Revolutionizing Agency Compensation – Pricing for Value

by Steve Koskela

For more than two decades, advertising agencies and their clients have expended enormous amounts of time, resources and emotional energy in the exercise of scrutinizing agency cost structures for purposes of negotiating “fair” agency compensation.

Twenty years ago, the traditional spending-based commission system that had been the prevailing dominant mechanism for determining agency compensation began a steady and relatively rapid decline in use.  Spurred by growing recognition that agencies were realizing windfall revenues (i.e., commissions) simply by virtue of escalating media costs, and fueled further by widely published stories of the substantial value being placed on agencies and resultant huge personal profits realized by some high profile agency principals, clients sought an alternative approach to compensation that could better control how and what agencies were paid. 

It was largely these events in the mid-80s that helped spawn a cottage industry unique to the advertising business.  Enter the client compensation consultant, a new breed of mainly ex-agency types who jumped at the opportunity to lead clients to believe in a new world of agency cost-based fee compensation, a different methodology which they and clients could better control by specifically linking (and limiting) agency pay to the costs of labor.  This approach would offer its own equally formulaic way of determining agency pay to that of the commission system, but with the added irresistible appeal to clients of limiting agency fees by requiring the agency to justify its costs every step of the way in exchange for the opportunity to earn a “fair”, and very carefully controlled, profit for providing its services.

Little has changed in the last twenty years as clients, consultants and, more recently, client procurement departments continue to struggle to understand agency organizational structures and seek full disclosure of agency operating costs, all in a constant effort to find the lowest common cost denominators in agency compensation.  Countless hours are spent debating the fine points of agency overhead calculations, evaluating what are reasonable salaries to be paid for agency staff resources, and attempting to rationalize what should be a permissible level of profit for agencies to earn.

We’ve had task forces, position papers, agency surveys, client surveys, booklets defining agency costs, papers aimed at clarifying what is and isn’t agency overhead, debates over what are fair multiples, acceptable margins, “appropriate” hourly rates, agency staff utilization factors, agency efficiency studies, panels, conferences, forums, and editorials all about agency cost structures, best work processes and the desire to tie agency compensation to performance standards, most of which are impacted by innumerable factors far outside of the agency’s control.  Virtually every major new business pitch involving a client consultant starts with a multi-page questionnaire, much of which is aimed at uncovering an agency’s cost structure, oftentimes including specific salary costs and details of operating expenses.

Myths and Fallacies – What the Compensation Traditionalists Want Us to Believe

In a continual effort to defend the status quo, a whole belief system has been perpetuated, a kind of alternate universe of misinformation intended to keep labor based systems in favor.

Myth and Fallacy #1:  Efficiency and productivity are hallmarks of successful agency-client relationships.

Advocates of labor-based compensation approaches have attempted to deflect criticism of the methodology by admitting that focusing solely on cost may not necessarily result in the best approach to “fair” agency compensation.  Instead, these traditional supporters of the labor theory of value have attempted to dress up their position by using terms like “efficiencies,” “productivity” and “best work processes” to describe what agencies should be striving to accomplish. 

It may be a shock to the system of a lot of client compensation consultants, but agencies do not exist to be efficient; they exist to create wealth and brand success for their clients.  While productivity is not unimportant, and in fact is likely in the agency’s own self- interest, it is not and should not be a core focus of its business.  To pose what should be an obvious question, what if an agency is very efficient at doing the wrong things?  Procurement specialists or compensation consultants focused primarily on efficiencies and cost optimization are left to justify how outstanding creative results are on paper worth no more than average, or even below par, creative results, if both are carried out with the same time investment.  The unspoken reality:  efficiency remains a euphemism for putting an artificial ceiling on the potential value of agency services.

Myth and Fallacy #2:  Performance-based remuneration as a supplement to labor based fees results in a compensation plan that aligns the interests of advertiser and agency and incentivizes the agency to do its best work.

