How to move to a value-based approach to compensation

How marketing communications firms can begin to adopt a compensation approach based on value instead of cost.

By Tim J. Williams and Ronald J. Baker, Ignition Consulting Group

The current cost-based compensation model for marketing communications firms is flawed for a simple reason: it misaligns the economic incentives on each side. The client pays whether the agency adds value or not and the agency is paid a fixed amount regardless of the value it creates. Clearly, this present model is not in the best interests of the client or the agency.

Even more perniciously, the existing compensation model focuses entirely on the wrong things: efforts, activities and costs. It does this at the expense of focusing on the right things: outputs, results and value.

To some extent, both sides are locked in a form of intellectual embargo, thinking there is no better way to enhance value on each side. Each party largely believes that a dollar more to one side comes only at the expense of the other side. Little wonder the status quo is characterized by a degree of mutual distrust, lack of communication, and underinvestment in a more rewarding compensation model.

It surprises most agency executives to learn that clients (even procurement agents) are intensely interested in changing the agency compensation game. A study by the Incorporated Society of British Advertisers (ISBA) shows that 70% of global advertisers are unhappy with their current agency compensation agreement. The reason? Agencies naturally assume it’s because clients want to cut costs. But according to a recent survey by the Association of National Advertisers, the leading reason for interest in a new compensation agreement is to “improve performance.” Similarly, a AAAA study conducted by Millward Brown shows that that “lagging business results” is a much more important driver of changing agencies than “lack of agency cost efficiency.”

Meanwhile, agencies are paying attention to the wrong things. A survey of agency pricing practices conducted by the AAAA shows that 94% agencies track labor hours and costs, yet only 22% track client results.

The current state of affairs

The cost-based compensation model in place in most agency-client relationships presents significant problems for both parties.

The root of the problem is that agencies get paid for hours worked rather than value provided. This means compensation agreements are based on costs, activities, efforts, and inputs, rather than results, outcomes, value, and outputs. By counting and charging for hours, agencies are only fueling the “faster, cheaper” fire raging in our industry today.

A cost-based agreement usually fosters a production mentality, because the focus is on accomplishing the scope of work within a specified number of hours. On the other hand, a value-based agreement creates an entrepreneurial mentality, because the goal is not efficiency but rather effectiveness, which leads to more innovative, creative ways to solve problems.

Ironically, a time-based approach means that an increase in efficiency actually leads to a decrease in agency income, because it means fewer billable hours. Conversely, an agency is actually rewarded for inefficiency because its revenue goes up as hours increase. A cost-based approach also places an artificial ceiling on the agency’s income. None of these dynamics comes into play with a
value-based approach.

A cost-based approach also assumes that all hours are equally valuable, when we know that sometimes an hour of time can produce remarkable value, and sometimes it can produce absolutely nothing. But the client pays for that hour just the same. The truth is, not all hours are created equal, and billable hours don’t build
successful brands.

Value is created outside – not inside – the agency

The late management thinker Peter Drucker taught the marketing concept: The sole purpose of a business is to create wealth outside of itself. It is not to be efficient and control costs. The buggy whip manufacturers were, most likely, at peak efficiency. So what? What if you are 100 percent efficient at doing the wrong things? Becoming more efficient is not going to help create value for customers.

Yet if you examined the metrics clients use to evaluate agencies––hours, costs, full time equivalents, ad nauseam––you would discover they are all focused on internal operations and have nothing to do with the external value created for the marketer. They simply do not measure things that matter to the final customer, nor do they judge or predict how agencies create and influence value. In other words, we are chasing the wrong rabbit. 

Moving to a new model

There is obviously an intense interest among clients and agencies in moving from a cost-based to a value-based compensation model. But how to get there? If value is like beauty––in the eye of the beholder––how are we to define it? What factors create it? How can agencies be paid if they cannot fully control how clients create it? What happens if value isn’t created?

These are the questions that have led to the development of a new model that can be used to create a true value-based relationship. Rather than focusing just on lagging indicators, this model requires that both parties develop and test leading indicators that actually have predictive capabilities instead of just looking in the rear-view mirror, which is all most marketing metrics do currently.

Scope of value before scope of work

The foundation of a value-based approach is to address the “scope of value” before defining the traditional “scope of work.” What are the desired outcomes? What are the client’s measures of success? What value is the agency expected to deliver?

Consider that unless the scope of value is defined, the scope of work might
be wrong.

