Advertising Agencies Bill for Time and Are Paid for Judgement

The Original Model

Historically agencies earned a commission on media they bought on behalf of clients a standard percentage of spend

That agreement had a clear problem: the agency that advised how much to spend charged more when the client spent more. Clients noticed it

The industry pivoted toward fee-based compensation usually based on staffing plans hourly rates and scope of work sometimes with performance components attached

A Worked Example: What Utilisation Does to an Agency

The notice says that these are very different businesses. Building both on the same account shows exactly how different they are and explains every strategic decision the industry has made since

Take an account team. Ten people with an average cost of $120,000 each that is $1.2 million in annual personnel costs. Each person has approximately 1,800 hours of work available per year which gives a capacity of 18,000 hours. The agency bills $200 per hour

At 70 percent utilization Which is a healthy figure for this industry 12,600 hours are billed. Revenue is 12,600 times 200 or $2.52 million. If we subtract the $1.2 million in personnel and overhead expenses from about 30 percent of revenue which is $756,000 the operating profit is about $564,000 a margin of 22 percent

Now reduce utilization to 60 percent. People are salaried so the 1.2 million doesn't move. Billable hours drop to 10,800 and revenue drops to 2.16 million. Overhead costs drop with revenue to about 648,000. Operating profit comes to $312,000 a margin of 14.4 percent

Ten utilization points reduced operating profit by 45 percent. That's why the table in the next section lists utilization first: It's not one lever among several it's almost the only one and it's largely outside the agency's control because it depends on client demand coming in evenly

Now calculate the cost of the pitch which is outside of all this. Competing for an account consumes high-level unpaid creative and strategic time. Call it 400 hours at the same opportunity cost of $200 or $80,000 of lost billable capacity per launch

With a 25 percent success rate each won account has four launches behind it or $320,000 of unbilled investment. Compared to an account that generates $564,000 in annual operating profit that's roughly seven months of profit invested in acquiring it before a single hour is billed

Finally compare the previous model on the same account. Let's say the client spends $20 million a year on media. With a 15 percent commission the agency earns $3 million up from $2.52 million under the fee agreement

The difference in income is not the interesting part. The interesting part is what each number is associated with. The 3 million scales with the client's budget and has no fixed relationship with the workforce: if the client doubles its media spend the agency's income doubles without additional people. The 2.52 million increases with the hours so doubling the income requires doubling the team

One of them is a business with operating leverage. The other is a business without any. Everything related to agency consolidation margin pressure and the arrival of consulting firms stems from having exchanged the former for the latter. These are illustrative figures and the rates vary widely but the structure is exact

The Consequence of Billing Hours

A company that earns time fees has a revenue limit based on the number of people it employs and the amount of its billable time

Growth requires hiring meaning margin improvement depends on utilization and rate rather than operating leverage. This is the same structure as general professional services and produces similar margins

Filing costs deserve attention. Competing for an account involves significant unpaid creative and strategic work and the loss rate is high. That cost is in the bottom line regardless of whether you win the business

The Holding Company Structure

Large agency groups are holding companies that own many individual agency brands and often compete with each other

The reason is that conflicts prevent an agency from serving competing clients so multiple brands allow the group to serve both. It also allows acquisition without forcing integration

The cost is limited operational synergy. Centralized media buying and administrative functions generate some and creative work doesn't benefit from scale like manufacturing does

There is a second rarely mentioned justification that is more important. Individual agency brands have reputations and reputation is what wins proposals. A holding company that merged its brands would be consolidating cost centers and at the same time destroying the only asset that commands a premium rate which is why these groups appear structurally inefficient and continue to choose to remain that way. The conglomerate discount discussed elsewhere on this site applies to them in full force and the sum of the parties' argument reaches thefact that the parties are largely people who can leave

What Changed the Economics

Three shifts all in the same direction

Media buying became automated. Programmatic buying moved a substantial portion of media placement into systems reducing the human effort for which agencies were paid

The platforms sell directly. The largest advertising platforms provide their own tools and support allowing advertisers to run campaigns without an intermediary agency

Clients brought work home. Large advertisers have created in-house teams for media buying and increasingly content production hiring agencies for specific creative work rather than the entire relationship

Case Study: The Report That Started the In-Housing Wave

The third turn did not occur gradually. It had a trigger and the trigger was a document

In June 2016 the Association of National Advertisers the trade body representing the largest US advertisers released a study it commissioned from research firm K2 Intelligence. The report concluded that non-transparent business practices were pervasive in the US media buying ecosystem including cash rebates and other values ​​flowing from media providers to agencies in ways that had not been disclosed to clients and in some cases had been contractually prohibited

