Posts Tagged ‘Value Pricing’

Despite some recent reports about the small percentage of marketers who currently have a value-based compensation arrangement with their agencies, the move to a value-based approach will very soon become an imperative for agencies rather than an option.  Paradigms always take time to shift (germ theory was developed by 1700, yet didn’t take hold until the time of Joseph Lister in 1865) but when they do, entire industries shift with them.  In the not-too-distant future, it will be as hard to imagine that agencies sold “time” as it is to imagine the pre-germ-theory world of medicine where surgeons didn’t bother to wash their hands.

The fact is that billing by the hour is built on the wrong theory, and faulty theories are always exposed, refuted, and ultimately overturned. The labor theory of value, postulated by thinkers such as Karl Marx, states that value is created by and correlates directly with labor; the more work that goes into something the greater the value.  While this might have been true for the assembly line workers of the industrial age, it certainly is not true for today’s knowledge workers who live in a society where more than 70% of all wealth is created not by labor, but by intellectual capital.

Most agency executives still haven’t come to terms with the fact that their compensation agreements with clients are built on the wrong theory of value.  But the more they observe the fact that time expended bears no relationship to value created, the more they will begin to change their compensation practices.

It’s important to understand that there are many different forms of value-based compensation.   Today I read a piece by Rance Crain in Advertising Age, “Why Agencies — and the Media — Are Reluctant to Bet It All on Value-Compensation Systems,” which perpetuates the mistaken notion that value-based compensation equals outcome-based or performance-based compensation.  That’s just one way to think about it.

The foundation of a value-based approach is to accept the premise that advertising agencies don’t sell hours, they sell the “utility” that the hours produce. Economists going back to Adam Smith have taught that nobody buys a product or service; they buy the utility the product or service creates. This is as true for agencies as for anyone else.

There are innumerable ways for agencies to be compensated in ways that have nothing to do with hours or time. A fee doesn’t have to be tied to a complex set of metrics to be “value-based” — it just has to be based on something other than time sheets. Some digital firms, instead of charging for the time they invest in developing branded widgets, simply charge per download. We’ve seen direct marketing firms get paid per qualified lead. One Major League Baseball team pays its agency 50 cents for every non-season ticket sold. We know of an agency who was a finalist in a luxury car brand review whose compensation proposal took hours completely out of the equation and instead proposed to earn $50 for every car sold.

Of course, next comes the complaint from agencies that they don’t have complete control over any of these things and would therefore never agree to tie their compensation to them. But they’re looking through the wrong end of the telescope. If agencies want more control, this is precisely how to get it. As Dave Beals of the agency search consultancy Jones Lundin Beals points out in the above-referenced Advertising Age article, it fundamentally changes the dynamics of the agency-client relationship when the agency has some skin in the game. Because the economic incentives of the client and agency are aligned, there is a much higher degree of trust and mutual respect than in the standard pay-by-the-hour-regardless-of-results mentality.

Value-based compensation can also mean that the client pays the agency to use its IP. This isn’t a far-fetched idea; it’s being done by some progressive agencies every day. Firms like Sarkissian Mason have IP ownership at the center of their approach to compensation.

Finally, value-based compensation can also mean just quoting a simple, fixed price that is based on the value to the client rather than the costs of the agency. This is how pricing works in virtually every other industry, and it will become the standard in professional services as well. There’s a pricing revolution underway, and it’s up to the agencies (the sellers), not the clients (the buyers) to make it happen.

Under the flawed hourly-rate system good and bad ideas cost exactly the same.  Here’s how to change that.

Some of the biggest stars take the biggest risks when it comes to compensation by taking a percent of the box office.  A good film makes more than a bad film, and the leading actors get paid accordingly.

In the world of professional photography, a good photograph earns more than a bad photograph.  Because the photographer owns the rights, the more the photo gets used, the more the photographer earns.  The iconic Maxell photo showing a man in a chair “blown away” by the sound of Maxell tape is still earning royalties more than 25 years later.

Despite the fact that most of the professionals that advertising agencies draw upon to complete their work — photographers, actors, musicians, etc. — earn more for good work than bad work, most advertising agencies themselves are stuck in a compensation paradigm that doesn’t correlate to value.

