Optimizing to Maximum Profit

In the current economic conditions, marketers are re-evaluating their strategies. Many marketers have gone from maximizing orders subject to a maximum CPA or maximizing revenue at an ROI to maximizing profit. While many marketers think that profit maximization requires a different kind of approach, it is not the case. Profit maximization and revenue maximization are related. Indeed, if revenue maximization is done via model based optimization, not only can one maximize profit but can also gain a deep insight into the tradeoffs made when maximizing to profit.

$0 $5,000 $10,000 $15,000 $20,000 $25,000 $30,000 $35,000 $40,000-$15,000

-$10,000

-$5,000

$0

$5,000

$10,000

$15,000

$20,000

$25,000

$30,000

$0

$2,878$5,188

$7,388$9,448

$11,400$13,340

$15,188$16,788

$18,188$19,488

$22,488 $23,488 $24,088

$0 $1,188

$1,388 $1,448$1,400 $1,340 $1,188$188

-$512-$2,312 -$4,912

-$8,212

-$11,912

Efficient Frontier: Maximizing Profit

Profit Revenue

The graph above shows the efficient frontier for both revenue and profit. We have spoke about the revenue curve several times, so this would be a familiar looking curve to a regular reader of this blog.

Note, the corresponding profit curve. Profits first increase and then start to decline despite increasing revenues. This will always be the case for any SEM advertiser. Why ? The Marginal ROI. As the advertiser spends increasing amounts, the best available advertising opportunities reduce and the ones left are the less profitable ones. Further, as long as the marginal ROI is above break even, profits continue to increase. As a result, profits first increase when marginal ROI’s exceed break even and then decline when marginal ROI goes below break even.

The most interesting aspect of the profit curve is its sensitivity. A closer look at the numbers between $4,000 and $14,000 of spend (Table 1) reveals that the point of maximum profit is at a spend of $8,000 with a profit of $1,448 and revenues of $9,448. However, note that the difference in profit at the $8k spend level and the $14k spend level is only $260 ($1,448-$1,188). On the other hand, the difference in revenue is ($5,740). This insight brings us to the crux of the discussion: Would you be willing to forego $260 in profit (18% decrease) for an additional $5,740 in revenue (61% increase)?

Cost Revenue Profit $ 4,000 $ 5,188 $ 1,188 $ 6,000 $ 7,388 $ 1,388 $ 8,000 $ 9,448 $ 1,448 $ 10,000 $ 11,400 $ 1,400 $ 12,000 $ 13,340 $ 1,340 $ 14,000 $ 15,188 $ 1,188Table 1: Spend, Revenue and Profit at varying budget levels.

There are two other key points that I wish to make before ending this discussion:

Don’t get blindsided by rules: Theoretically, if I simply bid by the rule that I should bid every keyword to the position of maximum profitability I would be able to reach the conclusion as the models based portfolio approach; I should spend $8,000 for maximum profit and would get $9,448 in revenue. However, you would never know about the tradeoffs you are making by making this rule and that in our opinion is the more important question. I’ll ask again: Would you be willing to forego $260 in profit for an additional $5,740 in revenue ? The discussion also assumes you have excellent models to come to right conclusion, which brings me to my next point

Make sure you have great keyword models: Having accurate keyword models is crucial to optimize your keyword set. Poor models would lead to wrong bidding decisions which could adversely affect your business. Good models are important for revenue maximization but are absolutely crucial for profit maximization. Consider for example, that the revenue model at the $4,000 spend level overpredicts 10%. The revenue would jump to $$5,706 and the profit would be estimated at $1,706, the higest in the curve. If you were profit maximizing you would pick this spend level and make $5,188 in revenue. The correct decision would have been to pick the $8,000 spend level for $9,448 in revenue. This decision just cost you $4,260 in revenue !