Cost Plus and Value Pricing: A contrarian’s point of view

Pricing cannot begin to be improved until advertising agencies make other important changes.

It is commonplace among advertising agencies to view “cost plus” and “value pricing” alternatives as opposite ends of the spectrum, with “cost plus” evaluated as bad and “value pricing” evaluated as good. Surveys like the IPA’s 2016 survey on Pricing, Selling and Negotiation, show that it is very hard for agencies to move from bad pricing to good pricing. Most agency income is derived from cost-plus based billing. Change is an uphill struggle.

When challenged on price, agencies try to justify their costs - and then they capitulate. Few succeed in reducing scope or the seniority/mix of their personnel. In capitulating, they accept a de facto price reduction for the work they do.

Few agencies actually focus on value with clients when making pricing decisions. Few client-facing agency staff are trained in strategic pricing, and in fact, strategic pricing is not really considered a core discipline. My consulting experience with ad agencies, leads me to believe that things are even worse than this at the typical agency:

Absence of accountability 

There is very little management accountability for the alignment of fees, resources and Scopes of Work in ad agencies. The senior account people who manage client accounts do not have measures for the amount of work they agree for a given fee. They may be measured on account margin (fees less costs), but that is far from being measured on SOW workloads and fees. Their performance is not measured and reviewed by office heads, regional heads or agency CEOs. They are free to manage things tightly or give away work for free. No one knows what they do. Why should they be interested in pricing approaches that would make their job more difficult.

Lack of top-management interest in managing in a tighter way

Among all the management priorities talked about in agency circles, improved accountability for fees / resources / SOW workloads does not appear among the top 10 or top 25 priorities, according to my work and experience. Agencies are interested in improving creativity and improving new-business wins, but they are fundamentally uninterested in changing their loose internal management cultures. This makes pricing changes highly problematic.

Lack of interest in committing to improved client results

Unlike management consultants (who are paid on a cost-plus basis, but at a 5x billing multiple rather than the agencies' 2.2x billing multiple), ad agencies have never really committed themselves to delivering improved client results. They commit themselves to being creative and delivering high levels of customer services, but this is far from committing themselves to working in a focused manner for improved client results. Since clients are only interested in improved results (i.e. increased shareholder value), and they harbour a suspicion that agency work does not really deliver much value, they cut fees year after year. That's the real source of the agency pricing problem. Agencies, for their part, do a very poor job showing that their work delivers results - as much from lack of conviction as from ignorance.

Agencies complain about procurement's pricing practices, and they claim to be interested in shifting pricing from cost-based to value-based, but in my experience, this claim is not backed by the other initiatives that are required before this can be achieved:

SOW documentation and tracking

Agencies need to develop and implement uniform ways of measuring client SOW workloads, and ensuring that “every client in the agency has a documented SOW that will be measured for fee-setting negotiation purposes.” This policy needs to be articulated by agency CEOs. Without a uniform way of measuring work, agencies do not have a prayer of defending the value of their work!

Increased accountability

Agencies need to move away from the loose management practices that developed when agencies were highly paid via media commissions – and recognise that in today’s environment, tight management of individual accountabilities is an absolute requirement. This change needs to be led by agency CEOs. Client heads then need to manage pricing, workloads and resources in a tighter way, and expect their performance to be measured and reviewed.

Change in mission

Agencies need to migrate away from obsessing about “creativity,” and begin to focus more professionally on what it takes to deliver improved results for clients. This requires taking ownership for SOWs that “have the highest probability of delivering improved results in a dynamic and changing marketing environment.”

Only when agencies have committed to these types of changes will pricing become a core discipline, required by those who have accountability for assuring that their agencies are well-paid for the work they do and that all work is paid for.

Even cost-plus work, if paid at a high enough multiple, can be defined as value-based. After all, who is more valued? The £100,000 professional who firm is paid £500,000 for his / her efforts, or the £100,000 professional who generates only £220,000 in fees?

Ad agencies need to aspire to the pricing success of their management consulting competitors, but before this can happen, certain cultural disciplines need to be put in place.

Michael Farmer is founder and CEO of Farmer & Company LLC, a strategy consulting firm for ad agencies. He is author of Madison Avenue Manslaughter: an inside view of fee-cutting clients, profit-hungry owners and declining ad agencies, which won the Axiom Gold Business Book Award for the best Marketing / Advertising book of 2016.

Last updated 21 January 2022