Tag Archives: remuneration

4 Keys for Optimizing Direct Labor Based Remuneration Systems

9 Jul

punch clockAttorneys do it. So do accountants, consultants, architects and engineers.

What are these firms doing? Tracking billable hours. Why? Because time and material based compensation remains the predominant method of billing for professional services firms and this includes advertising agencies. In fact, according to the Association of National Advertisers’ 2017 “Trends in Agency Compensation” study, labor-based fees remained the “most used” method of remuneration for marketers of their ad agency partners.

There are many inherent benefits to direct labor based compensation systems from both an agency and advertiser perspective including simplicity and clarity, particularly for marketers utilizing multiple agency partners that may be collaborating on overarching campaigns or playing specific roles on comprehensive, integrated projects.

We believe there are four key steps to successfully implementing and managing direct labor based remuneration systems:

  1. Establishment of a clear, concise Statement of Work (SOW), with specific deliverables and estimated timelines.
  2. An agency Staffing Plan that identifies the individuals that will be assigned to the client’s business along with information detailing their department, title, bill rate and utilization rate.
  3. Build-up detail supporting the agency’s suggested billable hourly rate (i.e. direct labor, overhead, profit margin) to accompany the agency’s annual fee proposal.
  4. Timely, accurate time-of-staff reporting to facilitate the monitoring of burn rates and to support the fee reconciliation process.

While there are contractual language considerations that will also help to insure transparency and establish client and agency expectations, including limiting agency revenue to that which is agreed upon as part of the remuneration program, we want to focus our thoughts and recommendations on tracking billable hours.

Aligning advertiser expectations with agency resource requirements is the basis for any compensation system. Thus collaborating on an annual Statement of Work, complete with detailed deliverables and timelines is a critical first step in the process. The resulting document will inform the agency’s efforts to construct its Staffing Plan, which in turn will form the basis for its fee proposal.

Experience suggests that conversations should be had in advance of the agency’s development of its Staffing Plan. Specifically, the parties will need to agree upon the basis for the annual full-time equivalent (FTE) calculation and the rules related to the application of agency employee time in excess of the FTE standard for fully-utilized employees and how utilization rates are impacted by an employee’s “total” annual recorded time. As it relates to FTE standard, there is no normative data for the advertising industry. That said, an 1,800 to 1,875-hour standard (35 hours per week, multiplied by 50 weeks per year) represents a typical FTE range.

Once the SOW and Staffing Plan have been agreed to, reviewing and coming to agreement on the basis for the proposed billable rates is the next step in the fee negotiation process. The basic formula for calculating a billable hourly rate is as follows:

Billable Rate = (Direct Labor Costs + Overhead + Profit) / Total Projected Annual Hours

Ideally, billable hourly rates would be calculated by employee or by function, without revealing specific employee salary detail. As a fall back, calculating billable hourly rates by department are clearly preferable to a blended hourly rate for the agency as a whole. Thus for an agency associate with direct labor costs (salary + benefits) of $100,000 per year, an overhead factor of 1.0 x direct laborpunch clock, a target profit percentage of 15% and an 1,875 FTE standard, the billable hourly rate calculation would look as follows:

Billable Rate of $114.67 = ($100,000 + $100,000 + $15,000) / 1,875 hours                                                                                                                                             

From a reporting perspective, monthly time-of-staff reports detailing “actual” versus “planned” hours by individual are ideal to serve as the basis for regular discussions between client and agency on burn rates and what, if any, course corrections are required. The goal of the reporting and resulting conversations are to ensure that there are “no surprises” that would adversely impact either party. A formal time-of-staff reconciliation should be conducted annually, preferably by an independent third-party to validate that the time reported by the agency is consistent with the time in the agency’s time-keeping system.

Following the aforementioned steps will help protect the interests of both client and agency and will lead to a compensation program that is both transparent and fair.

How Do Agencies Do It?

