CPM, CPC, CPA, and the Transfer of Risk

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This is a post I wrote on Tumblr a long time ago (July 2011!) but no one read it.
The point is still valid, so I’m copying it here with slight updates.

I am currently employed in the CPA side of the online advertisement industry, putting me solidly in a minority. There are millions of sites that explain the definition of CPM, CPC, and CPA individually, but not many describe them relative to each other. Just to go over the basics:

  • CPM: Cost Per Mille. Advertiser pays the publisher per 1000 of visitors who the advertisement is shown to. Cost = # of Impressions / 1000 * CPM
  • CPC: Cost Per Click. Advertiser pays the publisher for each click on the advertisement. Cost = # of Clicks * CPC
  • CPA: Cost Per Action. Advertiser pays the publisher for each desired action such as a percentage of sales or a filled out form. Cost = # of Actions * CPA

So how do these different pricing models relate to each other?

  • # of Clicks = # of Impressions * Click Through Rate (CTR)
  • # of Actions = # of Clicks * Conversion Rate (CVR)
  • So, # of Actions = # of Impressions * CTR * CVR

If you are paying $100,000 for a campaign and you get 1,000,000 impressions, CTR = 10% and CVR=10%, what are the CPM, CPC, and CPA?

  • CPM = $100,000 / (1mm / 1000) = $100 (or $0.1 per impression)
  • CPC = $100,000 / (1mm*10%) = $1
  • CPA = $100,000 / (1mm*10%*10%) = $10

This means we can relate the three this way:
CPM/1000 = CPC/CTR = CPA/CTR/CVR

Except, we did not consider one thing, and that is this guy…


Risk.

Both click through rate and conversion rate will have a standard deviation, meaning those numbers are never constant.Sometimes the numbers will be above average and sometimes will fall below average. Even if you know the median CTR and CVR for the publisher, advertiser, and the advertisement, that’s not always going to happen (in fact that will almost never happen). The wider the distribution curve, the more likely the CTR and CAR will diverge from the median, which means higher risk for either the advertiser or the publisher.

Changing the pricing model from CPM to CPC to CPA is the act of transferring risk from the advertiser to the publisher. Let’s take a leap of faith and assume that the advertiser wants to drive sales.

In a CPM model, the advertiser is bearing both the risk in CTR and CVR. From the publisher’s perspective, all you need to do is drive traffic and you’ll get paid. If you decide to run a yamaka ad on a mormon website, you’ll still get paid. The advertiser is bearing all the risk.

In CPC, the advertiser transfers the CTR risk to the publisher. Now that yamaka ad is not going to do too well. The incentive for the publisher is to show advertisements that is relevant to the audience so they can generate clicks.

In CPA, the advertiser transfers not only the CTR risk but also the CVR risk. So even if the publisher is able to generate traffic to the advertiser website, they won’t get paid unless the user actually purchases something or fills out a form.

That is asking a publisher to do a lot. If you think about a percent of sale offer, the publisher is taking more risks than just CTR and CVR. If the user only spends $2 on the website, the publisher will only get a tiny pay. So the publisher is also taking on the risk of the average order value (AOV). In fact, CPA is basically riskfree for the advertiser and it should not even be considered a marketing expense. It is more of a cost of goods sold expense.

So, in order for the publisher to take on more and more risk, the below formula must hold true.
CPM/1000 < CPC/CTR < CPA/CTR/CVR
The publisher must be rewarded with a higher payday with CPA compared to CPC, which in turn will be more expensive than CPM.

Exactly how much more expensive should CPA be? That’s the million (billion?) dollar question. We are valuing risk based on standard deviation which from my knowledge, sounds awfully like an option…

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9 thoughts on “CPM, CPC, CPA, and the Transfer of Risk

  1. Bob Snyder

    it’s funny that CPA is usually a small percentage of sales, but alot of advertisers spend huge CPCs on google.

    Reply
  2. admin Post author

    The assumption for paying a high CPC used to be that publishers know their traffic better than advertisers. Now that advertisers can have visibility into and bid on impressions that visit the publisher website, there is no value add in having the publisher take the CTR risk. Ad spend is bound to move towards CPM, as we are seeing already.

    Reply
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  8. Garrett

    Hi Ron,

    Great article! There are quite a few publishers out there that say CPA works better for them, through affiliate offers that are extremely relevant to their content.

    However, I’d say that most publishers still prefer CPM payout model as it provides more predictable revenue.

    I was curious about your thoughts on how Ad Exchanges play a role in the ecosystem- and whether you foresee reduction in yield for publishers as exchanges commoditize their inventory?

    Reply
  9. ronkato Post author

    Thanks Garrett!
    In general, publishers who are in the business of creating contents and attracting traffic are better off monetizing on CPM. It’s the publishers who are in the business of attracting and converting traffic that should be on CPA. Take this blog as an example. I won’t monetize this on CPA because readers aren’t in the shopping mindset and my contents are not a good fit. Who would buy shoes while reading about ad tech? I would be better off creating great contents, attracting traffic, and monetize in CPM. Only issue is, I don’t get much traffic, hence the lack of advertisements here.

    I think exchanges and DSPs allow specialization. If you are a contents publisher, you are in the business of creating contents and attracting traffic. You are not in the business of understanding your traffic and targeting ads. That part can be outsourced to the exchange so you can focus on improving your contents. So CPM may go down but that doesn’t necessarily mean lower revenue. As you said, impressions have been commoditized and as with any commodity market, publishers now have to play the volume game.

    Reply

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