Lagging versus leading indicators

Most measures of performance––sales, market share, stock price, etc.––are lagging indicators that only tell us where we have been. That is all any measure can provide us. Even real-time measures only rise to the level of what economists call coincident indicators, telling us where we are at the present time.

What we need to develop are leading indicators, since the only way to peer into the future is to tie a measurement to a theory. For example, your FICO score contains five weighted measures: payment history, amounts owed, length of credit history, new credit and types of credit used. Why just these five among the hundreds that could be measured? Because these five have been empirically tested for predictive value. In short, they are the leading indicators that best predict a person’s
credit worthiness.

A performance measure can only confirm the past, while a predictive indicator can help us peer into the future. All of the metrics gleaned from financial statements are lagging indicators, and thus have zero predictive capability, unless your theory is the future will be an extrapolation of the past, a perilous assumption is today’s fast-changing world. In order to develop meaningful indicators, clients and agencies need to define the chief value drivers––the precursors of brand sales and profits. Most leading indicators never appear on a financial statement, but they have predictive causation with profitability––that is, they will drive the numbers that ultimately appear on the financial statements. The correct leading indicators will predict the
lagging indicators.

This is not to say there isn’t a place for lagging indicators on a Value Scorecard. Some lagging indicators – such as incremental profits generated from a campaign – are important and relevant measures of marketing success. The same is true with lagging indicators like brand penetration and average price per unit.

Measuring what matters

Many traditional measures of success are the result of historical practices rather than a careful study of cause and effect. Correlation is not the same thing as causation.

For example, while sales is the most common “hard” metric of success, campaigns that focus on reducing price sensitivity are more effective than those that focus on volume. In other words, value is more important than volume, and value share more important than volume share.

Knowing the metrics that matter should be part of the intellectual capital an agency brings to the party. Not all measures are created equal. Or as Einstein said, “Not everything that counts can be counted, and not everything that can be
counted counts.”

Efficiency versus effectiveness

What would you conclude regarding the efficiency of a particular laser beam that wasted 60 to 90 percent of the electric power received at its back end before projecting an intense, blinding beam out the front?

It doesn’t sound very efficient does it? Yet that’s the productivity of the laser beam used for cataract surgery to restore eyesight. It is not at all efficient. It is, however, highly effective. In this case, the waste of energy is clearly a virtue, not a vice. You would never draw this conclusion studying the ratio of output to input, as the math misses the miracle of restoring the joy of human sight. If you were the patient, inefficiency is clearly superior to ineffectiveness. Most people would choose an effective heart surgeon over one who was merely efficient.

This is why value-based agency-client relationships must focus on effectiveness rather than efficiency. A business does not exist to be efficient; it exists to create wealth outside of itself. An obsessive compulsion to increase efficiency (doing things right) reduces the firm’s effectiveness at doing the right things. The relentless pursuit of efficiency can hinder the client and agency from focusing on the things that truly matter most.

To add insult to injury, the efficiency measures that are being used tend to be lagging indicators that measure efforts and activities––the past––at the expense of leading indicators that measure results.

Effectiveness means that imprecise measurements of the right things are infinitely more valuable than precise measurements of the wrong things. It is more important to be approximately right rather than precisely wrong.

The Value Pyramid

(ADD VISUAL HERE)All of these dynamics can be displayed as a Value Pyramid. At the apex of the Value Pyramid are the Lagging Indicators that are the definition of success from the marketer’s viewpoint. Lagging indicators can be in the form of such things as market share, sales volume, stock price appreciation, market penetration, and so on. Ultimately, these indicators tell us whether value has, or has not,
been created.

One level down are factors such as brand awareness, favorability ratings, search engine rankings, web page visits, etc.––the things that directly impact the lagging indicators. These are the Leading Indicators of value. They are predictive. If they show a positive change, they create the value that eventually shows up as a
lagging indicator.

The base of the pyramid contains the Influencers of value, and are applied to both the agency and the client. They are the behaviors that produce positive changes in the leading indicators of value. The brand stakeholders on the marketer’s team rank and decide the most important influencers based upon the objectives of the relationship. The agency side does the same for the marketer.
These influencers are graded over a pre-defined period of time and compared to the goals established at the beginning of the relationship. The scores will influence agency compensation.

