There is much interest in value based compensation of which I have previously discussed the various components. But I was discussing the principles of the model with a CMO in London last week and found that by using a tangible example he was better able to understand the concept of a pricing matrix or strategy which is core to the output based component of the model.
Lets take a television commercial, because no matter what people say about digital, it seems that most brands with a high enough budget will invest here. (Obviously the numbers and details are illustrative only and do not represent any actual or real production.)
So the agency is asked to develop a brand or product television concept like the one above. Lets say the overall production budget is $2 million. Looking at the historical data, the agency was paid $500,000 in fees for the development of the concept. This included account management, strategy and creative time.
But this is a major brand or product activity with a plan to invest $10 mill in media over the coming 2 years. This gives the production to media cost a ratio of 4:1 or 25%. ($10 mill divided by the $2 mill production cost plus the $500,000 agency fee)
But if you were fixing the price or the value of the agency’s fee would it always be $500,000? What if the commercial was a short term tactical communication with only a $2 mill media budget and a $600,000 production budget to run on-air for just 6 weeks?
If it was based on the above media investment ratio then the agency fee would be $50,000 or if based on the production budget ratio the agency fee would be $150,000. This gives a production to media cost a ratio of between 32.5% and 37.5%.
This becomes a possible formula for setting the value or price for the agency’s services. But the agency will rightly point out that potentially their cost for developing an idea for a low budget idea and a high budget idea is the same. After all, how long does it take to come up with an idea?
And while that is true, paying the same fee for all television commercials makes cost-sense, but does it make value-sense? In fact the widely used cost-based system for remunerating ideas actually rewards the agency for taking as much time as possible.
Setting a price on the value of the outputs of the agency, depending on your level of investment, the strategic importance, the duration or geography etc sets an expectation for the agency and provides a clear indication of the expected or required level of investment from both parties.