It’s time for marketing communications firms to realize that they’re in the intellectual property business instead of the hourly rate business.  Here’s how agency principal Mike Reineck describes how his firm, Atlanta-based Kilgannon, captures the value they create:

“For the first 70 years of the twentieth century, agencies were paid based on how much media they bought for clients. This imploded after the growth of television drove the cost of media (and consequently the amount they paid agencies) through the roof. So for the next 30 years, agencies got paid based on how many hours of service they gave their clients. This imploded after client-side consultants and procurement folks practically drove agencies out of business by process-engineering the costs down to nothing.

Problem with all this is that it has nothing to do with the core offering of an agency. What is that – Media? Not anymore. Services? Not really. Most clients hire agencies because they want help persuading prospective customers to buy more of their stuff. That generally requires a bright idea that gets effectively communicated to those prospective customers. So, do clients pay agencies based on how bright the idea is? Or how effectively it reaches the customer? Or if it helps sell more stuff? Nope.

A media transaction is a market-determined price, so it’s easy to value. An hour of time is easily measured by a clock. But, how is the brightness of an idea measured, or the effectiveness of communication? These are really fuzzy, non-touchable things to measure. In the land of lawyers they’re called “intellectual property,” and payments for them are generally determined through royalties and licenses.

Underlying the license and royalty are the basic concepts of “Use” and “Value.” If intellectual property has value, it probably is going to be used a bunch. For example, Microsoft Office creates a lot of value to a personal computer. I am using it now to write and post this blog. Our enterprise decided to use it a bunch by loading a version on every computer in the agency.  Even though the disc it came on only cost a few cents, we paid a couple hundred bucks for each license on each computer. The program had value; we used it a bunch. We paid Microsoft accordingly. Our procurement people don’t pay Microsoft based on how many hours their programmers spent developing it, or on how many bytes of media the program occupied on the disc. A similar use and value license is employed in the music, publishing, or art world. Back here in advertising, though, we are a little slow on the uptake.

Despite the difficulty of measurement, agencies and clients need to move to a compensation model tied to “value and use.” It more closely links to what we do and what clients want from us. Most every idea gets embodied into some kind of material (an ad, a banner, content, SWAG, etc.). Most of these materials get used (TV, radio, internet, events). Generally speaking, the better the idea the more it gets used.

The payment system should deliver money to the agency based on the idea’s use and the value it creates, even if the client is still using the material and the Agency is not providing services. Why? Because the idea is still producing value to that client and they are using it. In a Darwinian Adam Smith-type system, this would ultimately lead to good ideas and the agencies that produce them flourishing, while bad ideas and their agencies go the way of the Edsel. Isn’t that the most efficient market mechanism?

At our agency, we have spent a long decade trying to transform our compensation systems to ones based on use and value. In the long run, it’s the only win-win for us and our clients. It involves us identifying ideas, tracking their use, and putting skin in the game based on whether they produce value or not for our clients. Last year 25 percent of our revenue came from intellectual property payments.”

(From the blog Kilgannnon Says.)

So next time you hear that an IP-based approach can’t be done, consider the fact that it already has been done.  It works because it aligns the economic incentives of the agency and the client, the hallmark of effective agency-client relationships.

Value-based compensation can take many forms, from simple to sophisticated.

Are you ready to get some experience with value-based compensation?  The first step, of course, is to be clear about what you’re really selling: the value you create, not the hours you work.  A value-based approach to pricing can take an almost endless variety of forms, but to get started here are three basic forms to consider.

1. Straight Fee

The simplest form of a value price is simply a straight fixed price based on the mutually-agreed value of an assignment.  This is different from a traditional estimate of hours multiplied by the hourly rate, because the value associated with the price isn’t correlated directly with time.

One of the best examples of a professional firm using a straight fixed price associated with value is the public affairs firm that brings tremendous value to an assignment by virtue of its contacts and relationships in government.  Sometimes a single phone call can create the desired value for the client.  It’s really irrelevant that the firm only invested a few hours in the assignment.  What’s relevant – and valuable – is that the client’s objective was accomplished.

2. Usage Fee

More and more, the best solution to a marketing problem is not a conventional advertising campaign, but rather some other form of branded content.  Yet structurally agencies still operate as producers and distributors of “ads,” even going so far as to stipulate that their work is “work for hire” that is wholly-owned by the client.

Compare this to the creative service partners agencies work with: actors, voice talent, models, musicians, and photographers.  A photograph is owned by the photographer and licensed to the firm or client.  The more a photograph gets used, the higher the price to the marketer.  The less it gets used, the lower the price.  This correlates directly to the value of the image to the client.

