In mid-May, Google will be rolling out changes to their exact match and phrase match types in Google AdWords. Exact and phrase match will now become more open, allowing the traditionally very strict match types to now pick up mis-spellings, plurals, and 'close variations'.
While this has caused a largely negative reaction among the PPC community, the concern of PPC advertisers is somewhat justified. As we will see with some economic analysis, this 'improvement' by Google is likely lead to increased Google revenues at the expense of PPC advertiser profit.
Normally: Higher Bids = More Click Volume -- But Revenue Per Click Stays The Same
Look at the line called CPC (marginal) in the diagram above. It's a marginal CPC line, which shows what happens to the cost of each subsequent click as click volume increases at the margin. It is upward-sloping, which means that each extra click costs progressively more than each previous click. As any PPC advertiser will know, all other things equal, higher bids are generally needed in order to increase click volume for a keyword.
Now have a look at the line RPC (marginal). It stands for Revenue Per Click, and shows how much revenue is generated from each subsequent click. Since we can assume that the 5th click and the 116th click has the same chance of generating the same amount of revenue, the marginal RPC line is flat. For the purpose of this analysis, let's assume that this keyword is likely to generate a marginal revenue of $0.75.
So we have an upward-sloping marginal CPC line and a flat marginal RPC line.
So There Is A Point Where Clicks Cost More Than They Make
Now, let's assume that the advertiser/business has no other costs other than PPC click costs. If an advertiser/business spends $1,000 on clicks and generates $1,500 in revenue, the advertiser/business makes $500 in profit (this is of course very unrealistic, but just bear with me for the sake of argument).
Look at where the two lines cross. This is the level (2,000 clicks) where the advertiser will make the most profit from this keyword. If the click volume is any higher (say 2,500 clicks), the cost per click will be higher than the revenue per click that the each extra click generates. The 2,500th click may be costing $0.90 and only generating $0.75 in revenue, so the advertiser is making a marginal loss. Reducing click volume would increase profits.
On the other hand, if the click volume is any less than 2,000 clicks, the revenue per click of an extra click ($0.75) will be higher than the cost of that extra click (e.g. $0.60). Raising click volume would increase profits. The point of profit maximization is therefore where MC = MR (the blue dot where the two lines cross).
Adding A Few Expensive Clicks Doesn't Increase Average CPC Much
We have now seen how the marginal cost and marginal revenue changes as click volume changes. Now let's consider what happens to the average cost and average revenue as click volume changes.
Since each extra click is likely to bring in $0.75 per click on average, the average revenue per click line equals the marginal revenue per click line. Each extra click for this keyword is likely to generate an average per click revenue of $0.75.
Now look at the average CPC line (red). Like the marginal CPC line, it's upward-sloping, but flatter. Why?
Think about it for a second.
Suppose each click costs you $1.00 each on average. If you then decided to purchase a few expensive clicks costing $4.00 each, what will happen to your average CPC price? It will increase, but not by very much, maybe to $1.01. Adding some expensive clicks will pull up the average, but only by a relatively small amount. Hence the flatter average CPC line.
And So We Can Get The Best Of Both Worlds
We already know that the point of profit maximization for the advertiser is where the marginal cost equals the marginal revenue (blue dot). At 2,000 clicks, the average CPC for this keyword will be $0.30. An average CPC of $0.30 is generating the most profit for this keyword.
The profit for the PPC advertiser is represented by the shaded area below. To find out exactly how much profit the PPC advertiser makes from this keyword, let's do a simple calculation:
At 2,000 clicks, the advertiser is spending 2,000 x $0.30 CPC = $600. At 2,000 clicks, the advertiser is generating a revenue of 2,000 x $0.75 = $1,500.
Profit for the advertiser on this keyword is therefore $1,500 - $600 = $900.
Now let's suppose there is a different keyword (mis-spell, plural, or close variation). It has a higher conversion rate than the first keyword, so generates a higher RPC of $1.50. However, it also has higher advertiser competition, so the CPC line is also higher.
Even though the CPC and RPC lines for this keyword is different to CPC and RPC lines for the first keyword, the point of profit maximization is still at the blue dot where the marginal CPC line equals the marginal RPC line, at 1,000 clicks. Again, profit for this keyword is represented by the shaded area, and is calculated at (1,000 x $1.50) - (1,000 x $0.70) = $800.
The PPC advertiser is therefore making a profit of $800 from this keyword and a profit of $900 from the previous keyword, resulting in a total profit from these two keywords of $1,700.
But Profits Drop If Google Charges Their Average Of Two Keywords
Now let's see what happens when Google makes an 'improvement' to their exact and phrase matching to send both keywords to the same keyword.
Revenue per click is now an average of the two original keywords ($1.00). The CPC lines are also now somewhere in between the CPC lines of the original keywords.
Again, profit maximization is where the marginal CPC meets the marginal RPC, at 3,000 clicks. The advertiser was previously receiving 2,000 + 1,000 = 3,000 clicks; and the advertiser is still receiving 3,000 clicks.
But look what happens to the advertiser's profitability. The advertiser's profit, represented by the shaded area, is now (3,000 x $1.00) - (3,000 x $0.60) = $1,200. The advertiser's profit has fallen from $1,700 to $1,200, even though the advertiser is still receiving 3,000 clicks.
Now here's the interesting bit - look what happens to Google's profit. Previously it was 2,000 x $0.30 = $600 from the first keyword, plus 1,000 x $0.70 = $700 from the second keyword, totaling $1,300.
Now it is 3,000 x $0.60 = $1,800.
The advertiser's profit has fallen from $1,700 to $1,200, while Google's profit has increased from $1,300 to $1,800.
The PPC advertiser is still receiving 3,000 clicks, but the average CPC for those clicks has risen from ($1,300 / 3,000) = $0.43, to ($1,800 / 3,000) = $0.60. Google has essentially increased the average CPC, without increasing the average CPC.
Very clever.
Implications
By rolling out their 'improvements' to exact and phrase match, Google has essentially removed the opportunity for PPC advertisers to take advantages of differences in CPCs caused by varying levels of competition of closely related keywords, and removed the opportunity for PPC advertisers to take advantage of differences in revenue caused by varying conversion rates of closely related keywords.
Instead of being able to set higher bids for high-performing variants, and lower bids for poor-performing variants, with this new feature PPC advertiser's can now only set one bid for the entire group of keyword variants. The opportunity to take advantage of differences between close variants is now removed, and Google's revenue increases as a result.
Recommendations
Luckily, it is possible to opt out of this feature.
Under this new feature, the way you will receive extra traffic to your exact and phrase keywords from mis-spells, plurals, and close variants, appears to be no different to the way you would previously receive traffic to your modified broad match keywords. Having allowing your exact match keyword [melbourne hotels] to receive mis-spells, plurals, and close variants seems to be no different from having a modified broad match keyword +melbourne +hotels.
I would therefore recommend to continue to let your modified broad match keywords pick up mis-spells, plurals, and close variants, and have your exact and phrase match keywords only receive EXACT and PHRASE match searches like they did prior to mid-May.
Broad match generation - an efficient and practical method to continually generate new exact and phrase match long-tail keywords - is now more important than ever. PPC advertisers who approach Google's exact and phrase match changes with extreme caution, and use this change as an incentive to improve the structure of their campaigns, are likely to notice minimal impact to their campaigns. For others who ignore this change, expect increased CPCs and increased Google profits...