Whether it relates to new product launches, store openings, catalog sales or a new advertising campaign, there are no guarantees that marketers will meet with success. No matter how sound the strategy or crisp the execution or the level of investment made to support these initiatives, there is no certainty that response rates, sales, market share or profitability results will achieve expectations.
The same can be said of an organization’s investment in marketing. Just because a firm spends 5.0% of revenues on advertising support, the investment alone doesn’t automatically guarantee an upward move in the organization’s key indicators. Further, there is always the risk of campaign failure, or under-delivery, which can have negative consequences on an advertiser’s bottom line.
Despite this risk, many advertisers continue to contractually guarantee a profit margin to their advertising agency partners. And yet, agency pundits continue to lament how “unfair” current remuneration programs are, and that the agencies don’t fully participate in the “upside” results of their clients’ demand generation efforts.
Turn it around. If a client-side CFO knew they could book guaranteed profits as a result of the advertising investment made by their organizations they would surely take that deal. Further, the industry would see a steady increase in advertising spending.
Shared pain, shared gain. As investors know, generally financial returns are directly proportionate to the risks incurred. In light of this truism, should there be any upside potential when agencies benefit from the security of a guaranteed profit floor?
With the move toward direct labor based compensation programs, agencies are able to recoup their sunk costs (i.e. labor, employee benefits, rent, corporate expense, etc…) and to secure a guaranteed profit margin typically ranging from 12% – 18% (excludes additional profit from in-house studio and the like). Perhaps it is time for advertisers to begin to question the efficacy of this practice. Don’t get me wrong. I believe that an agency should have the opportunity to earn a profit on each of their client account, and I don’t believe that agencies should bear inordinate risks to their remuneration for items and outcomes that are beyond their control. However, it seems that agency profitability should be more aligned with resource investments and the outcomes of their efforts.
Further, from a financial control standpoint, without the benefit of tight controls and audit oversight, a cost-plus / fixed profit margin remuneration system can inflate an advertiser’s fees as a percent of marketing spend. Too often client-agency contracts fail to adequately define key components of agency overhead or to identify employee compensation levels, agency staff utilization and out-of-pocket cost expectations. Beyond inadequate contractual clarity on these items, there is another factor which compounds an advertiser’s risk in this area… the lack of a disciplined process to verify actual financial performance for each of these categories.
To optimize agency fee investments and enhance transparency into this aspect of advertising spend, there are three items that an advertiser can include in their letter-of-agreement (LOA):
- Comprehensive definitions of key remuneration program components and examples of how various factors will be calculated.
- Quarterly reconciliation process for agency fees, time-of-staff investment and billings.
- An advertiser’s “Right to Audit” clause and an “Agency Records Retention Policy.”
Successful optimization hinges on a commitment to actually following through on the right to audit, whether through the advertiser’s Finance/ Audit team or by engaging a 3rd party agency contract compliance auditor.
To kick off the process, we would suggest an open dialogue and information exchange between client and agency to discuss profit expectations and to review those items which impact agency costs and client fees. This conversation should take into account a client’s total spend with the agency and its parent company, which offices the client’s account is serviced from, agency employee compensation, retention & training philosophies and the agency resources that will be brought to bear on the client’s business.
In the end, it is in each parties best interest to develop an agency remuneration program that incents an agency to deliver superior performance, recognizes an agency’s resource investment and where there is a shared investment in market-based performance stemming from the client’s and agency’s efforts.
If you would like to gain the benefit of what we’ve learned through first-hand experiences and would like to schedule a complimentary consultation on “Client-Agency Contract Trends,” please contact Don Parsons, Principal at Advertising Audit & Risk Management at dparsons@aarmusa.com.