Principle of Diminishing Marginal Utility in Affiliate Marketing

Diminishing Marginal Utility“Spend more!  Spend more!  We need more sales and we have to hit these numbers.  If you need more cash, just request it.  The bank is open.  Just as long as you deliver the ROI we need, the wallet is open, we just need marketshare.”  Those were the marching orders our team received from several of our clients over the summer.  And we were excited.  Delivering revenue at an ROI is what we are damn good at and most of the time, we are limited with budget.  We were salivating at the opportunity to really grow these programs.  In a vast majority of cases, budget is what we need to grow a program and the program is at a point where a substantial increase in spend won’t ruin our ROI.  But can increase spend blow up your ROI?  Yes.

The concept is called the Principle of Diminishing Marginal Utility.  Ok, thanks Paul Krugman, but what is that?  BusinessDirectory.com defines it as “Rule of thumb that successive equal quantities of a good consumed by an individual during a given period yield ever lesser marginal satisfaction, all other factors remaining unchanged.”

Wikipedia has a pretty good definition as well: “In economics, diminishing returns  is the decrease in the marginal (incremental) output of a production process as the amount of a single factor of production is incrementally increased, while the amounts of all other factors of production stay constant.”

English?  Sorry, I studied economics in college and I love this stuff.  It’s not often I get to “geek” out over laws of economics.  Basically, adding one more unit of input, while all out variables stay constant, does not mean you will get the same incremental return you received from the previous unit of input.  Or, adding another dollar of affiliate marketing spend, does not mean that that incremental dollar of spend will yield the same amount of revenue or profit that the dollar of spend before it did.  Does that make sense?  Let’s look at the graph:

Diminishing Marginal Utility

Love that graph?  I do, I did it all by myself, can you tell?  The good news is that my artistic skills are not how I make my living.  I did use a very cool tool to create this and walk our remote team through this concept last week, Twiddla.com.  If you have to white board things with remote players, this is the way to go.

Basically what you are seeing here is that over time we are increasing our Spend (bright green line), over time our Revenue continues to rise, but over time our ROI drops.  I’ll pause so you can let the awesomeness of my graph sink in.  Bask in the glory that is line art.

“Jamie, what are some reasons for the ROI decrease?” It’s story time.  Imagine you own a sub shop in a bustling strip mall in your home town.  The strip mall is also home to 100 businesses with 1000 employees.  The cost to sell a sub to those 1000 employees is going to be pretty low.  It’s the cost of your signage, the cost of a sandwich board in front of your store and maybe the cost of your time introducing yourself to your neighbors.  At some point those 1000 customers aren’t going to be enough, probably right away.  So you have to reach more customers.  So, like any good business owner, you look for advertising opportunities.  So now in addition to your sandwich board, signage and neighbor introductions, you start advertising on your very own car and in the local paper.  Your revenue goes up because your customers are increasing, and most likely at a much higher rate than your spend, so your ROI is either remaining good or getting better – probably better as your fixed costs are more easily absorbed.

But that isn’t enough, you need more customers.  So now you advertise on TV and the internet.  Again, revenue goes up, customers increase, cost increases, but your ROI is still steady and probably in it’s healthy and normal range.

But you need more.  You get more aggressive with local, search and TV and you start advertising across your greater metropolitan area.  But the costs start to tip your ROI in the wrong direction because each additional dollar (and each additional advertising vehicle is costing more) isn’t bringing in 3 customers like your other campaigns, it’s only bringing in one.  Your cost of customer acquisition is now starting to skyrocket.  It’s just too expensive to get someone from the next county to come buy your subs.  Revenue continued to increase, but the cost increased per acquisition.

Got it, tell me more about affiliate management now.

There are many reasons why this would be happening, but allow me to make one observation:  “Most programs are not at the point where an additional dollar of spend, or $10,000, will initiate this principle.  Most programs hold back on budget, placements and additional spend because of this very worry.”

Competition:  Are there new players in the space?  Are there new players in the channel?  Are you competing with product category competitors and non-product category competitors for affiliate real estate?  When new competitors enter the field, they drive up the cost of your advertising and the cost of acquisition as a whole.  Your old ROI may have been inflated simply because you were the only game in town.

You’ve Got Them All:  You probably don’t, but there are cases where a vast majority of the market were already customers and each new customer required significant training to learn why they should be a customers.

Advertising Vehicle:  In affiliate marketing if you are only offering commissions and not engaged in more hybrid relationships with paid placements, offers and increase commission incentives, you are missing some of your market for sure.  Grabbing that market will increase your cost.

The key in managing this is to maximize revenue while not hitting the tipping point where your ROI plummets and could even go negative.  One superbowl ad could destroy your ROI, we don’t recommend it :).  You have to find the sweet spot where you achieve the most revenue you can possibly get while achieving the highest ROI, or another way to look at it, the lowest ROI acceptable.  There is a sweet spot, but you have to test, spend, measure, quantify and re-test.  It’s an ongoing process and the variables often change.

I’d push you to rethink your needed ROI or simply the cost percentage.  Are you in line with reality? Could a 10% increase in available spend increase sales by 30%?  Is the current ROI goal acceptable in light of the competitive landscape and your revenue forecasts?  What is your testing methodology and evaluation criteria in testing new revenue vehicles?  We can help you answer all of this.