Advertising

Advertiser vs. Agency Debate – Part III – Follow the Money

20130917-211635.jpgLast month, Nancy Hill, CEO of the American Association of Advertising Agencies, published an article in The Wall Street Journal’s CMO Today column titled “Why Agencies are Starved for Talent” which indicted low compensation rates as the culprit in the talent crisis at advertising agencies today. In response, Bob Liodice, CEO of the Association of National Advertisers, published a rebuttal arguing that advertisers are overpaying agencies because their business models have failed to evolve.

This debate between the 4A’s and the ANA has been touted by Mike Shields as an “Epic Agency Rap Battle.” However, although seemingly at odds with one another, both sides are right. And they are both mired in a contradiction. To understand why, follow the money.

Ever since Volney B. Palmer started contracting for newspaper ad space in 1841, advertising agencies have been paid a commission on the media they purchased on behalf of their advertisers. However, starting around 1990, agencies moved from media commission models to hourly “Cost Plus” pricing models. This movement has been accelerated by shift of advertising spending to relatively expensive digital advertising. According to the 4A’s Labor Billing Survey Report, 91% of proposals today are priced using Cost Plus methods (despite scoring lowest among alternatives on the Grossman Grid).

When employing the Cost Plus agency compensation method, the advertiser pays the “cost” of the agency’s staff “plus” a reasonable profit margin. Instead of paying a commission on the media purchased, you pay for the time the staff spends planning and buying that media. Using this method, agency compensation is calculated as follows:

Agency Compensation = Hourly Rate × Number of Hours

This simple formula incentivizes two predictable but toxic offsetting behaviors: advertisers seek to minimize the hourly rate they pay and agencies seek to maximize the number of hours they charge.

Advertisers’ procurement departments are motivated to get the lowest possible hourly rate. Unlike an industry-standard 15% commission, hourly rates vary widely and are negotiable. The hourly rate is a standard currency to compare among agency alternatives. As such, procurement officers treat advertising services like office supplies and grind sellers down to the lowest possible price.

Ms. Hill is right: advertisers are not paying enough for agency services.

For advertising agencies, the biggest component of hourly rates is employee compensation. In order to beat competitors with the lowest hourly rates and to have a viable business, agencies seek labor at the lowest possible cost. In other words, they can’t afford to pay their employees very much if they want to win new business. This is why the average entry level salary at an agency is between $25,000 and $28,000. If you are an all star, why would you work for an agency when a technology company will pay you a $70,000+ starting salary?

Mr. Liodice is right: advertisers are paying too much for agency services.

Cost Plus compensation creates the perverse incentive to be inefficient. To grow revenue and profits, agencies are incentivized to maximize the number of hours they bill to the advertiser. A study we conducted revealed that a typical advertising campaign costs more than $40,000 in labor and 482 hours of highly manual work to execute. At a recent conference, an agency leader spoke up in front of a room full of media executives, “There’s an elephant in this room. I’m going to ask the question that everyone is thinking but is afraid to ask: do we really want to be more productive? After all, we get paid for our time and the slower we work the more we get paid.” Although much of this non-working media expense can be automated, advertisers are effectively punishing agencies for being more efficient.

As a result, agencies are currently staffed with an army of low paid employees manually performing unfulfilling tasks that could otherwise be automated. It’s no surprise that, according to a Digiday survey, more than two thirds of agency staffers plan to quit in the next two years.

The solution to the talent problem is to compensate agencies in a manner that encourages and rewards efficiency – a method that compensates agencies based on the work output rather than the labor input. This will incentivize agencies to implement automation that improves productivity. This automation will eliminate the laborious grunt work that makes people want to quit their job. By eliminating the low value brawny work, you are left with the high value brainy work. Advertisers are willing to pay top dollar for brainy work. Conveniently, brainy work also attracts the best talent.

Unless advertisers stop punishing agencies for efficiency through broken compensation systems, agencies will continue to have a talent problem and advertisers will continue to pay a steep inefficiency tax on advertising services.

Joseph Pych is a contributor to The Makegood, and the co-founder and chief executive officer of Bionic Advertising Systems.

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