What Is The Right Size Agency For You?

Fee vs. billings vs. capitalized billings – A confusing model that can lead to the wrong match.

There has always been confusion over just how big an advertising agency is, as it pertains to actual annual revenues. The revenue size of an agency is an important criterion for clients as they try to determine how much of their budget is part of the overall cost of their potential new agency relationship. Typically, clients want their budgets to be large enough to have access to top-level talent and agency principals. Comparing agencies with flawed revenue metrics can mean the difference of being a top 5% or bottom 5% client. It is important to understand how ad agencies can creatively shift their actual revenues to mislead for the sake of telling the client what he or she wants to hear. It is important for a client to evaluate the importance of agency size, and if size is important, then a thorough understanding of agency accounting is needed.

Historical Background.

The American Association of Advertising Agencies, the leading trade organization for the advertising industry, changed the rules for agencies that declare their revenues. In the past, many ad agencies’ sole source of revenue was in commissions for buying and administrating (aka placing) media, such as TV and print ad assets. The commission structure was historically 15% for every media dollar placed. If a client hired an ad agency to place $1,000,000 of TV media, then the agency would receive a commission of 15% for its services. The resulting $150,000 (15% of the total media spend) would actually be the gross revenue for the agency to develop the creative idea, produce the ad, place the media and provide services. The 15% is actually 6.67 percent of the total revenue (dividing 100 by 15%). Later, as clients began placing their own media, agencies scrambled on how to price their services ( the strategy, the creative ideation, and general client services). The solution was for ad agencies to price their professional services on a fee basis. The transition to a fee-based revenue model also made it confusing for clients to judge how big an agency’s revenue truly was. Agencies that placed media could use the cost of media as part of their revenue and appear larger than they really were. Imagine that Agency A and Agency B both provide $15 million in services to a client, but Agency A also places $100 million of media. Both agencies receive the same amount of money ($15 million) but Agency A looks bigger because it adds the media spend into its total revenue (which actually is just a pass through cost).

In order to level the playing field, AAAA allowed agencies to take their fee income and multiply it by 6.67 to adjust their revenues vis-à-vis media placing agencies. Naturally, this adjustment helps some agencies but also ads confusion to what the actual revenue is. This confusion has led AAAA to publish a guideline to help agencies and clients understand how to publish and present revenue.

Some agencies see these guidelines as setting a precedent for allowing too much access into their revenue stream. Agencies are hired to provide big ideas that are far more valuable than the hourly rate. Just think of household slogans like Nike’s “Just Do It” of Apple’s “Think Different”. These ideas were probably more valuable than the copywriter’s hourly rate.

Negotiating Pros And Cons.

Agency review consultants often use the AAAA models to help negotiate fees, which can create strife before the relationship starts. This is a perfect storm waiting to happen. Clients want the most for their budget, but this can often get in the way of creative people providing their best ideas rather than managing their time sheets against a strained budget.

Clients need to ask themselves if they have ever negotiated with service partners that are critical to the success of the business, such as lawyers and accountants. One can only image what the response would be from a top law firm when asked to expose their profit or negotiate their hourly rate. It can be insulting at worst and demoralizing at best.

Do Your Homework.

Be mindful of how publications ask each agency to provide fee revenue, versus billings versus capitalized billings from sources such as Advertising Age, ADWEEK, Business to Business, and listing directories such as AAAA, Agency Finder and AdForum. All sources are extremely different, and can have a profound effect on how the agencies’ bottom lines are presented.

The Simple Answer.

For clients looking for a retainer-based relationship, an easy way to determine the right-sized agency is to simply inquire about employee-to-fees ratio. For every full- time employee (FTE) working on your account, the agency should generate about $150,000-$200,000 of total fees, thus as an example, an annual $500,000 client budget for an agency should be equal to approximately 3-4 FTEs.

For clients that want a project-based relationship, they should disclose the amount upfront and let the agency figure out how to develop the required solution against the scope.

Or, you can simply pay for a million-dollar idea.

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