account is a machine that spits out cash. You set it up, then feed it some investment dollars, and it returns that investment with interest over and over.

Unlike most long-term investments, you’re really feeding your AdWords investment on a very short time horizon and getting nearly immediate returns. Maximizing our business profitability involves tuning this account and turning it into a cash cow.

### Revisiting the Definition of ROI

Let’s do a quick refresher from Business 101. ROI, stated simply, is the profit divided by the investment. As a practical tool for comparing the returns available from different investments, it’s also typically stated in annual terms. For example, my bank’s savings account will generate a 0.05% ROI for me right now, in 2015. If I invest $1,000 in a saving account and leave it in place for a year, I will have my original $1,000 investment, plus an additional 50 cents in interest. Not a great investment.

The formula for ROI is simply:

\[ ROI = \frac{Return} {Investment}\]

### Converting to Annualized Rates of Return

To make it easier to compare different investments against each other, it’s typical to express various rates of return in annualized terms. A ROI of 5% in the course of 1 month is far more valuable than an investment that will return 5% annually.

Converting from a different return period to an annual rate of return is simple:

\[ Return_{Annual} = [(1 + Return_{PerPeriod}) ^ {PeriodsPerYear} ] -1\]

If my bank gave 0.05% interest every day, I could covert this into an annual rate of return like this:

\[ \begin{align*} Return_{Annual} &= [(1 + 0.0005) ^ {365}] - 1 \\ Return_{Annual} &= 20.02\% \end{align*}\]

A 20% rate of return from a savings account! Wow, that would be nice.

### Calculating the ROI of Our Example

The monthly ROI from our example above is not the 8.33% gross profit margin. If we look at it on a monthly basis, what’s happening is that we’re spending $20,000 for advertising and another $24,000 in marginal costs, and we’re getting back $4,000 in returns. The ROI calculation is:

\[ \begin{align*} ROI_{Monthly} &= \frac {4000} {(20000 + 24000)} \\ ROI_{Monthly} &= 9.09\% \end{align*}\]

This monthly ROI is pretty massive. If you have some cash lying around, who wouldn’t invest it in something that would return all of the original investment, plus another 9% in only one month?!

Viewed from this perspective, we’re not spending $20,000 per month on advertising. We’re investing it and getting it back within a month, with interest. Then we’re choosing to reinvest it again next month, since the investment is so amazing.

So what is the annual rate of return in this example? Well, going back to our conversion formula, it’s:

\[ \begin{align} Return_{Annual} &= [(1 + 0.0909)] ^ {12}] - 1 \\ Return_{Annual} &= 184\% \end{align}\]

A 184% ROI sounds pretty amazing.

### What About Those Other Costs?

Now before I go further, I’m going to admit that I’m not getting really sophisticated with the other marginal costs in my examples. Some of those costs are not quite the same as the money going into AdWords. Most of our COGS is going to be money invested into product inventory, and we might be holding inventory for longer than the one month window in my above example. Some of the marginal cost is credit card processing fees, and labor cost for packing boxes if we have to give our shippers more hours.

Although necessary to consider for some business decisions, getting into the nitty-gritty on those details isn’t actually relevant for the point I’m trying to make. My point is that sales from online advertising can look expensive at the margins, but the returns are far higher than you expect because you’re getting your investment back quickly. And you have very little money actually committed to advertising.

So let’s gloss over those other details for now and just consider two things: We’re spending $20,000 a month on advertising, and it’s driving $4,000 per month in contribution margin after paying for all costs.

### AdWords Isn’t Actually a Monthly Return

Here’s the thing. The previous example still understates what’s actually going on. Because we’re not really committing $20,000 into our advertising for a month before we get it back with a return of $4,000. We’re actually getting it back much sooner. Much, much sooner.

Remember, in this example we’re getting about 600 conversions per month. That means, on average, we’re getting about 20 conversions per day, or about one conversion every 72 minutes.

So we’re sinking some money into our AdWords moneymaking machine and a bit over an hour later it spits out a conversion event for us, which is, on average, a return of our cash plus a return on that cash. So let’s look at an ROI analysis from the perspective of one of these individual conversion events.

In the example, our GPM is 8.33%. On an $80 average transaction, we get a marginal revenue increase of $6.66. Our average ad cost to get that sale was \(\frac {$20,000} {600}\), or $33.33. The other $40 in cost was our COGS and transaction processing. Bottom line: we invested $33.33 in our AdWords account, and it spit out $6.66 new cash for us, in addition to paying all the costs. And it does that every 72 minutes.

The periodic return on this, every 72 minutes, is:

\[ \begin{align*} Return_{PerPeriod} &= \frac {6.66} {33.33} \\ Return_{PerPeriod} &= 20\% \end{align*}\]

We invested $33.33 and got a 20% return in 72 minutes. There are 20 of those periods per day, and 7300 of those periods per year. The formula for our annual rate of return is:

\[ Return_{Annual} = [(1 + 0.2) ^ {7300}] - 1\]

When I punch that into my old-school financial calculator that I use for quick math, the resulting number exceeds the 10 digits available on the display. That’s because it’s actually a 581 digit number:

10 546 203 510 194 006 984 935 775 287 170 570 284 975 505 823 167 209 439 097 598 034 194 246 783 801 246 469 543 648 267 744 019 981 105 166 645 166 864 800 099 738 834 741 806 102 943 800 573 664 495 382 499 380 738 080 706 822 601 336 062 784 037 118 616 928 436 323 529 151 611 980 582 120 346 164 766 710 693 629 009 635 289 190 975 534 560 035 383 694 471 420 235 152 511 601 716 744 789 135 859 846 312 972 050 563 612 891 009 774 559 711 612 859 355 424 888 328 554 079 290 772 115 670 315 649 232 047 604 036 700 555 541 470 494 115 571 062 585 823 210 250 975 889 283 475 854 741 071 365 767 149 272 466 984 051 307 546 597 507 195 753 334 328 653 750 253 851 637 741 610 417 814 111 283 958 709 634 768 246 407 175 744 117 435 782 348 257 108 620 589 337 369 360%

Okay, that’s a bit ridiculous. But it illustrates my key point:

AdWords isn’t a huge expense. It’s a tiny investment that you make over and over again, with a massive return.

In this case it’s a $33.33 investment that you reinvest every 72 minutes, with a 581 digit annualized rate of return.

### So What?

Being able to invest $30 or $40 with a massive rate of return isn’t really impressive. I want to invest thousands of dollars with a great rate of return. Actually, a lot more. And there are real limits to how much you can actually invest in AdWords before you experience declining returns. That said, there are ways to optimize this so you can get the best bang for your buck.

I hope this changes your thinking a little bit. The monthly expense isn’t the whole story. It’s certainly useful for certain kinds decisions. Other decisions are better made using cash flow models or considering the financial returns on the relatively tiny amount of cash that is tied up in AdWords.

As long as you’re generating any positive contribution margin, and getting a reasonable conversion rate, keeping money invested in AdWords is a higher-NPV activity than any other investment option that you have open to you. Cutting the budget is always the wrong answer to increasing the profitability. The monthly spend obscures the true amount of cash that’s being tied up in AdWords. The key is to ensure that everything you spend on your PPC online advertising is generating margin. After that, maximizing your profitability will come not from controlling costs, but from investing more and working to increase those rates of return. That will look like a larger monthly ad spend to your tax accountant, but it will also show up on your income statement where it truly matters: the bottom line.

Psyberware specializes in managing online advertising for ecommerce businesses, and nothing else. If you want to build a great relationship with a group of dedicated people who really understand ecommerce, get in touch with us.