Ignorance of Pricing is Ruining Ad Agencies

This post is by Michael Farmer, Chairman of TrinityP3 USA and author of Madison Avenue Manslaughter: an inside view of fee-cutting clients, profit-hungry owners and declining ad agencies, which won the Axiom Gold Business Book Award for the best marketing / advertising book of 2016.

Ad agency pricing

All companies sell products or services at a price, and managing price is a major responsibility of top management.  Car companies sell cars, and sticker prices are marked on side windows.  Coca-Cola sells concentrate to its bottlers, setting price per gallon to match market circumstances.  Pizza-Hut sells pizzas in restaurants, and pizza prices are marked on the menus.  Bain sells consulting studies to corporations and prices them by study length and complexity.

Agencies, though, are confused about what they sell and how to price it.  Their ignorance of pricing is ruining agency operations and destroying agency value for clients, employees and holding company owners.  The advertising industry is the only industry in the world without a concept of pricing.

Let’s keep it simple.  Creative agencies do not sell Big Ideas, creativity, Cannes award-wins or brand building any more than General Motors sells transportation, Apple sells communications or Bain sells analytics.  Creative agencies sell ads, or more broadly, content in the form of deliverables.

Bundled with the deliverables are strategic insights, of course, just as iPhones are bundled with high value functionalities.  Agencies are in the deliverables business.  The business is expected to deliver results.  Prices should be high enough to reflect anticipated results. The number of deliverables is high and growing.  Price is income divided by deliverables.  Price per deliverable (with deliverables normalised by size) is the relevant pricing metric.

Research for my book Madison Avenue Manslaughter shows that deliverables have been growing and fees have been falling for decades. Consequently, price has fallen dramatically, and there is nothing in management’s toolbox to manage or stop it. 

Price (in constant dollars) is now 70% below what it was in 1992.  Since 2004, which was the last year that price and deliverables were in balance, price has fallen by 42% and has been below the level required for appropriate agency staffing.  Falling prices stretch agency resources, reduce quality, create client dissatisfaction and limit holding company growth.

Agency CEOs are on the hook for this adverse performance.  They’ve responded, wrongly, by focusing on cost reductions, downsizing since 2004, cutting out creative, analytical and senior muscle instead of seeking better and more logical prices for their growing deliverable workloads.  Worse, they blame procurement for their predicament.

Price curve ad agencies

Source: Farmer & Company client data.
Price is calculated ‘per ScopeMetric® Unit (SMU),’ our normalized unit of agency work

Agencies confuse “how they are paid” with “what they are selling.”  Just because agency costs are the basis for calculating fees does not mean that agencies are selling costs or that clients are buying man-hours.

A hot dog seller in Yankee Stadium could calculate prices on daily attendance: $2.00 on “low capacity days” (below 30,000 fans), $3.00 on “average capacity days” (30,000-35,000 fans) and $4.00 on “high capacity days” (above 35,000 fans), just like the airlines. The vendor is still selling hot dogs, whatever the price, not the day’s attendance level. Get ’em while they’re hot!

Agencies act as if they have no control over income.  They’ve abdicated pricing to their clients, who determine what the agency costs are (through benchmarking), what the fee levels will be (through zero-based budgeting) and what the Scopes of Work will involve (more work than last year).

Agencies do not systematically use Scope of Work deliverables to establish their prices and calculate their fees, even though deliverables are the foundation of what they sell. Deliverables are not documented, tracked or negotiated in a consistent way.  This is crazy, because deliverables are growing, and remuneration based on deliverables could grow rather than decline.

There is a gap between how much agencies are being paid and how much work they are doing.  How big is the gap?  It is now about 24%, I estimate.  This gap could be viewed as “unrealised income” for agencies and their holding company owners, or as 24% too much work, with agency staff stretched to carry it out.

If half of this surplus work is unnecessary for the brands, and can be cut out, then the agency fee gap is 12% or so — still a very considerable amount.  The fee gap represents “agency underperformance” from an income and profitability standpoint.

Agencies are not realising all the income that they could.

Agencies need to take control of pricing.  First, they need to acknowledge that they have a price problem, not a cost problem. (Since they do not measure their deliverables or work, though, they cannot measure price, so this is a separate problem that needs to be solved.)

Second, they need to recognise that future pricing must be handled on a per-deliverable basis.  Third, they need to ensure that the work they plan and carry out adds value — enhancing client brand growth and profitability.  Otherwise, their efforts to improve pricing will fail, since they will remain in a commodity business, competing against other commodity-like agencies.

Agency CEOs need to take control of pricing as their most important strategic priority. What could be more critical for the long-term success of their clients, their employees and their owners?

Cartoon credit: Leo Cullum, The New Yorker, The Cartoon Bank. With permission.

TrinityP3’s Agency Remuneration Agency Remuneration and Negotiation service ensures that the way in which you pay your agency is optimal. Read more here

About Michael Farmer

Michael Farmer is Chairman of TrinityP3 USA and author of Madison Avenue Manslaughter: an inside view of fee-cutting clients, profit-hungry owners and declining ad agencies, which won the Axiom Gold Business Book Award for the best marketing / advertising book of 2016. He currently serves as Adjunct Associate Professor of Branding and Integrated Communications at The City College of New York (CCNY) and is at work on a new book about the challenges facing Chief Marketing Officers.

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