The Five Types of Client Compensation Profiles
By Tim Williams
It's a curious fact that the advertising agency industry is one of the only businesses on the planet where the buyer — not the seller — sets the price. Or so most agencies believe. The subservient attitude many agencies bring to the negotiating table produces a lopsided conversation in which agency executives expect client-side procurement professionals to propose the pricing structure, which is usually supported by references to industry benchmarks that indicate the current market rate for agency services.
When my friend Ron Baker, a "recovering CPA," first learned about the way most advertising agencies are paid, he compared our industry to public utilities. Your local power company or natural gas supplier is only permitted to charge rates that are pre-approved by government commissions based on a thorough analysis of the companies' costs. Their profits are therefore limited and regulated by the buyers of their services. This isn't much different from RFPs from brand companies that specify a "maximum profit of 11%," which will be carefully monitored through ongoing disclosures of the agency's cost structure. Can you imagine any other free-market company operating this way? That's not capitalism — it's Marxism.
The fact that the agency business has permitted this to happen could be the subject of an entire book. The underlying factors include everything from the disintermediation of the media business to the erosion of self-confidence in agency leadership teams. But the destination at which the agency business finds itself has created five types of clients:
1. Clients who hire you for inputs and want to pay you for inputs
This is, unfortunately today's dominant compensation approach. Based on your firm's published schedule of hourly rates (by person or position), your client wants to pay you for the time your team spends on their business. The pitfalls of this system have been the topic of countless articles, white papers, podcasts, speeches, and books.
The primary reasons for burying the billable hour can be summed up in these seven arguments:
1. It focuses on efforts, inputs, hours, costs, activities rather than what customers really buy, which is solutions to business problems.
2. Hourly billing misaligns the interests of the firm and the client. The client wants their work done with fewer hours, whereas the firm wants to bill more hours.
3. It penalizes technological advances and operational improvements, lessening a firm's revenue if it performs work more efficiently. In particular, AI-powered solutions cannot (and should not) be billed based on time.
4. It commoditizes the firm’s offering into a unit of time, making it difficult for buyers to see any differentiation between one firm and another.
5. It places an artificial ceiling on a firm’s revenue and profits, since there are only so many hours in a day — indeed, a lifetime.
6. Timesheets discourage innovation. Recording time discourages the kind of creative thinking that creates real value. It motivates professionals to be "billable," not innovative.
7. Feeding the time machine is expensive. Somewhere close to 15 percent of a firm's gross revenues are spent supporting the timesheet system -- resources that could be much better spent on other initiatives that would make a real difference to your firm.
If these counterpoints aren’t enough to convince you, read “Time’s Up” by my friends Paul Dunn and Ron Baker.
2. Clients who hire you for outputs but want to pay you for inputs
This approach produces an even worse outcome for the agency than being paid for actual time spend. The ultimate manifestation of this system is the "all-you-can-eat buffet," in which clients have an exhaustive list of deliverables they want you to produce, but if you end up spending more time than estimated, the agency eats it. On the flip side, if the agency team spends less time than estimated, the client often expects a credit or refund, robbing the agency of the ability to profit from its ability to do the work faster than planned.
3. Clients who hire you for outputs and are willing to pay you for outputs
Now we're getting into the territory that conforms with the spirit of "value-based pricing." This system is the one we recommend for most agencies endeavoring to adopt modern pricing practices. In most markets, this is how business is done. A product or service has an established price, and the buyer pays accordingly. As consumers, this is how we buy iPhones, cars, or kitchen appliances. It's based on the principle "Willing seller, willing buyer" where the established price is evaluated and accepted by both parties, regardless of the time or costs required to produce the product or service.
This approach enables the agency to benefit from its ability to produce work faster (time) and cheaper (internal costs) because of its experience and expertise. It also has the benefit of arming the client with a clear understanding, upfront, of what they can expect to pay you for a scope of work, regardless of the hours logged on a timesheet. In fact, this approach ultimately negates the need for time tracking altogether, since your firm has a good idea of a what a fair price is for commonly-produced outputs.
This system requires agency executives to build and maintain a "pricing guide" that lists all the firm's outputs, categorized and classified, with a "small, medium, large" price attached to each output. Developing a compensation proposal changes from walking around asking your colleagues to guess at time requirements for a scope of work to simply consulting your pricing guide and constructing an output-based compensation proposal.
Essentially this is the "fixed price for fixed scope" approach that simplifies not only the front-end pricing but also the back-end resource management. Behind every output is a roadmap showing which team members are required to produce each deliverable and how long it will take them. Every agency in the world can adopt this system within a matter of months, and it will produce an instant, significant improvement in your bottom line.
4. Clients who hire you for an outcome but want to pay you for outputs
It could be argued that outcome-based compensation is the gold standard, but it is by far the most difficult approach to effectively execute. For starters, not every client is a candidate for an outcome-based approach. To even consider proposing this to a prospective client, look for these four pre-qualifications:
1. Do you have a high trust level with this client? Are they willing to share what is often considered to be confidential information with you? Will they be as transparent with you as they expect you to be with them?
2. Are they able and willing to focus their time and attention on a serious project that transcends the demands of the day? Do they have the patience for a process that will take some large chunks of their time, but pay rich dividends in the long term?
3. Does your client understand what makes their enterprise successful? In other words, can they articulate their brand’s key success drivers?
4. Is your client willing to invest in their own success? Identifying and measuring the metrics of success that will serve as the basis of an outcome-based relationship will cost money the client hasn't spent before.
If you sense that an outcome-based approach could be mutually beneficial, the top watch-out is ensuring that your client is clear that the definition and management of outputs is in the hands of the agency. They're paying for an outcome (or set of outcomes), and your method of achieving that result might be startlingly simple.
For example, your original proposal may outline 16 outputs you expect will be required to achieve the outcome, but thanks to a brilliant behavioral science expert in the ranks of your strategic planning group, you happen upon an insight that creates an unexpected shortcut to success. Is your client still obligated to pay you for the outcome, even though you were able to achieve it in three months instead of 12, with much fewer outputs than originally expected? The answer is a resounding yes.
5. Clients who hire you for an outcome and are willing to pay you for an outcome
For the right kinds of clients (see above), this type of relationship can be a true win-win for both parties. As the client benefits (from increased sales, improved market share, or whatever the parties have agreed to), the agency benefits from increased compensation. To be fair, every potential upside must also carry a potential downside. There is no such thing as a risk-free outcome-based relationship.
This approach is based on the principle of "shared risk, shared reward." In fact, look up the definition of "partner" and this is precisely what you'll find. Agencies are fond of referring to themselves as "marketing partners" but mostly behave as suppliers, because of their aversion to accepting any risk in the relationship.
---
Early in your preliminary discussions with a prospective client, engage in an exploration of their attitudes toward compensation. Don't just assume they will want to pay you by the hour. Recent research (Association of National Advertisers, World Federation of Advertisers, etc.) shows that the majority of client organizations are unsatisfied with the hourly rate system and want their agency partners to propose a more progressive remuneration approach.
At a minimum, propose some form of payment based on outputs — work delivered instead of hours worked. But make sure they understand the implications and logistics of this approach so your expectations are aligned. For more enlightened clients, consider incorporating remuneration based on outcomes into your compensation agreement. Just don't allow the compensation conversation to revert back to the outdated and impractical idea of "renting people." It's high time for the professional services sector to adopt the pricing practices of the rest of the business world.
