At the ANA’s 2013 “Advertising Agency Financial Management” conference I attended an interesting session surrounding perceived misconceptions about the role of agency overhead rates in assessing the efficiency of an agency.
My takeaway was twofold. One, I agree with the premise of the speaker’s presentation that “overhead rates are not efficiency metrics.” And secondly, overhead rates are both an important and often little understood component of any agency remuneration program. Ironically, many advertisers spend little time in familiarizing themselves with the various components that make up agency overhead. Further, most client-agency agreements are weak with regard to defining the composition of the overhead rate which gets applied as part of the compensation calculation.
To be fair, this is an area where often time advertisers and agencies can “agree to disagree.” In 2006, the ad industry’s two leading advocacy groups the Association of American Advertising Agencies (4A’s) and the Association of National Advertisers (ANA) jointly published a “Compensation Guide” that delved into this very topic.
Let’s start with why agency overhead matters. In short, it is a primary component of the multiplier utilized in marking-up agency costs to arrive at a total compensation rate in a “Cost-Plus” or “Labor-Based” fee arrangement. Therefore, determining what is included in or excluded from overhead rate calculations has a direct impact on the fees paid by the advertiser to the agency. Detailing these inclusions and exclusions within the agency Agreement is of utmost importance to promote clarity. It should be noted that these are not static measurements; overhead rates vary within holding companies, from one agency brand to another and across geographic locations. For advertisers utilizing services in numerous offices across an agency network, this can be an important consideration.
The basic approach in the application of overhead is to base the allocation on the client’s pro-rata share of the agency’s direct-labor costs. However, sophisticated advertisers can and do negotiate overhead rates utilizing custom methodologies.
It is in the advertiser’s best interest to understand the individual components included in the aforementioned categories prior to negotiating overhead rates. Does “Indirect Labor” include agency personnel time invested in new business development? Are other non-billable new business costs embedded in “Corporate “Expense?” What parent and or holding company costs are assigned to the “Space & Facilities” and or “Corporate Expense” categories. Transparency into this area is vital for advertisers to begin to understand the differences in overhead rates across agencies and geographies and will result in a much greater level of comfort when discussing this topic with their agency partners. As well, costs that the agency is including into the overhead pool should be verifiable, and the client’s allocated portion should be recalculatable. Such that the agency is not covering their overhead costs more than 1x across the client base. Lack of transparency in this area can lead to abuse opportunity and inflated fees.
Just as important as defining “what” is included in overhead and negotiating the overhead rate, is monitoring what this rate and or the resulting multiplier (i.e. direct-labor costs% + overhead allocation% + profit rate%) is applied to.
As an example, are there hours from individuals at the agency incorporated into direct-labor costs that should not be? For instance, freelancers, independent contractors and or consultant time investment should not have overhead applied and therefore not be allocated to agency direct-labor costs. The expense for these individuals’ involvement on client business should be handled on a pass-through cost basis and billed to the client with no mark-up. The subject of part-time and or temporary W-2 employees is a topic for conversation between the advertiser and their agency.
So while, overhead rates may provide limited insight into agency efficiency, they do have a significant impact on an advertiser’s agency fee investment and therefore the components of overhead need to be understood, discussed, defined and tracked.
Interested in finding out how an advertiser can verify whether its agency is adhering to what has been mutually agreed to be included in overhead? To learn more about advertising agency overhead and or agency remuneration practices, contact Cliff Campeau, Principal at Advertising Audit & Risk Management at firstname.lastname@example.org for a complimentary consultation.