Examples of
Agency Value Influencers 		 Examples of
Advertiser Value Influencers 
Working with client in collaborative way Providing time to allow agency to do its best work
Assigning agency’s top people to work on business Identifying desired outcomes
Developing fresh, unexpected creative ideas Giving timely and constructive feedback
Providing relevant insight about brand’s customers Facilitating good communication 
Developing clear, well-supported strategies Providing access to information and people
Executing programs that generate brand buzz Having well-organized approval system
Providing expert online marketing solutions Minimizing revisions and rework
Developing big multi-channel ideas Involving senior decision makers
Providing non-traditional marketing solutions Breaking down internal silos
Integrating agency teams and functions Providing clear, complete direction to agency
Providing proactive ideas that transcend advertising Understanding brand’s key success drivers
Adopting systems that result in smooth workflow Creating environment of mutual respect

How will you know if each side is grading fairly, and not just abusing their power to negatively influence the compensation? This is an issue of trust, not pricing. Why be involved in a relationship without mutual trust, respect and honest communication? The beauty of the influencers on each side affecting compensation is the alignment of the incentives to do the right thing, and to relentlessly communicate.

Determining Value Indicators and Influencers

How should measures of success be determined? The lack of data in many companies leads some executives to conclude that identifying the right metrics is close to impossible. The truth is, most of the metrics that matter involve a heavy dose of judgment. There is as much art as science in identifying the Value Indicators and Influencers that impact the success of a brand.

Using an approach based on response modeling, key stakeholders at both the agency and the client can identify, rate, and rank the vital brand value-drivers. A series on online worksheets and onsite workshops allows key stakeholders to ascertain and clarify both hard and soft measures of success. The most important aspect of this process is the dialog it produces around the question “what are we trying to accomplish?” Lack of hard-and-fast data shouldn’t be an excuse for failing to articulate the expected outcomes of a marketing program.

Skin in the game

It’s common practice for most agencies and clients to refer to one another as “partners,” yet most agency-client relationships don’t really qualify as true partnerships. Why? Because the nature of a partnership is shared risks and shared rewards. Agencies may sometimes share in the rewards of a client’s success – such as in the case of a performance bonus – but seldom do they share in the risks.

A true value-based compensation arrangement therefore incorporates both of these elements into the relationship. There must be both an upside and a downside to both parties; in other words, skin in the game. When an agency is willing to tie its compensation to the same metrics that CMOs and CEOs are judged by, then they are entering into a real partnership.

Agencies can put some “skin in the game” by establishing what we call a Value Reserve – a portion of the agency’s income that is dependent on the accomplishment of specific outcomes. The higher the Value Reserve, the higher the risk, the higher the price.

Easy versus right

Cost-plus pricing is, to borrow a medical analogy, an iatrogenic illness––a disease induced inadvertently by a physician while providing treatment. Since we have to assume most business people are rational, and are profit optimizers––or at the least, satisfiers––one is drawn to the conclusion that executives perpetuate this compensation method because it is safe and simplistic.

One of the reasons for the widespread use of this form of pricing is the rule of the bean counters. Cost accountants have had a significant impact on pricing decisions in companies, and it is time to bring their tyrannical rule to an end. Cost accountants and CFOs focus on the inside of an organization, yet all the value takes place in the external world, beyond the four walls of the firm, as Peter Drucker’s marketing concepts teaches. By and large, accountants are not well equipped to judge and measure value.

As Henry Ford pointed out, no one knows what a cost should be. Yet, cost accounting has held hegemony for far too long over agency compensation, embedding the conventional wisdom that costs determine price, when in fact it is the exact opposite––price always determines costs. What possible good is it to know what something costs if the client does not see the value for the price?

Changing the dynamics of agency-client relationships

Nothing can change the dynamics in an agency-client relationship more than moving away from a cost-based compensation system to one that is based on value. A true value-based model, like the one we’re describing here, aligns the economic incentives of both marketer and agency, putting each into a value-based mindset with the ultimate goal of creating ever-increasing value on each side. Rather than misallocating resources to solve problems, it pursues opportunities. It gives the agency incentive to think and be more proactive. It helps focus and prioritize the time, energies, and activities of both parties. It infuses the relationship with a higher level of trust and mutual respect, because the agency and client are trying to achieve the same outcomes, with the same level of risk and reward.

It’s not an easy thing to do, but it’s the right thing to do. The agencies that show the initiative and make the move to value-based compensation will become highly attractive to a client community that is under increasing pressure to show a return on their investment.

Questions or feedback? Contact us.

Copyright © 2011 Ignition Consulting Group, Inc. Terms of Service