Your Costs Are None of Your Client's Business

LinkedIn Article by Tim Williams 
December 14, 2015

Can you imagine taking a test drive in the breathtaking new BMW 7 series, turning to the salesman and asking "Wow, I'm really interested in buying this 750, but how many hours did it take to build it?" This question is out of place because buyers don't generally expect to know what something cost to build before they buy it. They judge the price based on a variety of factors -- the quality of the product, the reputation of the brand, and a whole set of other rational, emotional and sensory factors -- but not the actual cost of making the product. 

In the great majority of categories, buyers have no idea what actual production costs are, nor do they expect to know. Buyers accept that costs and margins are the seller's business. They know that sellers have to make a profit, and that prices are set above costs, but they don't presume to be able to dictate what the seller's margin should be. The main judgment buyers make is about the product's value, both real and perceived.


These buyer/seller dynamics apply to everything from leasing a car to buying a new mobile phone. In an Apple store, it's unlikely you would ever hear a prospective iPhone customer remarking to a blue shirted Apple employee "I can't really justify spending this much for a phone unless I know what Apple's actual cost is. How much exactly do they pay Foxconn to build it?" A potential iPhone buyer is instead going to make the decision to spend $800 based on the phone's features, design, functionality, and integration with other Apple services. 

So why is it the buyers of most professional services -- like advertising, accounting, and law -- request to see the actual costs of the services being provided? At the very least, most procurers of professional services request to see a schedule of hourly rates (which they know are a cost-plus calculation). Worse, many procurement professionals now consider it their right or privilege to know a firm's actual costs, right down to salaries, benefits, and overhead. These professional buyers can then precisely calculate the seller's profit. Some will go so far as to dictate what profit margin they consider to be acceptable. 

When searching for a new advertising agency partner, a major retail chain distributed a Request for Proposal that contained the language "Requested net profit margin," as though the winning agency will be granted a profit as some kind of favor. This same RFP goes on to ask for the agency's tangible direct labor costs, specifying this "should include but not be limited to vacation, pension plan contributions, 401K contributions, and payroll taxes." Are you feeling insulted yet? 

Unfortunately, most ad agency execs have come to accept this intrusion into their business as standard operating procedure, dutifully filling out spreadsheets that sometimes even demand to the salaries of individuals by name. The built-in formulas on these client-provided spreadsheets effectively show the agencies involved exactly what will be "allowed" as overhead (regardless of what the agency's actual overhead is) and of course the resulting maximum profit margin the client will accept. Many of these repressive vetting processes cap profit margins at around 11%, despite the fact that the stated profit goal of most agencies -- especially those owned by the big holding companies -- is roughly twice that (20%). Why would an agency agree to a compensation deal that yields only half of what the firm needs to remain financially healthy? If you suspect that most agencies find a way to make better margins than those "allowed" you would be right. And guess how they do it? 


This nonsensical buying and selling of inputs (hours, FTEs, time of staff) produces neurotic behavior on the part of buyers (who live in constant fear of getting less than they paid for) and less-than-scrupulous behavior on the part of sellers (who fret about getting all their hours billed by the end of the year so they can earn their full fee). This serious misalignment of economic incentives produces not only an environment of mistrust, but virtually insures that neither party fully gets what they want. It also prevents the type of "partnership" that is a stated goal of both the firm and its client.

Curiously, this type of financially-asymmetrical relationship doesn't really exist anywhere else in the business world except for the buying and selling of commodities (think pork bellies). Surely professional services, performed by highly educated experts, is not a commodity. How, then, did this become an accepted practice, and -- more importantly -- how can we change it?

As for the devolution of agency pricing practices, there is no better recap and explanation than the book "Madison Avenue Manslaughter" by Michael Farmer. As Farmer points out in his excellent retrospective, the reasons are not really economic as much as they are psychological (lack of confidence) and cultural (lack of effective management practices).

But to the question of how to change it, I'll offer a simple prescription. Professional services firm must stop selling inputs (hours, efforts, activities) and start selling outputs (end-products, programs, solutions). They must price the destination instead of the journey; the hole instead of the drill. 

Furthermore, it's the seller's job to implement new pricing practices, not the buyer's. Do you recall the airlines asking your permission last time they changed their pricing structure? 

Costs and profits are the seller's business. Transparency is for windows, not for pricing professional services.