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How To Advertise On Facebook: Demystifying How Facebook Ads Work

Michael Taylor

July 15, 2021

Facebook always wants to make more money off ads. Here’s an insider’s guide on how to advertise on Facebook & drive performance without wasting your budget.

Table of contents

  1. Pay attention to algorithm changes
  2. Number of ads
  3. CPM
  4. Conversion objectives
  5. Funnel optimization using Facebook Ads
  6. Lookalike audiences
  7. Choice of objective
  8. Bid strategies
  9. Lifetime budget
  10. Actionable takeaways

You will hear conflicting reports from different people online about how Facebook ads work (and how to advertise on Facebook).

The truth is it’s tricky. Most account reps and developers don’t know how it works. Plus, Machine Learning and algorithms change all the time.

The best approach is always to:

  • Think logically about whether the advice someone is giving you even makes sense based on Facebook’s incentives,
  • Test it and see if it works to improve performance, then
  • Update your assumptions with what you learned (and we’ll keep doing that in this post as we learn more!)

Pay Attention to Algorithm Changes

In January 2018, Facebook announced a new update to its news feed algorithm, which prioritizes posts from friends and family to foster “more meaningful social interactions.”

As a result, it became harder for brands, media publishers, and marketers to organically reach their audience. It also impacted ad prices – as AdStage found, in Q1 2018, Facebook’s CMPs went up 91% year over year.

Back then, the platform’s CEO, Mark Zuckerberg, said that this change would likely mean more users spending less time on the platform, thus higher ad prices.

Fast forward to 2021, and it is still the most popular social media platform out there, with over 2,701M monthly active users.

Moreover, there’s a big update in ad limits coming out this year. As stated by Facebook:

Since each ad’s performance improves the more it is shown, advertisers of different sizes should use different ad volumes to improve ad performance. We will be introducing four limit tiers to encourage advertisers of different sizes to use an ad volume per Page that optimizes their performance.

The advertiser’s size is determined here based on their highest spending month in the last year. And so:

  • Pages with under $100K spending will be limited to 250 ads;
  • Pages with under $1M spending will have 1,000 ads;
  • Pages with under $10M spending – 5,000 ads;
  • Pages with more than $10M spending – 20,000 ads.

Should you be worried? Not necessarily, but these algorithm changes help us answer a crucial question: What does Facebook want?

The answer: to make more money.

Although Facebook’s algorithm changes often, here’s my simplified calculation of how Facebook ads generally work:

$$$ per User = CPM * # of Ads

DISCLAIMER: This is my interpretation and oversimplification of how Facebook (and many other ad platforms) work, based off my own personal experience ($25m spent across channels) and countless conversations with account reps and other marketers. With that said, let’s break it down.

# of Ads

If Facebook’s users get pissed off and leave, they can’t show them ads anymore. For that reason, the platform has to strike a delicate balance between providing engaging content from friends and sponsors to avoid overwhelming users with ads.

That’s part of the reason why ad relevance diagnostics exists.

If users hate your ad or don’t engage with it, Facebook’s advertising algorithm will also hate you and will likely either charge you more money or just reject showing your ad to their users.

That’s when Ad Relevance Diagnostics comes in. It scrutinizes your ad in terms of quality and engagement and conversion rate ranking and tells you what to improve.

CPM

CPM, or cost per mille, is a cost calculation of how much money it would cost to land 1,000 impressions on your Facebook ad.

If Facebook does a better job finding the right users, advertisers are willing to pay a higher CPM to show ads (impressions). That’s why their team works so hard to expand targeting options and increase their advertising algorithms’ efficiency.

Here’s how the math works here:

$50 Conv. Value * 2% CVR * 1% CTR = $10 CPM

  • Conv. Value = Revenue per Conversion
  • CVR = Conversion rate
  • CTR = Clickthrough rate
  • CPM = Cost per Mille (1,000 impressions)

$50 Conv. Value * 2% CVR * 2% CTR = $20 CPM

If Facebook matches you to users that click twice as often, they can earn a 2x higher CPM.

$50 Conv. Value * 4% CVR * 1% CTR = $20 CPM

The same goes for the conversion rate. Double the conversions means double the CPM they can charge.

Note: This is only if advertisers are efficiently bidding. Some caveats and inconsistencies allow platforms to game the system, but this holds true over the long run.

Conversion Objectives

To decide what users to match you to, Facebook needs to know what your objective is. That can be anything from website clicks to app installs to video views. There are plenty of options Facebook provides you depending on the type of ad you want to run.

When creating new ad campaign on Facebook, you can choose from various objectives that will help you with either awareness, consideration or conversion stage.

If it’s website clicks, they’ll match you to people who historically show a high clickthrough rate on ads.

If it’s conversions, they’ll look for people likely to convert, based on what they’ve seen on your pixel so far.

The more data they have, the better they can match your ad with the exact type of user that would convert.

But how exactly do they match you to the right users?

Say we only had 10 users in our Facebook audience, each with a different likelihood to convert and some more expensive to reach than others.

Other advertisers are trying to reach these users too, maybe based on different targeting than what you’re using.

facebook audience in Facebook Ads

So the first thing they’ll do is order these users descending by likelihood to convert (or click, if that’s your objective).

Next, they’ll figure out which are the cheapest to reach. Let’s choose the cheapest 40% of the audience we have.

audience segmentation - facebook ads

When Facebook shows your ads to these people, they know they’re giving you the best possible chances of success while still maximizing your budget usage.

The real algorithm is much more complex, but it’s the same basic idea:

  • Find the best users in your audience;
  • Do it for the lowest price;
  • Maximize the effectiveness of your budget;
  • Keep you coming back for more.

