Skip to content

Are Ad Agencies Stuck with Commodity Fee Levels?

2010 February 24

Ad agency services are procured as if they were a commodity.  Is there any way out?

Unlike other professional services, ad agencies are constantly under price pressure.  Consequently, shrinking margins have led to intense consolidation.  The industry today is dominated by a handful of vast holding companies that offer every service imaginable, yet still struggle with profitability.

Despite their huge market share and broad scope, the combined value of these corporations is less than $30 billion – a mere trifle compared to what is probably a trillion dollar global market for marketing services.

The industry is not doomed, but as consolidation has neared its limit, a new model needs to emerge if the industry is to prosper.

“Good Enough” Commodities

Clayton Christensen, in his book The Innovator’s Dilemma, provides a useful model for understanding the industry’s woes.  He points out that once consumers are satisfied with industry performance, they are only willing to pay commodity prices.

Innovative industries , on the other hand, thrive where performance is not good enough. Being just a little bit better has enormous value when quality is an issue.   When it isn’t, price becomes the primary differentiator.

A good example is the computer industry.  Once processor speed became fast enough, it ceased to be an effective selling point.  In the 1990’s, Dell computer thrived not because of product performance, but because of price, convenience and service.

Ad agencies need to perform everyday.  Familiarity not only breeds contempt, but also intense fee negotiations.  There is a vast pool of very talented people created by decades of “good enough” performance. The industry does not suffer from a lack of proficiency, but its excess.

In order to gain some insight into the problem, let’s look at some other professional services who command the fee levels that the agency world covets.

Management Consulting

Companies like McKinsey and Bain specialize in the realm of “not good enough.”  They take on projects that companies are unwilling or unable to do themselves.  They are able to generate vast fees for finite projects that have a beginning and an end. Sometimes they have specialized knowledge in the project area, but often they don’t.

Other companies specialize in restructurings.  When a business hits the rocks, investors are more than happy to bring in a 3rd party.  Management is suspect and an outsider with no internal loyalties can slash and burn like no insider can.  There’s huge money at stake, so fees don’t endure much scrutiny.

In both cases, a one-time expense, even a big one, can be amortized financially almost as if it was a capital asset.  Conversely, ongoing service inevitably becomes a procurement issue. Even a small fee reduction will flow nicely through a five year financial model.

Accounting, Auditing and Legal Services

Accounting firms, like advertising agencies, provide an ongoing service that is “good enough.”  There is a vast pool of qualified professionals and innovation is incremental.  According to Christensen’s model, they should also be priced as a commodity.

However, there is a crucial difference.  Accounting and auditing are legally mandated functions.  Moreover, accountants need to be certified.  Both of these facts make the negotiating positions of accounting firms vastly superior to ad agencies.

Corporations who think nothing of putting their ad business out to pitch on a regular basis would not do so with their accounting or law firm. A corporation who switches ad agencies is often seen hard driving and cost conscious; one who changes auditors often raises red flags and sees its market value plummet.

Law firms, on the other hand, are a “port in a storm.”  You go to them when you are in trouble.  When you need them, negotiating their fee is the last thing on your mind.  Human nature being what it is, we will always pay more to assuage fear than to engender hope.

Financial Planning

Another analogous industry is financial planning.  Skilled practitioners are contracted to manage money, much like media agencies.  They do so for commissions that are usually between 1% and 2% (hedge funds and venture capital firms who manage money more actively also get success fees).

Yet again, there is a crucial difference.  Financial management has enormous economies of scale. It’s not much harder to buy a $100 million dollar security than it is to buy a $1 million dollar security.  Big funds buy big assets.

Ad agencies, on the other hand, do not enjoy economies of scale to the same extent.  They still need to buy individual TV spots, ad pages etc.  Campaigns have specific objectives and need to be bought individually.  They can’t be lumped together.

IBM and Free Newspapers

While marketers do not enjoy the natural benefits of other disciplines, much can be learned from industries outside professional services.

In 1993, Lou Gerstner arrived at IBM, a company with a great legacy and tons of red ink.  He realized that the vast scope of the business gave them unique insight into technology and developed a great high-margin business in consulting services.  By mining internal information he created a whole that was immensely more valuable than the sum of its parts.

Free newspapers employ a similar strategy.  On the daily edition, they break even at best.  Daily newspapers are a losing proposition.  However, they do reach a lot of people and money can be made through high margin weekly supplements.

The result was the second fastest growing medium (behind digital) of the last decade, although the industry has had some problems since the onset of the financial crises.

In both cases, low margin, commoditized businesses were used as a substrate to create highly profitable products.  It’s not a “freemium” model, but it’s a similar idea.

The Way Forward

The advertising holding companies do seem to realize the value of high-end consultancy services.  They all have built up impressive capabilities in econometrics, non-standard promotions, new media consultancy, etc.  However, integration remains poor and therefore the bottom line impact is minimized.

The same problem continues to drive industry profit levels. Sooner or later,ongoing strategic consulting becomes a commodity business. The inevitable result will always be escalating demands and shrinking margins.

