One area of agency remuneration that creates confusion for many marketers, procurement and even agencies is the calculation of the agency overhead.
Overhead is the indirect cost of business and is usually presented as a percentage of the direct salary cost. Agencies traditionally had overheads of 100% or higher. That meant that for every dollar of direct salary cost the overhead was a dollar or more.
But with greater efficiencies of operation and the competitive pressure of the market place, the overhead has fallen.
But apart from the disagreement that often arises between procurement and the agency on the overhead level, the next disagreement is what is included in the overhead.
What is in?
It is generally accepted that overhead includes indirect business costs that are incurred in the day to day running of the Agency. However, where they are discretionary costs, they should also not be unreasonable or exorbitant in nature and if they are considered to be, should be omitted for the purposes of calculating overhead.
What is disputed?
Some clients may expect some indirect salaries (finance/admin/legal) and indirect time of management where they work on Corporate matters and indirect time of direct staff to be excluded from overhead. However, agencies should include them in the overhead as these are genuine business costs incurred by the business. The other area of dispute can be on what is considered an “exorbitant” or “unreasonable” amount of discretionary expenses.
What’s not included?
- Severance Entitlements
- Bonuses that aren’t a part of annual remuneration i.e. Sign on bonuses, discretionary bonuses, LTI, Profit sharing, stock options
- Any expenses incurred specifically for other clients (i.e. training for a specific client, entertainment spent on other clients)
- In-house Entertainment
- New Business Costs (where non-recurring or extreme)
- Donations / Charity contributions
- Fines / Penalties / Damages
- Extraordinary items – M&A, bad debts, Relocation, loss on sale, cost over-runs
- General market / media research costs
Do you agree? Or do you classify overhead costs differently? And why? Leave a comment here as I am interested in understanding why there is often so much dispute about what is in and out of the agency overhead.
We find in the uk that most advertisers do not have a conversation with their agencies about overhead at all never mind drilling down to the granular detail of what’s included. I find this very surprising considering the vast majority of UK advertisers pay their agencies a retainer based fee with overheads playing a big part in the calculation.
We produced guidance many years ago now to prompt discussions, and have found agencies reluctant to discuss detail with their clients, especially large network agencies where their overheads are dictated at group level.
With a continued focus on cost reduction in the region, mainly driven by procurement Debbie, there are constant discussions and disagreements with agencies on the framework of the resource based remuneration model. Even what constitutes direct salary cost with some agency networks including all costs to company such as superannuation/pension, payroll tax and the like, often to then also account for it in the overhead as well.
Meanwhile we are also doing agency remuneration work in the Nordic States and it seems that some of the agencies there have little or no understanding of overhead and profit mark-ups and how they apply to the agency multiple. But that is probably going to be another post.
Great subject to get a conversation started. I encourage my team to have these conversations with agencies, if for no other reason than to understand more about how their businesses work. When an agency is either unwilling or unable to share this information it should set the alarm bells ringing. As Debbie alluded to in her comment, many UK based agency relationships have a retained fee element as part of their remuneration so it is essential to understand the make up of that as best as possible.
Transparency in this space should encourage a more grwn discussion about account profitability rather than seeing agencies make up lost margin out of inflated overheads.
Dan, I agree to a certain extent, but then I have seen some marketing procurement people start to want to 'interfere' in the agency's business, trying to drive down the overhead cost. I think there is a big difference between understanding the business fundamentals which is a good thing, and then interfering in a suppliers business, which is a slippery slope because if that business becomes untenable or involvement, then who's fault is it?
Perhaps the most controversial overhead is the cost of pitching for business. I've not seen many businesses factor this in as an overhead yet still agree to pitch unpaid. Additionally for job overruns – where they think it is creatively worthwhile for the showreel, or simply for a lack of understanding of the impact on the business overhead.
Yes Anne, business development is a hot topic in overhead allocation. My point of view is that you want your agencies to be successful so you should let them budget to grow their business through winning new business. If an agency stops winning new business it stagnates, has trouble retaining good staff and attracting new staff and ultimately the incumbent clients suffer. As for the job overruns, I am sure that in the majority of cases the cost of this is usually held within the job. I think allocating a fee into the overhead for this is challenging as it is such a variable and subjective cost. Do you agree?