The flawed economics of falling agency salaries and falling overhead rates

It is interesting that when you listen to some marketing procurement and consultants there appears to be a consistent story regarding agency fees that goes like this, “Agency salary costs and overheads are decreasing”.

For marketers wanting to get more agency services for their marketing budget this is a terrific trend because it means that agency costs are falling.

In fact this trend is well documented in Michael Farmer’s book “Madison Avenue Manslaughter” where he demonstrates that agency productivity had been improving since the mid 1990s for ten years when it hit bottom and further cost reductions have been at the cost of talent quality and quantity.

But for procurement and consultants to explain this continued price reduction as reductions in overhead and salary is most likely confusing cause and effect.

Calculating agency overheads

The agency overhead, like all business overheads, is the indirect cost of the business, that is the costs not directly related to revenue.

In the case of the agency business this includes the usual business costs such as real estate, utilities, recruitment costs etc. A more comprehensive list of overhead costs can be found here.

The overhead of the business also includes those salary costs for the resources not directly generating revenue, including support staff, finance and accounts and administration. The issue with agreeing an overhead rate is that it has become a point of negotiation on a client-by-client basis.

The interrogation of the agency overhead by advertiser procurement teams has seen huge variation in what is allowed and disallowed in the overhead calculation.

I personally know of several organisations who will not allow their agencies to include business development costs and yet expect their agencies to be financial healthy and therefore growing, with no contribution to the cost of that growth from the advertiser.

The other factor is that most agencies do not have a clear and detailed understanding of their overhead costs by office or market and so the industry has defaulted to an overhead benchmark, which in turn has become a negotiable figure.

The relationship between salaries and overhead

The overhead cost, in the case of agencies, is typically expressed as a percentage of the salary costs directly involved in generating revenue. Therefore if the agency overhead cost is $1,000,000 and the direct salary cost across the agency is also $1,000,000 then the overhead factor is 100% of direct salary costs.

Likewise if the agency overhead cost is $800,000 and the direct salary costs across the agency is still $1,000,000 then the overhead factor is 80% of direct salary costs and so on.

Therefore for any client of the agency it is simply a matter of taking the sum of the direct salary costs and then multiplying it by the overhead factor and then multiplying the sum of this by the agreed profit margin. Details on these calculations can be found here.

This relationship means that salaries and overheads are interdependent. Lets look at how they interact with each other.

What happens to overheads when salaries rise?

There are a number of factors affecting salary costs including economic growth, talent quality and talent availability. With global growth slowing or flat-lining in some markets, salary growth has slowed and in some cases fallen in real terms.

But what happens if salaries rise?

Lets say the agency salaries maintain inflation or cost of living, it is reasonable to assume that likewise the costs associated with the overhead costs would also increase proportionally. In this case the overhead ratio would remain the same.

e.g. Salaries $100,000 increases 5% to $105,000 and the overhead increases likewise from $100,000 to $105,000. Therefore the overhead factor remains at 100% or 2 times multiple.

But what if the salaries do not keep up with cost of living but the overhead costs increase by 5% then the overhead factor would increase and not decrease.

e.g. Salaries maintained at $100,000 while the overhead increases from $100,000 to $105,000 then the overhead factor increases to 105% or 2.1 times.

And what if the salaries increase beyond the cost of living by 20% but the overhead costs only increase by cost of living or inflation at 5% then the overhead factor would decrease and not increase, but salaries went up.

e.g. Salaries increase 20% to $120,000 and the overhead increases just 5% from $100,000 to $105,000. Therefore the overhead factor remains at 87.5% or 1.75 times multiple.

How do both salaries and overheads fall?

In none of these scenarios do the salaries decrease and the overhead decrease. What would it take to reduce both salaries and the overhead factor. It would take a decrease in salaries and an even bigger decrease in the overhead costs.

e.g. Salaries decreases 10% to $90,000 and the overhead decreased 20% from $100,000 to $80,000. Therefore the overhead factor remains at 88.9% or 1.78 times multiple.

So that is what it takes to reduce salaries and reduce the overhead factor. But how would you sustain successive year on year reductions in both salaries and overhead factor while still maintaining the quality of the resources being provided?

You can’t.

Let’s bring logic to the discussion

Consultants and procurement professionals who use falling salaries and falling overheads as proof of their ability to negotiate better deals for their clients are certainly driving down costs.

But what are the implications of a strategy that drives down agency salaries? Less-experienced people?

And while lowering overhead costs is a sign of improved cost management, there is a point where the cost reduction impacts the effectiveness of the resources these overhead costs support.

The problem is that while there are multiple points of negotiation in the cost based resource model of remuneration, including annual billable hours, salaries, overhead costs and profit margins, they are all connected and all impact on the ultimate efficacy of the model.

Simply driving down any number of factors will end up in lower costs. But what is the consequence of paying less and less over time? Can you still expect the same quality of resources on your business?

Logic would tell you that you can’t.

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