While giving a wink and a nod to the possibility that cost-based fees alone may not adequately reward an agency for contributing to outstanding results, the labor cost camp tends to talk a lot about the desirability of performance-based reward systems, that allow agencies to earn additional “bonus” compensation, while having the opportunity to become a true business “partner” with the client.

The unspoken reality is that most so-called performance based reward systems (PBRs in the consultant vernacular) are toothless.  The typical circumstance is that the agency is asked to substantially discount what otherwise would be considered a reasonable fee for its services in exchange for the opportunity to earn back the discount plus an additional amount of “bonus” pay recognizing goal accomplishment.  In many instances, these incentive plans are simply not so cleverly disguised efforts to reduce agency fees.  They are often set up more to penalize than to reward.  Measurement criteria are oftentimes left to the sole determination of the client with little real effort made to isolate measurement of the contribution of the agency.  Rarely, if ever, is the bonus opportunity so substantial (and realistically attainable) to warrant putting all or even a substantial portion of the agency’s profit at risk.

Bottom line: Can’t we all acknowledge the obvious?  Virtually all agency-client contracts are already performance-based, without the illusory incentive criteria and formulae.  The agency can be fired with little notice for any reason.  How much more “performance-based” can we get?

Myth and Fallacy #3:  A meaningful, generally accepted and understandable model to measure advertising return-on-investment is on the verge of being developed, a “just around the corner” solution to help clients assess the real value to be placed on their advertising expenditures, and finally put minds at ease that agencies are not being overpaid for what they do.

It’s all the rage among marketers, consultants, procurement people, and various other interested constituents to find the killer application for measuring advertising ROI. 

This quest seems to ignore a key dilemma: Any return on investment model requires fairly careful definition of at least two key factors – (1) what return are we looking to measure?, and (2) over what time frame are we applying the measurement?  Lofty discussions about the need for accountability and the desirability of the ability to evaluate cause and effect of advertising, beg the larger questions.  When it comes to advertising, and the contributions of an individual agency in particular, what are we measuring?  Is it simply the linkage between sales and ad spending?  Sales in which period?  The next quarter?  Next year? Over a two-to-three year period?  What about all the non-sales variables?  And what about the non-linear effects on sales performance?  What about, as one example, the impact of advertising messages on the consumer’s brand perception and when that happens to result in a sale?

The unspoken reality:  It’s all poppycock at this point.  As it relates to agency compensation, it’s mostly another spurious exercise to avoid the admittedly difficult challenge of placing a value on what an agency does and agreeing to pay a fair price for those services, except by adhering to the old, flawed labor-based theory.

A Call to Action

Big Ideas.  Breakthrough Thinking.  Innovative.  Bold Strategies.  All terms that most agencies would love to have mentioned in response to their names in a game of word association.  Yet, when it comes to the lifeblood of their financial existence – how they are paid for what they do – most advertising agencies seem perfectly willing to follow rather than lead.

It is time, correction, past time to put an end to the madness.  A breaking of the rules and end to the tail chasing behavior of the last 20 years is in order, based on challenging the critically flawed presumption that the value of agency services should be primarily defined by the labor costs required in performing the service or producing the end product.

We in the advertising agency business have been our own most formidable enemies in simply accepting the practices of the last two decades.  There is simply nothing written in the gospel of agency-client relations or how an agency should conduct itself that suggests that it must follow a labor based theory in pricing its services.  There are no sacrosanct rules of engagement or business codes of conducts that bind an agency to a particular methodology of what it charges.  And there is certainly no sound economic theory or business logic to suggest that cost-based fees represent the value of what an agency delivers for its clients.  Yet, like the lemmings depicted in Apple’s iconic “1984” spot, we continue to march in lock step to take our seats in the auditorium.

