Diseconomies of paid marketing

Digital marketing generally will create more sales, especially given the distribution capabilities of today’s leading ad platforms, but marketing spend is rarely frictionless. The cost to acquire more of a given population increases faster than sales because the quality of the additional traffic tends to decline, but this doesn’t necessarily mean you should stop spending.

Simple example

Say that you run a company that sells widgets, with a product margin of $10 per widget. You have recently been spending money on an ad platform called Poople, obtaining new widget orders at a cost of $5 per order. You are acquiring about 1000 orders per month through Poople, and now have the opportunity to increase your spend to acquire 1100 orders per month. To do this, you have calculated that your cost will now come out to $6 per order. Do you spend the money and increase sales at the increased cost?

Framing the problem

It helps to think of this decision in terms of marginal costs and profit. As far as you know, every additional widget sold will earn you $10, so your marginal profit is flat. You’ve now calculated that your additional cost per acquired order on Poople will increase from $5 to $6. So the question is whether the additional cost of the additional orders is lower than the additional margins from those additional orders (which you already know is $10).

The math

Once you’ve framed the problem, the math is fairly straightforward:

Marginal product margin = $10 / widget order
Marginal cost from marketing spend increase
= ($6 x 1100 - $5 x 1000)/(1100-1000)
= ($6600-$5000)/(1100-1000)
= ($1600)/(100)
= $16 / widget order

In this case, the marginal cost is higher than the marginal product margin. So each additional order is actually unprofitable, and it’s not worth the growth unless you are getting $6 worth of additional value from those orders outside of what the customers are paying.

Let’s say you would have been able to achieve 1200 orders after the added spend instead of 1100. In this case the marginal cost ends up being $8, meaning you’d continue making money on the additional widgets. At $8, the profit is less per widget than you make on the baseline 1000 orders, but it’s still a positive return, which makes the growth worth it.

Conclusion

Make sure to understand and pay attention to marginal costs (and marginal gains) when deciding whether to increase marketing spend. Also, different ad platforms have different pricing models (CPC, CPM, etc.), so make sure to have the data to effectively translate that pricing into marginal costs.