You’ll notice that Facebook doesn’t just blindly minimize my CPM: I’m paying $2 for Dave because he has a better propensity to convert than any cheaper options below him.

I altogether skip Sarah and Sally: Facebook can now sell those impressions to other advertisers that they know are more likely to convert and will be willing to pay a much higher CPM.

That’s how Facebook makes more money while also saving their advertisers money.

Of course, they do all this at lightning speed with complex machine learning algorithms based on millions of variables, but you get the idea.

Funnel Optimization Using Facebook Ads

Improving your conversion rate, revenue per conversion, clickthrough rate, or targeting has a direct impact on your bottom line.

marketing funnel optimizations

That’s why it’s crucial to test new ad creatives (CTR), landing pages/onboarding (to improve your conversion rate), and CRM campaigns (Revenue per user).

You can either take the cost savings and bid down on CPM to be more profitable, or bid on CPM to get more volume (attract more of the Daves and Bills of the world).

Lookalike Audiences

You might not know this, but every Facebook audience is a lookalike audience. Even if the example above was “Millenials who like Dogs and buy Pet Food in Manhattan,” Facebook has just taken the top 20% of that audience and shown your ad only to them.

It’s why you rarely reach the full audience and why it hurts performance to increase spend — everyone else is either too expensive or not as interested in you.

Lookalike audiences work the same way, but with the entire population of a country. Ever noticed how a 1% lookalike of any conversion event or email list for any client always equals the same number of people?

lookalike audience in facebook ads

It’s because they’re ordering the entire country based on their likelihood to convert on your pixel, then selecting just the top 1% to go into your audience.

This approach is wildly successful and performs amazingly well because Facebook’s algorithm is better than a human at determining the “likelihood to convert.” Further, it finds these cheaper people you wouldn’t usually see.

For example, maybe you know that people who use your product are Entrepreneurs who, like Gary Vaynerchuk, use Mailchimp, are 25-35 years old, and live in New York.

How Facebook Lookalike Audiences Work
Photo Caption: My Dream Store University

BUT do you know that there are tons of small pockets of entrepreneurs living in places like Texas and North Carolina?

Do you have a list of every single startup influencer or email service provider?

Can you identify the few 45 years old who would also like your product?

Facebook can do all of the above. They have several orders of magnitude more data than you do. More importantly, they can decide what’s more relatively essential to predict whether someone will convert.

That’s why lookalike audiences work so well, why Facebook is one of the best ad platforms ever created, and why we still use them daily.

Choice of Objective

Facebook needs data to do what it does best. So if you choose a conversion pixel too far down the funnel, it won’t find the right people.

If you choose an objective too high up the funnel, like clicks, it’ll optimize to people likely to take that action, regardless of whether they’re likely to convert further down the funnel.

Unfortunately, clicks do not equal conversions.

Sometimes I’ve seen click campaigns drive much better CTR on the same audience, but at a much worse cost per acquisition because the conversion rate was awful.

And that doesn’t even consider revenue-driving factors like qualified vs. unqualified leads, average order size, lifetime value, etc.

Here’s how each objective works:

Conversion Objective

$20 CPM * 0.5% CTR * 2% CVR = $50 CPA

Click Objective

$20 CPM * 2% CTR * 0.2% CVR = $125 CPA

Bid Strategies

Campaign objective affects not only Facebook’s ability to target the right people from your audience but also the bid strategies you will be able to choose from. 

The most common propositions are:

  • lowest cost – focuses on bringing you the most results for your budget, but you have no control over the cost, so a lead may cost you $1 or $100;
  • cost cap – gives you consistent results, and the overall cost will average around the cap you set (for example, if the limit is $25, then some leads may cost you more than the set limit, but at the end of the month, the average cost per lead won’t be higher than that);
  • bid cap – centered around profitability, meaning that the algorithm will bid below the limit you set (for example, if the limit is $25, then you will usually pay less than that for your leads). 

If your objective is conversion, go first for the lowest cost with a set budget and once you find the median, change your strategy to cost cap.

Lifetime Budget

As you can imagine, some hours, days, or weeks are more expensive on Facebook than others. If Disney is launching a new movie, you can imagine they’re spending millions buying up all the inventory, increasing the prices for everyone else.

So one way to improve performance is to move to a lifetime budget. This takes away some control in how much you spend per day and some more fiddling around when the campaign ends, but it lets Facebook spend less on expensive days, more on cheap days for you.

Facebook Lifetime budget - Facebook Ads
Photo Credit: I Make FB Ads

Actionable Takeaways – How To Advertise On Facebook

  • Default to conversion campaigns. Note that you can’t change this afterward (i.e. from Traffic to Conversions), and you can optimize to clicks or impressions with a conversion campaign anyway.
  • Facebook learns from all your organic traffic converting on your pixel.
  • Optimizing to clicks will get you a lot of shitty clicks. You should have a conversion goal for every campaign (driving awareness is worthless)
  • Default to higher up the funnel. To get more data, try optimizing to the first step of your funnel. Don’t go too far (clicks) because you don’t want poor quality traffic.
  • Watch your funnel like a hawk – optimize each stage to improve your ROI.
  • Learn how to do these funnel calculations when planning campaigns.
  • Understand that the more volume you need, the more expensive your campaign will be.
  • Don’t assume that ads with high CTR will also have high CVR.
  • Don’t use CPA caps/target bids unless you’re willing to spend nothing.
  • Use Lifetime Budget if the consistency of daily spend not an issue.

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