Project based consulting, however, is a time tested, winning strategy.  Services based on the street level data accumulated though regular service combined with highly skilled advice and one-time fees could be the industry’s salvation. While it won’t change annual negotiations, short term projects with sky high margins can change the overall profit picture.

To achieve this, agency networks need to de-balkanize and skill levels need to be raised.  Front line personnel should be encouraged to spend time in a variety of divisions to encourage cross-pollination, discourage group-think and minimize the ridiculous interdisciplinary rivalry that the industry has raised to an art form.  Sabbatical and graduate study programs also need to be adopted.

The only alternative is…well…there really isn’t one.

– Greg

16 Responses
  1. February 24, 2010

    Interesting insight, Greg. I’ve always felt that the value proposition which we inside the industry felt was understood is misunderstood by our clients. I was always taught to build value first, then negotiate price. But agencies tend to focus on price first (to cover fixed costs) and then roll out the delivery model.

    There will always be someone out there who will provide the service for less. And as long as the industry focuses on price before service, that kind of thinking will cannibalize the industry.

    Remember years ago when designing and marketing web sites was beneath most high profile agencies? While working at smaller agencies with more agile business plans, we took advantage of those “scraps” and built up good relationships. I fear that many agencies are doing the same now with social media. As you and I have discussed before, the metrics are still emerging, so many agencies don’t know how to sell it – again based on price. Why not figure out how to deliver the audience through social media first, then work out the pricing structure once the value is evident to the customer?

    “Skilled advice” is what we should endeavor to deliver. If we can all make a living at doing that, the industry will survive. Otherwise…

    Great post, as always, Greg.

    – John
    .-= John Cavanaugh´s last blog ..Toyota: Finally An American Auto Company =-.

    Greg Reply:

    John,

    Nice to see you back.

    Unfortunately, the reason major agencies have trouble moving into new areas isn’t because they don’t want to, but their ability to do so is limited. They have very big, very demanding clients who push them to offer more and more of what they are already doing. Meanwhile they have a business to run, people to pay, etc.

    What makes sense for a small entrepreneurial agency, usually doesn’t make sense for a large one. One false step, a lost client and lots of people get laid off. At any given time, there are a number of emerging areas, agency networks tend to pick the ones that their clients are willing to pay for.

    What’s a little bit more unnerving is the inability to do the things that other large corporations do:

    – Why are there so few digital buyers with TV buying experience and vice versa?
    – Why are there so few creative account planners who have done media strategy and vice versa?
    – Why aren’t there graduate education programs so that young up and comers are encouraged to get advanced degrees?

    Instead, there are interdisciplinary rivalries and middle management that lack depth and breadth in their skills, not to mention the upper management relationships that come with graduate study.

    – Greg

    Scott Cone Reply:

    I think your getting to the core of one of the problems with the current agency model in that it’s systemic…they have a business model that’s predicated on having lots of butts in every seat and pushing to work to the lowest paid tiers so they can remain profitable.

    In addition, most traditional marketing service firms are focused on the wrong thing…creating better interruptions when the consumer has shifted their desires to having conversations. In a world where we can all of us can zip through your ads with our TiVo’s, nuke them with spam blockers or avoid them all together with subscription or content on demand, agencies should be focused on creating better connections, conversations and communities. But, they’re not.
    .-= Scott Cone´s last blog ..The State of the Internet =-.

    Greg Reply:

    Scott.

    Thanks for your input.

    – Greg

    Tim Bradburn Reply:

    “They have very big, very demanding clients who push them to offer more and more of what they are already doing.”

    In my experience many of these big, very demanding clients tend to be brand managers in their mid to late twenties – certainly in the consumer sector. Could it be that many large consumer brands are being stewarded by people who perhaps don’t have the experience to demand anything other than what the agencies are already doing? Yes, these brand managers are often executing a strategy set higher up, but nevertheless they seem to have a lot of freedom in how they implement it and are usually the ones who deal with the agency.

    An area where this is not the case is the pharma sector – I’ve always been struck by the age difference between brand managers working on pharma brands versus consumer brands. The pharma sector is a very technical and sensitive area and presumably for this reason, companies put their brands in the hands of more experienced managers. Fundamentally though, it is a similar role – to take the brand forward.

    Greg Reply:

    Good points, Tim. Clients can indeed be regimented.

    However, it is the agency’s job to lead, not merely to service.

    Thanks for your comment. Have a great weekend.

    – Greg

  2. February 24, 2010

    This is a also problem in software development (inc. websites), where cost is always an issue. It suffers an additional handicap in that the client is often incapable of determining value.

    There is a huge gap in the quality between good and bad implementations of any given project, which will only surface a long time after the guilty party has taken the money.

    The client quite often has to sign-off a project based solely on what they can see in front of them, which, unlike advertising campaigns, is always only ever the tip of the iceberg. Persuading a client in a case like this that they should pay more for better quality is a real problem, particularly when some of the worst offenders are the big ‘names’.
    .-= Hugo Rodger-Brown´s last blog ..Crowd-sourcing (II) =-.

    Greg Reply:

    Hugo,

    That’s a very good point, especially as regards scalability, documentation and security, which most people don’t realize the value of until it’s too late.

