Economics of Lead Generation - The Price Fallacy
This post stems from work I did for the March 9, 2006 DM Confidential. You may view the two part article here and here. Many thanks to those who have already read and commented on these pieces. Presented below is a condensed version. If any would like a hard copy, white paper version please let me know and I will circulate.
History of commerce tells us that the more we buy the cheaper it should be per unit. Shopping at places like Wal-Mart, Sam's Club, or Costco illustrate this and have trained consumers to expect to pay less per-unit the more units we buy. For example, a single soda might cost $.60 a can, a six-pack $.40 per can, and a dozen $.30 per can. This per unit cost reduction happens through economies of scale. The stores can sell it to us for less because the manufacturers charge them less. The manufacturers charge the stores less because their cost per unit drops the more they make, and big orders mean larger amounts of money coming in more digestible and predictable chunks.
Lead generation as a market does not, however, follow this pattern. On the whole, the more leads you want to buy, the higher the cost per lead will be. There are no economies of scale for an advertiser at higher volumes. What's more, the price per lead over time does not drop; there is no Moore's Law with lead marketplaces. The economics of lead generation mirror more closely those of scarce resources, like oil extraction.
There is only so much oil in existence. The question around oil is not how much is left but how much can be produced, i.e. the supply. In a given reserve, the early oil is the easiest and cheapest. Costs increase as the reserves empty out. This is the key to understanding lead generation pricing. The easiest and cheapest leads come first. The more you buy (extract) the more it costs, as leads are in many ways a non-renewable resource. Unlike oil, we will not use up every lead – the constantly evolving economy and population insures fresh supply. The demand for new leads, however, laps the natural market growth, insuring costs per leads will both increase over time and as volume for leads increases.
With the respect to the economics of lead generation, the important thing to remember is that buying leads is not the same as buying fixed price media. Were you to buy media in bulk on a fixed price, you would get a price break - that is guaranteed revenue for the owner of the inventory, and they would lower the price in order to secure the revenue. Leads, though, are not guaranteed for the seller. Each lead must be earned, and the incremental cost to acquire a lead increases with each one for the sellers and thus the buyers. Over the past six years the market has shown this to be the case across countless verticals. When companies ask for more money for increased volume they do so as a reflection of their costs not in attempt to fleece the lead buyers.
To understand lead pricing, you must understand 1) how lead markets change over time and 2) the cost curve that a particular lead buyer should expect. Presented below are those two graphs. The first is a view of a lead market over time containing the costs for both buyers and sellers. The second is from the perspective of a lead buyer (the advertiser) and looks at cost per unit as it relates to volume of leads.
Note: The red line represents the average cost per lead paid by a buyer in a particular vertical. The blue line represents the average cost of acquisition, i.e. the cost of media; the difference between the two is the profit.
- Stage 1, “Early” – when just introducing a new type of lead into the market the cost per lead an advertiser needs to pay is at its lowest. Latent demand exists; the audience has not been exposed to the offer, and it does not directly compete for media space, nor are many sellers running it. The cost per lead for the lead seller (the publisher) is low but not at its lowest point as there is some economies of scale they will experience as they learn how to market the offer effectively. This period is the “fresh oil” for buyers and sellers.
- Stage 2, “Mature” – the offer has proven itself in the marketplace; this is the point where great strides in volume are made as more and more sources of traffic are used; prices begin to increase as the offer becomes prominent and it begins to compete against other offers for media space. Lead seller costs can decrease during this period as they understand its performance, e.g. where to buy, keywords, landing pages, etc. Towards the end of this period though, both costs for the buyer and seller begin to rise. This period is where “peak production” is reached and a flood of additional sellers will enter the market.
- Stage 3, “Saturated” – costs for the lead buyers begin to rise steeply as the market saturates; the demand for leads outstrips the production rate of supply; incremental costs for leads increase dramatically as buyers and sellers compete heavily against other offers in the market place, and each other; performance declines due to overexposure, which only increases the difficulty the offer has competing for, not just media but, seller attention. Margins for lead sellers shrink, their costs rising proportionately faster than those of the buyers; this is the period of final extraction from the well where vast quantities might exist but in a manner that costs more and more to extract. The lead buyer must focus internally and look for areas of fragmentation and differentiation to stimulate supply and/or reach the remaining supply economically. The seller must try to become more efficient in order to compete for inventory and among other sellers for the same offer. Think Hungry Hungry Hippo; it’s not pretty.
Explanation of Graph 2 – this graph looks at the cost per lead as a function of volume of leads desired by a specific buyer. This graph illustrates why a greater number of leads will cost more money per unit. As mentioned in Part One, this graph is not speculation or fleecing by sellers (publishers); this is the established trend that has emerged across all mature, high volume lead verticals.
- Phase 1, “Low Hanging Fruit” – buyers of leads in low volume tend to pay more per lead than buyers of similar leads that buy in bigger amounts; as buyers increase their capacity they can experience some economies of scale; lead sellers charge more for small clients because of their internal costs and the opportunity cost, i.e. the seller needs to earn a higher margin per lead to cover their fixed costs and to make up for not working with a larger client; as buyers begin to scale, though, they will achieve both internal and external economies of scale resulting in the ability to pay a lower cost per lead on all leads bought; as they grow, they enter into the “Sweet Spot.”
- Phase 2, “Sweet Spot” – during this phase lead buyers reach the optimum balance of volume and cost per unit; companies can scale the number of leads without significantly increasing their cost per lead; here the number of leads purchased matches available demand; it is comparable to the period of oil extraction where production reaches a constant flow and stable costs; as the desire for greater lead flow during a given period increases, companies enter Phase 3.
- Phase 3, “Chasing the Tail” – a section characterized primarily by diseconomies of scale and a non-linear relationship between cost and volume; during this period, as volume increases, it passes the optimal point, meaning there is no added benefit for both the buyers and sellers; the easy leads are gone; there is competition with other advertisers for the better converting inventory; the offer is saturated, and sellers have other, potentially more lucrative uses for their resources; with eroding performance and margins, prices must rise to finance the high production costs; peak production will be reached and buyers will find themselves hitting a volume wall where increases in cost yield negligible increases in volume.
The market view and buyer view, Graphs 1 and 2, are designed as two complimentary ways to explain, visually, how costs for leads rise over time. Both time and volume play similar roles. Lead prices will increase over time as the easy leads get taken early and auction effects come into play. As volume needs increase, more and more of what’s left are the harder to reach leads, combined with more expensive media, and increased competition among sellers to reach the shrinking pool of people. All of which add further price pressure as sellers have an incentive to work on other industries. It’s a cycle that cannot be escaped, having already played out in countless companies in a variety of lead verticals. Increasing prices for leads are as the Matrix’s Smith says “inevitable.”