An Analysis of the Profitability of Fee-Based Compensation Plans for Search Engine Marketing

Abstract

Many advertisers hire agencies to run their search engine marketing campaigns; increasingly, they are using innovative performance-based compensation plans, in which they pay the agency a fee for each conversion (i.e., acquired customer) but require the agency to pay all search engine marketing costs. The authors for the first time address compensation decision problems in a search engine marketing context and reveal that such fee-based plans lower the advertiser’s profit by as much as 26-30%. This article uses a simulation study and four empirical data sets to better understand what drives this loss in profit. Two reasons account for the loss: First, the agency spends less on advertising than would be optimal for the advertiser. Second, the agency often earns more than it minimally requires to manage the advertiser’s campaign. This higher profit for the agency results because the advertiser must pay the agency more to limit its potential underspending on advertising. The authors show that the latter reason accounts for more than one-third of the advertiser’s profit loss. This article also offers insights into how the advertiser’s profit changes if it is uncertain about its profit per conversion or if it does not truthfully reveal its profit to the agency.

Keywords: electronic commerce, internet marketing, advertising, search engine marketing, agency compensation