Read it against the first section of this article and the meaning is clear. The industry had spent decades moving away from the commission model precisely because receiving a percentage of customer spending created a conflict. The report suggested that one version of the conflict had survived the transition and had simply become less visible

The response came more quickly from the world's largest advertiser. In January 2017 Marc Pritchard chief brand officer at Procter and Gamble gave a widely covered speech in which he described the digital media supply chain as murky at best and fraudulent at worst and laid out demands for transparency: rewritten contract terms permitted audits agreed visibility standards and agency roster reduction

So P&G did it. Over the next few years the company reduced agency and production expenses by about $1.2 billion substantially reduced its agency roster and built internal capacity for work it had previously purchased

Two consequences for the industry followed which combine with the previous arithmetic

The first is direct. Internal work is billable hours that no longer exist and the worked example shows that a drop in utilization from 70 to 60 percent reduces operating profit by 45 percent. Losing volume in a company with fixed personnel costs and no operating leverage causes disproportionate damage

The second is more subtle and worse. Transparency demands changed what agencies could earn for the same work. Rebates and arbitrage in media buying had been supplementing commission income and their elimination exposed the commission model like the entire business. The industry simultaneously discovered that it had less volume and that the volume was worth less than the accounts had implied

The New Competitors

Management consultancies have acquired creative and digital agencies and are now competing for the same budgets arguing that marketing technology and customer experience are a problem

They come in with existing relationships with senior clients higher billing rates and an established position advising on strategy. Agencies compete from a position where their historical strength and creative work is the part that clients find most difficult to objectively evaluate

Where the Decline Narrative Overreaches

All of the above describes an industry under structural pressure and it is.Four qualifications

The holding companies are still here and still profitable. This decline has been predicted for about a decade during which major groups have continued to generate billions of dollars of revenue at margins that most industries would accept. Structural pressure and imminent collapse are different claims and coverage routinely conflates them

The domestic sector has partially reversed. Building an in-house creative and media team means taking on fixed costs across campaign channels recruiting specialists who would rather work across many brands and losing the outside perspective that was part of what you were buying. Since then several in-house advertisers have aggressively rebuilt relationships with agencies for exactly the reasons agencies existed

Consulting firms face the same arithmetic. The worked example applies to them without modifications. They bill hours carry fixed personnel costs and their profits depend on utilization. They have higher rates and better relationships and they have not solved the problem of scalability because it is a property of selling time rather than a property of agencies

And the real threat is newer than the one being discussed. A company whose revenue is hours multiplied by a fee is directly exposed to anything that reduces required hours and generative tools do exactly that for a significant portion of production adaptation and version control work. That pressure applies identically to agencies and consultancies and is a much broader structural question than which of them wins the account

My opinion is that the industry is not dying but is permanently smaller in the parts that were processed and that the billable hour is the vulnerability rather than the competition

What Remains Defensible

Genuine creative ability is not automatable and is difficult to develop internally as the best people generally prefer variety to a single brand

Strategic positioning work brand development and campaigns that require original ideas instead of optimization remain the agency's territory. The parts that were process media placement and campaign execution are the parts that remained

There is a pricing problem hidden in that phrase and it is the deepest in the industry. It is easy to price process work because the hours are countable and the result is verifiable which is why it was the first thing to be automated and done in-house. Judgment is the opposite. A single idea can be worth a hundred times what it cost to produce it and there is no defensible way to bill it by the hour because the hour is not what the customer buys. An industry whose defensible core cannot be measured in the unitInvoice has a structural mismatch between what it sells and how it charges and every attempt to fix it (value-based pricing performance commissions client equity stakes) has been tried repeatedly and narrowly adopted. Until that is resolved the most valuable thing an agency does will remain the hardest part of its own business to capture

The Bottom Line

Agencies moved from commissions on media spend to time-based fees which limited scalability and made utilization the primary driver of profits

The arithmetic is relentless. A team of ten with a salary of $120,000 each billing $200 an hour at 70 percent utilization produces about $564,000 in operating profit on $2.52 million in revenue. If utilization is reduced to 60 percent and profits fall to $312,000 a 45 percent decrease because salaries don't change. Add about$320,000 of unbilled presentation costs behind each account won at a 25 percent win rate and the acquisition cost alone accounts for seven months of profit. Under the old commission model 15 percent of a $20 million media budget paid $3 million and required no particular template

The transition had a trigger. ANA's 2016 transparency report found non-transparent reimbursement practices in American media buying P&G's Marc Pritchard turned them into public lawsuits in January 2017 and then the company cut roughly $1.2 billion in agency and production spending. Programmatic buying platform self-service and customer-in-home eliminated the work process and in came consultancies competing for what was left. The defensible core iscreative judgment which is the most difficult to value and the most difficult to replicate