Value Based Agency Compensation – A New Direction

The legendary Bill Bernbach, a source of  many memorable observations regarding the nature and workings of the advertising industry, offered the following:

“I warn you against believing advertising is a science.”

and

“Rules are what the artist breaks.  The memorable never emerged from a formula.” (italics added)

Clearly, he was referring to the essence of what an advertising agency does in its strategic thinking, the creation of intellectual property and the application of creativity to the marketplace.  But, he could have just as appropriately been describing a new direction for  agency compensation.  There is no science, and should therefore be no formula, to the determination of the value of agency services. 

A New Compensation Doctrine

• Adherence to a labor cost based approach to compensation is the primary contributor to the consistent undervaluation of agency services, the increasing effort to commoditize agency services, and the perpetuation of artificial ceilings on the level of profit margins that agencies can attain.
• Value is by definition a subjective notion, and the presumption that the value of agency services is primarily defined by the costs incurred to produce an end product or result should be rejected.  The focus should instead be on the desired outcomes and attaching a value to the objectives to be achieved.
• Agencies should be paid for providing solutions rather than the doing of things as measured by time.
• Benchmarking of an agency’s internal cost structure is an irrelevant exercise in determining the fair value of its services. The effort to standardize agencies from a cost perspective is an unacceptable practice intent on eliminating agency differentiation.
• Efficiencies in agency work processes, while mutually beneficial to agencies and clients, are also not appropriate determinants of the value of agency services.
• Client consultants and procurement specialists can play a role in aiding client advertising and marketing professionals to arrive at a determination of the value of agency services.  But, value determination is not dependent on analysis of the cost of resources deployed.
• Pricing is a discipline.  Agencies must give it priority in how they engage with clients and develop the internal specialized pricing expertise that other professional service businesses (and most major advertisers) already have in place.

Value Based Pricing – The Basics

• A well defined scope of work that articulates a specific “scope of benefits” to be achieved is at the heart of a sound value based compensation plan. Scope and goal setting is necessarily a client driven exercise, with the agency as facilitator.
• With a well-defined scope and specifically defined goals, the agency should be ready, willing and able to establish a guaranteed fixed price (fee) for the performance of services.
• Changes to the agreed upon scope of work should be managed by a change order process, which places a supplemental value on the additional work/goals to be pursued.
• Agencies should insist upon consistent focus on goals, outcomes and effectiveness rather than the cost of doing things.  An agency’s profitability is its own business, not that of its clients, and should be managed by focusing on factors beyond labor utilization rates and time billing.
• In agreeing upon a price for services, the agency’s anticipated cost of labor is only one of a myriad of factors to be considered in setting a price.

Changing the current face of advertising agency compensation requires revolutionary action, not satisfaction with a gradual evolution from existing antiquated methodologies.  Agencies and clients alike need to face up to an imposing challenge: The determination of a fair price to be paid for the VALUE of services received. 

All parties need to realize that current practices are not addressing the realities of today’s agency-client relationships.  Agencies should not expect clients to guarantee or “fix” agency profits.  Clients should in turn not expect that they can intervene in their agencies’ internal cost or strategic growth plan decisions for purposes of controlling what agencies are paid.  Rather, the parties should be striving to determine a fair PRICE for the services offered and the VALUE received.  The fact that the definition of value is a difficult exercise cannot be a convenient excuse to avoid the need to attempt it.

In a business in which we are not only the caretakers of intellectual property, but also its creators, agencies need to embrace the challenge of demanding pay for value delivered.  Big ideas and innovative strategies are worth much more than the mere costs it takes to produce them.

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Steve Koskela has more than twenty five years of executive level finance and operational management experience in the field of advertising and marketing communications with both small and global scale organizations.

He is Chief Financial and Administrative Officer for Ground Zero Advertising, Inc. in Los Angeles, and also acts as Managing Principal of sjk advisory group, an independent financial management consulting practice specializing in marketing service organizations.

Steve also serves as the current Chairman of the Western Region Finance Committee of the 4As.