For example, a photographer typically charges a flat fee to take a photograph, but this never comes close to the income the photographer needs to make the assignment profitable.  The photographer’s “session fee” is subsidized by the licensing fees for the use of the image.  A similar approach could be used by agencies where the development of branded content is priced significantly lower than in the traditional “work for hire” model; the firm then makes its real money on the usage.

With the usage fee, the more effective the branded content, the more it gets used, the more the agency earns.  This approach actually solves the problem many marketers have with hourly-rate system where a bad idea costs the same as a bad idea. Not so when you charge like photographers do.  (See American Society of Media Photographers for a look at how the usage concept works.)

3. Results Fee

Unlike the “straight fee” which is a fixed price, a “results fee” is a variable price.  In the results fee approach, the firm ties its compensation directly to specific indicators.  Progressive consulting firms pursue this approach.  Over 30% of Accenture’s contracts include some type of performance measures.

When identifying KPI’s — Key Predictive Indicators — keep in mind that the health of a company is not measured exclusively by one metric any more than the health of the human body is measured exclusively by heart rate.  Choosing the right metrics is critical, of course (the subject of a much longer discussion), but keep in mind they can all be weighted based on the agency’s ability to influence them.

For example, agencies are famous for arguing that they don’t have enough control over sales to tie their compensation to it.  Fair enough.  Make sales just one metric of several, and assign it a low weighting.  Assign a higher weighting to things where you have more direct control and influence, which might include such measurements as brand awareness, brand likability, website page views, etc.

Beyond these three basic approaches, marketing firms can exercise remarkable creativity in developing compensation approaches based on value created vs. hours worked.  All it takes is your willingness to start experimenting with a better way to get paid.

The most important things to consider before establishing a compensation agreement.

The key to improving your firm’s profits is to improve its pricing.  Nothing can improve your bottom line more than improving the price you get for your services.

Says the author of Priceless, a new book that explores the power of pricing,

“Because profit margins are small to begin with, adding a percent or two can boost profits immensely.  Very few interventions can have such an effect on the bottom line.”

Remember that estimating your costs is not pricing; it’s counting.  More importantly, clients don’t buy your costs — they buy the outcomes you help produce for the brand.  So as you begin thinking about how you’d like to be paid for an assignment, ask yourself these 10 questions:

Questions to ask yourself

1. Who is the economic buyer at this client and will we have access to him or her?
2. How profitable is this company?
3. What level of marketing sophistication does this client have?
4. To what degree do they have professional buyers (procurement)?
5. At what price would this engagement be so expensive a client would not consider buying it?
6. At what price would the engagement be expensive, but the client would still buy it?
7. At what price does the engagement become inexpensive?
8. At what price does the engagement become so inexpensive the client would question its value?
9. What would justify a premium price?
10. What costs can we afford to invest at the target price and still earn an acceptable profit?

As the buyer, it’s your client’s “job” to try to get the best price for your services.  This means they’ll immediately press you to talk about costs.  It’s your job to push back and steer the conversation to value.  Here are some questions that can help:

Questions to ask your prospect

1. How does your brand/company make money?
2. What is the profit model for your brand/company?
3. Based on your profit model, which of our offerings do you most value?
4. What specific results do you hope our services will help you achieve?
5. What have you identified as the drivers of success for your brand?
6. How do you measure success today with your agency?
7. Ideally, how would you like to measure success?
8. If price were not an issue, what role would you want us to play in your business?
9. What are the service standards you would like for us to provide you?
10. What resources can we expect your organization to devote?

Studies show that just a 1% improvement in the way you price your services can result in at least a 10% improvement in profit.  That should be a pretty good reason for your firm to take pricing more seriously.

*sky 3 courtesy Fontplaydotcom Flickr

Now more than ever, marketing communications firms need to analyze their revenue streams and find more ways to extract value from the services they provide.  “Business as usual” isn’t an option in today’s economy.

Agencies need to apply creativity to solving their revenue problems, just as they do to solving their clients’ marketing problems.  Here are twelve good questions to help you capture more value:

1. What opportunities could we pursue to develop or package our intellectual property for sale or license?

Instead making all our money in a “work for hire” model, do we have a knowledge base or proprietary information we could turn into a source of revenue?  What would it take to develop and package it for sale?

2. Could we experiment with charging minimal fees for concept and production and then charging for usage?

This is the business model of most of our creative services suppliers: photographers, musicians, talent, etc.  If it works for them, why couldn’t it work for us?

