November 15, 2020

Decisions and Risk

You have a paid search program, and you expect the program to deliver the following metrics this month:

  • Conversion Rate of 1.5%.
  • Average Order Value of $90.
  • Average Cost per Click = $0.50.
  • Profit Flow-Through = 40%.
  • Expected Profit = 0.015 * 90 * 0.40 - $0.50 = $0.04.
You tell your agency that all efforts need to break-even. The data suggests that given the metrics, you should make a few pennies per click, on average.

But how much "risk" is there in that situation?

Here's the result of a 10,000 simulated runs, runs where I apply variability surrounding the conversion rate.

On average, you are generating $0.04 of profit per click ... but the amount of profit could vary between a loss of $0.10 and a profit of $0.17 in most cases. In fact, you'll lose money 23% of the time. In other words, even though your plan suggests that you should make money, 23% of the time you will not make money.

If you were told that your decisions needed to be profitable, would you make a decision that will lose money 23% of the time?

Almost every reader out here fails to perform this style of analysis.

But every reader out here SHOULD perform this style of analysis. All decisions have some sort of risk tied to 'em. At minimum, you need to understand how much risk surrounds your decision.

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