A lot of retargeting platforms push advertisers into buying ads on a cost-per-click (CPC) or cost-per-action (CPA) basis. Many advertisers are just fine with this arrangement, as it comes with a long list of advantages, but to make fully-informed decisions about how you allocate your ad budget, it’s important to understand what’s going on behind the scenes.

Isn’t CPC basically a “risk-free” way of buying ads?

CPC buying seems like a logical way to buy ads: in order to generate sales, you need clicks, and you’re happy to pay up to $X per click in pursuit of your sales targets. If you don’t get clicks, you don’t pay a dime. Sales revenue rises and falls in lockstep with advertising spend. It’s the holy grail of advertising!

CPM to CPC arbitrage

However, it’s important that you understand what might be going on behind the scenes when you buy ads on a CPC basis. It’s called CPM to CPC arbitrage. And if you know what “arbitrage” means, that should raise a red flag, because at the heart of every arbitrage, there’s an information asymmetry; Party A knows something that Party B doesn’t, and Party A exploits that information asymmetry to extract very-low-risk profits at the expense of Party B. And when there’s money changing hands, it’s best to not to find oneself on the losing side of an information asymmetry (remember the last time you had to hire a plumber or an auto mechanic?).

The pros all buy on a CPM basis

First, it’s important to understand a simple fact: the overwhelming majority of the world’s trillions of ad impressions are bought and sold on a CPM basis. If you’re buying ads on a CPC basis, it’s because there’s at least one (and probably several) middlemen sitting between you and that retargeting impression on businessinsider.com, and they’re all taking their cut along the way.

Hold your nose, here’s how the sausage is made…

Here’s how CPM to CPC arbitrage works: a retargeting vendor buys real-time-bidding (RTB) ad impressions on a CPM basis while asking the advertiser to pay on a CPC basis. However, you, the advertiser, only know what the CPC rate is, while the retargeting vendor knows what both the CPC and CPM rates are (there’s that information asymmetry we talked about).

Here’s some simple hypothetical math*:

CPM: $1.00 (i.e., the retargeting vendor buys RTB impressions at $1.00 CPM)

CPC: $1.00 (i.e., the advertiser is willing to pay the retargeting vendor $1.00 per click)

CTR: 0.5% (i.e., the ads are clicked 1 out of every 200 impressions)

* Emphasis on hypothetical. This is meant to explain how the arbitrage works, not to provide actual CPM, CPC, and CTR figures. Your retargeting vendor, could, in fact, be poorly managed and hugely unprofitable.

The advertiser pays the retargeting vendor $1.00 for the click. The retargeting vendor had to buy 200 impressions in order to get the click. At $1.00 CPM, 200 RTB impressions cost the retargeting vendor $0.20. The retargeting vendor keeps the $0.80 difference. With well-managed overhead, the retargeting vendor is looking at enviable double-digit operating margins.

You’re keeping $0.80 on the dollar? But I did all the hard work!

So did the retargeting vendor earn the 80% profit they extracted via CPM to CPC arbitrage? It depends on who you ask. But if the advertiser were to ever learn the retargeting vendor’s CPM rate, the advertiser might well ask themselves: Why can’t we just bypass our retargeting vendor and buy our own media on a CPM basis, thus lowering our media costs by a whopping 80%, while still getting the same number of clicks? Better yet, let’s keep our ad spend the same and get 8x more clicks.

Retargeting on a CPC basis looks even more disadvantageous to the advertiser when you consider that retargeting targets visitors that the advertiser, and not the retargeting vendor, had to invest heavily to attract in the first place. So the advertiser pays to attract the visitors initially, then pays to retarget them at $1.00 CPM, and then pays again to give the retargeting vendor an 80% arbitrage profit. Isn’t it starting to seem like the advertiser is doing all the hard work, while the retargeting vendor just swoops in at the last minute and keeps eighty cents on the dollar?

You’ve convinced me that CPM buying is better. What’s the catch?

In fact, there are multiple catches:

• To access the best CPM buying tools (i.e., Demand Side Platforms) or agencies that will buy on a CPM basis for you, you will almost certainly need to meet minimum monthly ad spend requirements, often in the thousands per month. So if you’re a small advertiser, and CPC is working fine for you, then stick with it. The CPC markup you’re paying is probably fair compensation in exchange for access to optimized retargeting.
• With CPC retargeting, your retargeting vendor is doing a lot of behind-the-scenes work to optimize campaigns and maximize their arbitrage profit. When you start buying on a CPM basis, you will take on responsibility for your own campaign optimization, and you may need to hire additional staff or a new agency to manage it all. But for large-scale campaigns where that 80% savings may translate to millions of dollars per year, the net gain of moving from CPC to CPM may more than offset any new costs.

CPM buying comes with additional risk. You’re no longer paying only when you get clicks; you’re paying whether you get clicks or not. But this can cut both ways. You may launch your campaign and see an immediate and discouraging performance drop, but after diligent optimization, you may be able to get an even better click rate than your retargeting vendor, causing your retargeting ROI to skyrocket. The bigger the risk, the bigger the potential rewards; it’s just up to you whether you want to dive into the deep end of the pool.

This guest post is by Myles Younger, co-founder of Canned Banners. Canned Banners provides advertisers, ad networks, and agencies with technology and tools that streamline the process of designing display ads. Follow the company on Twitter at @cannedbanners.