3. What missed opportunities have we had to apply some creativity to pricing (rather than just estimating our costs)?

This is the first and most essential question we should be asking.  How can we get our people to understand that we’re not selling our costs, but rather our value?

4. Do we have any current clients with whom we could structure a simple compensation agreement in which we are paid for leads, inquiries, clicks, downloads, etc.?

Which of our clients might be willing to pay us for the results we produce rather than the hours we work?

5. Which of our clients would be willing to pay us more money if we take more risk?

Do we have a client who is sophisticated enough to want to “grow the pie” rather than focusing on how big of a slice they give us?  Are we willing to accept a different form of risk (knowing that every client relationship carries some risk, not the least of which is the risk of not making money!)

6. Could we propose a “value audit” for current or prospective clients to help identify drivers of success upon which we could base a compensation agreement?

Rather than jumping straight to “scope of work,” could we get some experience with the concept of “scope of value” Could we use this approach to help differentiate ourselves in a new business situation?

7. How can we help our clients identify their real brand success drivers and measure what matters (not just sales and market share)?

Could we employ account planning or analytics to help our clients identify and test their real success drivers, then build our compensation around our ability to move these drivers in the marketplace?

8. Would we make more money if we raised our prices on “high value” services and lowered our prices on “low value” services?

Could we make most of our profit on the services that are most highly valued by clients?

9. Could we add value to a particular service and charge more than other agencies?

How could we take a “standard” service and differentiate it in a way that adds more perceived value?

10. Could we find a more efficient way to deliver a particular service and charge less than other agencies?

Could we use technology or streamlined work processes in a way that would allow us to deliver a production/distribution service at a much lower cost than other firms?

11. Which 20% of our clients produce 80% of our profit?  How can we cultivate more work from them?

Knowing that a handful of clients produce most or all of our profit, how could we provide (and capture) even more value from these clients?

12. Who are our low-value, unprofitable clients?

Unprofitable clients really offer us only two options: develop new compensation agreements with them, or resign them.  What are we waiting for?

If clients employ professional buyers (procurement agents), shouldn’t agencies employ professional sellers? And shouldn’t it be the job of professional sellers to know not only how to deal with pricing objections, but how to structure a deal that will solve both parties issues?

Why do procurement departments exist?

a. To get the best possible price.

b. To get the best possible value.

What procurement is really trying to achieve

It’s easy to assume that procurement professionals are interested only in saving money by getting your services as cheaply as possible. But procurement exists as a function to secure value for the company. Consequently, procurement departments drag agencies through a series of detailed, invasive questions about their process, cost structures, competencies, experience, financial strength, etc. all with one central goal in mind: to make sure the agency is capable of delivering what it says it can deliver.

In the faulty world of time-based compensation, the client organization really has no other way to evaluate or assure performance. As long as agencies continue to price their services based on costs (hours) instead of value, procurement professionals will always be looking for compliance to their process as a means of evaluating whether an agency really, truly is capable of delivering what it promises.

Compliance to process vs. alignment of incentives

In the end, procurement has a detailed process for selecting agencies because of the total lack of alignment of economic incentives between clients and agencies. In fact, in the current cost-based system, there is a real misalignment of incentives. The agency actually has an incentive to spend more time, not less.

Next time you’re working with a procurement department, ask “What if we proposed a form of compensation in which the economic incentives of both parties were in near-perfect alignment?” We recently asked such a question of a respected procurement professional of a major company. His response? “Then there would be no need for compliance to our detailed process.” We then asked, “So why not just bypass the process and go directly to what it’s supposed to accomplish; alignment of incentives?” He was compelled to agree that this is actually the ultimate job of procurement.

Dead or alive

Consider this example. When Great Britain sent prisoner ships to Australia, they initially paid the shipping companies based on how many prisoners boarded for the journey. The problem was many of the prisoners died making the trip.

They could have proposed a process and documented compliance ––such as with the ludicrously expensive Sarbanes-Oxley law –– insuring that adequate food, medical supplies, etc., were on board.

An economist would laugh at this. Rather, a good economist would suggest they pay the shipping company for how many prisoners they deliver to Australia alive. Once the incentives are aligned, who care about process and compliance?

Try this next time

If you want to disarm procurement, you must first walk away from the notion that you’re selling time. Then give procurement the assurance they need right up front by proposing compensation based on your ability to create the value they seek in the first place.

