An analysis of the profitability of fee-based compensation plans for search engine marketing

Many advertisers hire agencies to run their search engine marketing campaigns; increasingly, they use innovative performance-based compensation plans. In these plans, the advertiser pays the agency a fee for each conversion (i.e., acquired customer) but requires the agency to pay all of the search engine marketing costs. In this article, the authors address compensation decision problems for search engine marketing for the first time and conclude 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 profit loss. Two causes account for the loss: first, the agency spends less on advertising than is optimal for the advertiser. Second, the agency often earns more to manage the advertiser's campaign than its minimum requirement. This higher profit for the agency occurs because the advertiser pays the agency more in order to limit the agency's potential underspending on advertising. The authors show that this 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 the advertiser is uncertain about its profit per conversion or if the advertiser does not truthfully reveal its profit per conversion to the agency.