Most advertisers are operating on a standard labor-based fee model that pays the agency for outputs. It’s based on development of Scope of Work documents that identify and drive the workflow—i.e., specific projects and programs–paying the agency based on their level of projected time and cost commitments on those projects. The agency proposes and the client agrees to a blended hourly rate by agency function.
These rates are established by taking each individual’s direct costs (total salary and related benefits), applying the agency’s overhead factor (a percentage of direct costs—usually around 100%), and then adding on a 20% profit margin. The agency then divides that number by an employee’s total billable agency hours per year (usually in the 1,600-1,800 range) to determine the hourly rate for that individual. Once the agency calculates the total time required by each individual to accomplish all the items in the Scope of Work documents, they can then determine the total annual agency income required.
In addition, projects outside the Scope of Work are handled and billed separately and paid for according to the time required and hourly rates already established. In essence, the agency is being paid for every hour they invest in the client (with a built-in 20% profit “guarantee”). And, while that’s great for the agency, it’s not so great for the client for one very important reason: there is little or no accountability for results. Clearly a win-win for the agency as there is virtually no risk. They are paid the same regardless of the quality of their efforts, outcomes or business results. And, while we recognize the need for the agency to be fairly compensated, we would like to see improvements to the current arrangement that encourage and reward the agency for outcomes, not just outputs.
And it seems that more and more advertisers agree with us. Since Potomac opened its doors in 1992, we have been evangelists for pay-for-performance agency compensation. And it’s paid off in stronger agency ties for our clients and for other advertisers as well. At this point, there is no denying that the ad industry business model is transforming from pay-for-time into pay-for-performance. This certainly makes sense. After all, agencies have long maintained that they do not offer a “commodity” product. If that is true (and we believe it is) then why should they be paid as if what they are selling is time—not ideas, creative solutions or program results? It won’t come as a surprise to most agency execs that nearly 70% of global advertisers are not satisfied with their current agency compensation agreements. The reason? Agencies naturally assume it’s because clients want to cut costs. But, according to a recent survey by the ANA, the leading reason for wanting a new compensation agreement is to “improve performance”. Also, a study for AAAA’s by Millward Brown concluded “lagging business results” is a far more important driver for changing agencies than is “lack of agency cost efficiency”.
It’s no secret that advertisers are demanding more and more agency accountability, which is illustrated by a growing number who are moving toward pay-for-performance agency models. To be sure, being open to some kind of pay-for-performance involves some degree of risk. But those agencies that decide against true risk-sharing are taking a bigger risk: being left behind. As client marketing feels the pressure of added accountability for results from their organizations, that pressure is rightly being shared with their agencies. The message is clear: If the agency is confident in the results they can deliver and are looking to build a long-term client relationship, now is the time to share the risk and align their goals with their clients. And, while the jury may be out regarding success rates of performance-based compensation, the trend is undeniable and will continue. So, if the agency wants to be an important player, to have a seat at the table and not just pay lip service to the idea of being a “marketing partner”, then they’ve got to step up and be prepared to:
Be open to the concept of pay-for-performance
– It’s the best way to escape continued downward client pressure on hourly rates.
– Provides an opportunity to more fully align the agency with the client’s business goals.
– Agencies unwilling to accept some risk only encourage new competition to fill the void.
Refocus agency talent
– Many agencies seem to believe their job is to create advertising that is paid for by the hour. (Change the paradigm where billable rates are the only driver for compensation levels).
– Focus on outcomes rather than projects. This will enhance the agency’s growth potential by contributing more value to its client relationship.
Become an evangelist
– Show leadership and commitment. Pay-for-performance can be uncomfortable for some of the agency’s clients as well.
– An evangelist agency can help clients see new opportunities and increase their success.
We should point out that this shift from output to outcome-based compensation is not only happening in the advertising/ marketing world. Clients are also driving pay-for-performance models through their other “service provider” relationships. Both legal and accounting firms—long bastions of fee-based models regardless of performance—are now moving into performance-based compensation, driven by the same need to justify and align investments and outcomes.
Many agencies may balk at pure performance models because many variables are beyond their control that make (or fail to make) customers buy. The reality is that this evolution is about far more than how agencies are paid. It’s about how they engage with the brand, immerse themselves in the business, and find ways to drive the right outcomes that make those sales and not merely highlight the many reasons they can’t. The shift is inevitable. Advertisers expect more. They’re looking for partners who truly understand marketing’s responsibility beyond brand impressions. Those who can build a brand by directly building revenue and share are the ones that will ultimately endure.
Excerpt from White Paper, “New Directions in Ad Agency Compensation”
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