13 Feb

ad agency profitsEarlier this month the Japanese agency holding company Dentsu announced quarterly financial results.  For the nine-months ending December 31, 2012 revenues were up 4.5% and net income was up 48.1% year-over-year.  Impressive?  Certainly, but not inconsistent with other players in the ad sector; WPP achieved a 43.3% increase in net income on a 7.4% revenue gain and Omnicom Group reported a percentage net income increase which was twice that of its revenue growth. 

A healthy advertising sector represents good news for clients and agencies alike.  Growing, profitable advertising agencies are able to invest in; infrastructure, personnel and research which ultimately allows them to better serve their clients.

There are two interesting observations with regard to the aforementioned agency financial reporting; 1) the recent results fit a pattern of extraordinary net income growth for the category, relative to revenues. 2) In a professional services business, the ability to generate net income growth of 2X to 10X that of revenue can only be achieved through a combination of significant expense reductions and or dramatic increases in direct margin.

Let’s be clear.  Like most other professional service providers whether in the financial, legal or consulting sectors, payroll makes up a disproportionately high percentage of an advertising agency’s expense base.  The publicly traded agency holding companies break out salary expense within their financial reports, allowing for a review of this cost center.  In a 2010 review of agency expense structures, Adweek reported that for the top five agency holding companies, expenses represented between 83% and 94% of revenues.  Salary expenses ranged between 59% and 72% of revenues.  The difference between the two is largely made up of real-estate and overhead costs.

Thus it is unlikely that agencies are relying on expense reduction as the primary source of net income accretion.  This would have a dramatic, negative impact on the caliber of work, service levels and ultimately, client retention and would be unsustainable over any prolonged period of time. Therefore margin growth would appear to be the primary contributor to the extraordinary net income gains.  But how you ask?  After all, industry compensation surveys consistently report that the average agency profit level identified within client/ agency agreements is 15%.   

Unfortunately the answer is clear, while not altogether transparent to advertisers.  A portion of the improved margin is tied to the provisioning of agency-owned services such as in-house studios, trading desks, poster specialists, barter firms and production companies. These services have tremendous margin upside for an agency because there is limited disclosure to the advertiser of the rates paid to the ultimate media seller and or the fees earned by the agency in the form of incremental commissions, spread between planned and purchased costs or volume rebates paid by the media.  Then there are sources of agency revenue which are seldom discussed and rarely audited which contribute to an agency’s bottom line profits.  These include but are not limited to AVBs, interest income from float, earned but un-processed discounts, rebates and no-charge media weight.

These practices are neither good, nor bad they simply represent the nature, albeit murky, of the global advertising industry today.  In the end, knowledge is power.  For example, the agencies that have been smart enough to vertically integrate and to leverage non-transparent income “opportunities” have generated solid bottom line performance. 

For advertisers the answer is simple, extend your knowledge of what is clearly a dynamic and often opaque marketplace: 

  1. Revisit your agency contracts to make sure that the requisite legal and financial controls have been incorporated to protect your interest. 
  2. Make sure that your agency contract extends to the parent company and any sister divisions which may be engaged as part of your agency’s service offering.   
  3. Examine your agency performance evaluation process and remuneration methodology to ensure that you are incenting the behavior and outcomes which you desire.
  4. Engage an independent auditor to assess your marketing service agencies contract compliance and performance to make sure that the requisite level of transparency is always maintained.

In the words of Sir Edward Coke, the renowned seventeenth-century English jurist;

Precaution is better than cure.”

If you’re interested in a second opinion of the soundness of your client/ agency agreement or would like to discuss the benefits of an agency contract compliance audit, contact Cliff Campeau, Principal at AARM via email at ccampeau@aarmusa.com.

There are no guarantees. Are there?

10 Sep

profit guaranteeWhether 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):

  1. Comprehensive definitions of key remuneration program components and examples of how various factors will be calculated.
  2. Quarterly reconciliation process for agency fees, time-of-staff investment and billings.
  3. 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.

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