Are Ad Agencies Stuck with Commodity Fee Levels?
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.
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.
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.