    Incidentally, the same is true not only of external suppliers, but internal ones as well, which is one reason why so many media companies have trouble making the transition to digital.

    – Greg

  3. Dick Laurie permalink
    February 25, 2010

    Great post Greg and couldn’t be closer to the truth.

    Having worked for several of the ‘big holding companies’ and crossed swords with many others – I have found them to be an unforgiving lot, almost exclusively focused on the bottom-line and by default hanging on to clients (particularly the large and global) at any cost. You would think, as the many are run by ex-financial management people, that they would understand the value of project quality over price, sadly this rarely seems to be the case.

    The eternal squabbling over client fee “scraps” (some of which are enormous) between sister companies from within the same holding company is a bizarre scenario, driven by an almost myopic focus on bottom-line deliverables. The degree of mistrust, unwillingness to share and collaborate is at an all time high (of course the financial crisis and pressures on costs has been escalated to new levels). Consequently the emphaisis has consistently moved further away from great work to driving fee margins, bringing in additional services (digital, content, analytics et al) to bring in a greater share not to add client value.

    Of course there are exceptions to this, even in a big holding company sense. Grey’s production team have set themselves up to handle independent projects and to date seem to be succeeding in picking up non-aligned assignments because they’re good at what they do. The more recent opening of Media Barter, with Bernard Glock spear-heading the entity, might put paid to bulk media buying at significant scales – where the likes of GroupM, Media Brands and others have ‘claimed’ to deliver.

    For me, another area that’s really starting to come (back) into it’s own is “Tradies” – plumbers, electricians, carpenters etc. These are skilled workers, but have been in increasingly short supply as apprentiships were either scrapped or faded out due to unpopularity among younger people. They provide essential services and because of their relative scarcity, are able to charge high prices. I had an experience of being on the receiving end of a £100 call-out fee for a plumber in London last year, repairs etc. were on top of this and I had to wait for more than a week (this with no hot water and coming into Winter last year).

    We have commoditised ourselves to a point of ‘sameness’, and where clients are more and more appointing on cost vs. quality.

    Cheers
    Dick

    Greg Reply:

    Dick,

    Thanks again for another insightful comment.

    I agree on the facts, but have a slightly different perspective. The increasingly procurement driven environment has certainly commoditized the business and clients certainly stress price over quality. However, I strongly believe that’s because the quality is so uniformly high that it has become less relevant as a differentiator.

    Moreover, I think that the proper way to evaluate the industry is not against itself, but against other, similar industries. I’ve had the opportunity to work with both management consultants and ad agencies and have found that in many cases the ad agency work to be of demonstrably higher quality with lower cost.

    One area where ad agencies sorely lag is breadth, rather than depth of experience. It is largely made up of highly skilled specialists who have little or know knowledge, understanding or experience outside their field of expertise. This puts them at a severe disadvantage in high level strategic discussions on the client side. It also increases the frequency and intensity of interdisciplinary rivalry.

    How can it be that ROI emerges as a major issue in the industry and virtually nobody is familiar with the Capital Asset Pricing Model (CAPM) – the primary method companies use to evaluate investments? Why is it that so many talk about social media and so few have taken the time to learn anything about social networking theory?

    So again, I don’t think the issue is a lack of quality in the sense that people don’t know how to do their jobs. Rather, that individuals in the industry know so few jobs. Collectively, there is more than enough knowledge but usually a particular person in front of a particular client is privy to a very small part of it.

    And as the old saying goes, if all you have is a hammer, then every problem looks like a nail…

    – Greg

  4. February 25, 2010

    I have not worked at an ad agency, but I really like your comments on having people work in many different areas to “encourage cross-pollination, discourage group-think and minimize the ridiculous interdisciplinary rivalry that the industry has raised to an art form”.

    I once worked for a large, family owned company. The president was, in all honesty, president by birth. But he was very successful due in large part because he worked his way up through the company starting as a sales rep far from the corporate headquarters. He learned about his company in the trenches and had the respect from everyone in the company.

    Thanks for the article.

    –Greg

    Greg Reply:

    Greg,

    Thanks. One of the strange things is that it’s a common practice among ad agencies’ biggest and most successful clients.

    – Greg

  5. February 27, 2010

    Greg,

    This is another very valuable post! I have read recently a forecast that in the next ten years ad agencies will stake on developing proprietary research technology as compared to outsourcing it (probably to just a few global vendors). Do you consider proprietary, or just better, research technology also a differentiating factor that can help an ad agency command higher margins?

    Stan

    Greg Reply:

    Stan,

    This is one area of heavy activity. It’s also important to remember that the holding companies own research companies as well (i.e. Milward Brown is owned by WPP). So again, integration of skills is a major issue.

    – Greg

  6. March 26, 2010

    If Advertising Agencies are in the business of generating ideas, why doesn’t our compensation model parallel other intellectual property businesses? Our CFO offers his opinion at http://bit.ly/cF0P18

    –pam

    Greg Reply:

    Pam,

    With respect, there is an obvious answer to your question. There is a lack or perceived value.

    – Greg

Comments are closed.