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This article was originally published on the CMO site.

How the enterprise pays its ad agency actually matters. Here’s why.

I have been working for a company that makes software solutions for buying digital media, and I have worked for a number of ad technology companies in the past. In a world where digital banner ads are still purchased through email and fax, and media plans are mostly created using Microsoft Excel — technology dating from 1985 — the ad technology industry sees an opportunity to create efficiencies in the way media is bought and sold.

One of the odd industry dynamics we have encountered in bringing our product to market is how independent agencies are more apt to embrace new efficiencies than some of the “big four” owned agencies that lead the space in terms of media spend.

Logically, you’d think that gigantic media agencies, managing hundreds of media planners and buying on thousands on digital media channels, would grasp at the chance to do more planning with fewer personnel, migrating towards web-based tools that offer efficiency and centralization. The evidence has shown otherwise.

On the surface, it may seem as though the biggest difference between independent agencies and the majors is size. The majors have Ford, and the independents have the Ford dealers. They both work very hard to identify digital audiences, perform against marketers’ aggressive KPI goals, while trying to understand how they got there through detailed analytics. At the core, the difference between what media teams within holding company shops and a smaller agency does is minimal. So what accounts for the reluctance of bigger shops to innovate with technology tools?

One reason may be the way they get paid.

The biggest shops consistently rely upon cost-plus pricing, which pays them based on hours worked, plus an additional, negotiated margin. The typical $500,000 digital media plan takes an alarming 42 steps and nearly 500 man hours to complete, which can cost up to $50,000 — and that doesn’t even include developing the creative.

If you are paying your agency on a cost-plus basis, your agency doesn’t have a lot of incentive to create your plan faster, or with less labor. In fact, this type of pricing scheme creates an incentive for inefficiency, or what economists call a “perverse incentive.” Unfortunately, every cent you pay towards the labor of creating a media plan subtracts from the amount that can be dedicated to the media itself.

Spend

So, what to do? The most obvious choice for those working with a large agency under such a scheme is to try and change the payment terms. Pay-for-performance is optimal, but a careful analysis may show that paying on a percentage-of-spend model yields more reach, when you are not paying for the labor of building a media plan.

Some marketers are choosing instead to build small, efficient in-house teams to leverage the demand-side technologies that their agencies want to discover and buy digital media. Other marketers choose to work with multiple smaller, independent agencies that have specific expertise in different digital verticals. Those shops usually offer flexible fee structures, and you are far more likely to work with the team that pitched you after you hire them.

As they say in finance, it isn’t what you make, it’s what you keep. In digital media, moving away from cost-plus pricing relationships and towards new technologies for media buying means keeping more of your money for reach, and spending less on labor that doesn’t help you move the sales needle.

The inefficiency of digital media buying is well-known. Tools and methods to improve workflow and efficiency have been developed over the years, but they’ve not been widely adopted. Could it be that agencies aren’t properly rewarded for being efficient? Or, worse yet, could it be that agencies are actually punished for being more efficient?

Let’s take a look at the economics of efficiency at an advertising agency.

Starting around 1990, agencies have moved from media commission models to hourly (or “cost plus”) pricing models. This movement has been accelerated by shift of advertising spending to relatively inefficient digital advertising. According to the 4A’s Labor Billing Survey Report, 91% of proposals today are priced based on hourly rates (despite scoring lowest among alternatives on the Grossman Grid).

Imagine a new technology has been just been developed that doubles staff productivity through automation. In other words, this automation would enable you get the same amount of work done at the same level of quality with half the number of people. Furthermore, this technology costs only 5% of the value created. In other words, it would only cost $5,000 for every $100,000 saved.

Purchasing and installing this new technology would normally be a “no brainer” decision. However, for the typical agency using hourly rates (or “cost-plus”) it’s not so simple. Consider the following before and after comparison:

As you see, the technology would enable the agency to serve the same 10 clients with half the number of people. It would reduce personnel costs by 50% saving the agency $2,000,000 per year while costing only $100,000 per year. That’s fantastic ROI on this new technology!

How would the agency be rewarded for this breakthrough? Since this agency uses hourly billing, there is no reward. In fact, there’s a huge punishment: the agency’s revenue would get cut in half, there would be a painful round of layoffs, and (assuming the agency can’t pass through the cost of productivity technology) the agency would suffer a 65.5% decline in profits. Not cool.

If you were making the decision, would you advocate this technology be purchased and installed? Given these numbers, that would be risky. Doing so would be what I call a CLM – a “career limiting move.”

The best argument to install this technology would be to gain a competitive advantage to win new business. But that would be a big bet. You’d have to more than double your business to make up for lost profits with existing clients.

Or you could change your compensation model to a value-based model, which would be a difficult transition. Would that be worth the risk?

This over-simplified example makes the point: digital media buying wants to be inefficient because of hourly compensation models. Until compensation move away from time-based models, there’s not much motivation to be more efficient.