Balancing risk and reward in value based advertising agency compensation

Last week in NYC I was speaking at the WFA COMPAG group about Value Based Compensation (VBC). During the discussion I made the distinction that VBC can be segmented into two approaches – Output Based Price and Outcome Based Performance. This approach I have previously spoken about here.

The response from the group was really interesting and not unusual. People were wondering if agencies would accept risking revenue for an increased bonus and would advertisers and marketers be willing to carry the bonus payment as a liability in their budget?

The interesting part is that when assessing compensation models there appears to be an underlying assumption that one model will need to suit all circumstances.

The fact is that even in the heyday of the media commission, not all agencies were paid this way. Yes, it was the predominant model, but not the only model. Since then the category had become more and more complex and so now the possibility of a “great unifying theory of agency compensation” is as dead as the dodo.

Also, what is the real benefit of a unifying compensation model? Instead, we now have the opportunity to customise the model to suit the circumstances of the advertiser and the agency and agencies.

What I mean by this is that all compensation models have upsides and downsides for each party. There are risks and rewards and it is up to the advertiser and the agencies to assess the risks and rewards to decide what is the preferred model.

Let me provide a couple of points of view based on situations we have managed:

Moving from Commission to Resource and Performance Based

An agency has a long term relationship with a client. They were originally on a media commission and service fee. The client consistently spent year on year and so income was consistent and grew steadily. Then one day the client had a fire at the factory and suddenly all advertising stopped for 6 months.

The agency wanted to move to a resource based fee to guarantee certainty of income and cash-flow. The client agreed with the provision that the agency’s profit would be included as a significant performance bonus or profit sharing based on sales.

The agency was unsure as they felt they had so little control of the sales revenue. But the client argued that this is no different to the media commission. After all when sales grew, marketing investment grew and so more was spent with the agency meaning under the commission system they had more revenue.

Under the new system the agency had guaranteed cash flow but profit was still predicated on the revenue growth of the client company.

Is the certainty of cash flow worth the risk on profit?

Moving from commission to output based value

Over a number of years the scope of work had shifted from media related production to more direct, point of purchase and online with some or little associated media spend. The agency was complaining because under the current media commission and service fee model they were not recouping their salary and overhead costs, let alone profit.

The agency wanted to move to a retainer based on resources but because the client had a number of divisions all with their own budget, their contribution to media spend was easy to calculate but a contribution to a retainer was problematic.

Instead the client wanted to use a pricing matrix where the agency and client would agree a price or fixed fee for the services provided, therefore each division of the client would know what their contribution would be to the agency fee.

The agency argued that due to the seasonal nature of the client’s marketing activity this would mean they would not have the consistent cash flow under this model to maintain a team of resources dedicated to the client.

When the numbers were done the agency was currently under-recovering on overhead and salary by almost 20%. Under the new model the agency would improve this position  to profit depending on how well they managed their resources.

Should the agency take the risk? Is the improved profitability worth not achieving guaranteed cash flow?

Moving from a resource cost model to an outcome based model

A direct response charity client was paying their agency a retainer based on year-on-year resourcing salary costs and overhead and profit multiples. They were looking to reduce this cost, which was being heavily resisted by the agencies.

The clients cost per acquisition / sale was $1800 all up, of which the agencies were a significant component (calculated and apportioned) and reducing this cost would have a dramatic improvement in the client’s operating cost.

It was proposed that the agencies take on a model where they were paid a fee based on a reduced component of the cost per acquisition. Therefore the more sales the greater the fee for the agency, the less sales the lower the fee. Built into the calculation was a factor based on the conversion rate in the call centre.

Is the risk worth it for the agencies?  Is the upside up enough and the risk of downside small enough? 

In each case the agency took the risk. Why? Because the benefit outweighed the risk. But agencies will heavily resist these models where they are used purely as a way of reducing their income. Which in reality is just smart business.

What risks and rewards are in your compensation and remuneration models?