By Ron Baker

The history of commerce teaches us that almost every single innovative pricing change has been done by sellers, not buyers. This is because most pricing strategies are often changes in business models — that is, how companies monetize the value they create.

Yet, across the professional knowledge sector we hear endlessly how firms and their clients are going to have to jointly get rid of the billable hour. This is nonsense.

Intellectual capital isn’t sold by the hour

Professional firms will have to eliminate the billable hour by changing their business model, from one of “we sell time,” to “we sell intellectual capital.” Companies that sell intellectual capital don’t price by the hour.

Netflix founder and CEO Reed Hastings tells this story about the inspiration behind a change in a pricing paradigm:

“I had a big late fee for Apollo 13. It was six weeks late, and I owed the video store $40. I had misplaced the movie. I started thinking, ‘How come movie rentals don’t work like a health club, where whether you use it a lot or a little you get the same charge?’”

Hence, a new business model, and pricing strategy, was born with Netflix. Customers didn’t demand it, suggest it, or even agree with it in advance. They had nothing to do with it, except to vote with their dollars their approval.

A form of value pricing called “yield management” – a pricing innovation developed approximately 20 years ago – is gradually being adopted by banks, hotels, apartment managers, retailers, live entertainment (such as sports teams, symphony orchestras, ballets, etc.), car rental companies. And yes, even some progressive advertising agencies have adopted value pricing and ditched their timesheets.

Your clients don’t control your pricing strategies

You are in control of your pricing strategies, not your clients. Clients don’t have anything to do with it, except to validate it by voting with their checkbooks. Clients don’t run your business, nor do they spend their waking hours dreaming about how you should monetize the value you create. It’s amazing to hear professionals repeat how the client has to be involved in developing an alternative to the billable hour. The truth is that most clients dislike the billable hour, but they aren’t going to have an alternative until more firms step up and proactively offer a different pricing paradigm.

Knowing exactly what your clients are paying you for is the essential first step. Does anyone really think marketers pay agencies for time?

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Ron Baker is Chief Value Officer of Ignition, a consultancy devoted to helping marketing organizations create and capture more value. He welcomes your comments at rbaker@ignitiongroup.com

By Tim Williams

Survey the thousands of advertising agency websites and you’ll find that most of them contain the word “partnership.”  As if it were a unique point of difference of some kind, agencies almost universally use “partnership” as a selling point, with language like:

“We are true partners with our clients.”

“We enter into every relationship as marketing partners with our clients.”

“Partnership is the very essence of the way we do business.”

Partner or highly-paid vendor?

TBWA/Chiat/Day’s Lee Clow once remarked agencies need to accept the fact that they aren’t really partners with their clients, but rather highly-skilled, highly-talented, and highly-paid vendors.  Most agencies bristle at this kind of language because “vendor” connotes a master-servant relationship when what they desire is a peer-to-peer relationship with their clients – one in which the agency is seen as a trusted advisor. Is Clow right?

In a recent national survey conducted by Ignition on behalf of the Association of National Advertisers and American Association of Advertising Agencies, we learned that most agency professionals actually feel that “partnership” is missing in their client relationships.  We heard comments like:

“Clients need to consider the agency as part of the team, not as a vendor who can be replaced by tomorrow morning.”

“Clients should stop holding power and treating agencies like ad factories.”

“Agencies should be treated as a respected business partner versus the low-cost vendor.”

The essence of true partnership

Why the frustration among agencies?  Because clients feel that most agency-client relationships don’t really qualify as true partnerships.  That’s 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.

As long as agencies are compensated as vendors they will likely be regarded as vendors.  The truth is, many agencies are in fact paid like regulated utilities, with clients telling them exactly how much they can earn and what their maximum profit margin can be.  That’s far from the spirit of a “marketing partnership.”

In partnerships, there must be both an upside and a downside to both parties; in other words, skin in the game.  If you’re a partner in a business, there is always both risk and reward.

Agency self-confidence and self-worth

If agencies are serious about becoming partners with their clients, they must stop being so risk-adverse and start having more confidence in the quality and power of their work.  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.

More importantly, having “skin in the game” can profoundly change the dynamics of agency-client relationships, leading to increased trust and mutual respect.  That’s because you have aligned the economic interests of both parties.  In other words, you have a partnership.

By Tim Williams

Agency professionals are rightly concerned about whether they have the right set of business practices to guide them through today’s cross-functional multi-channel marketing environment. This becomes an even more burning issue when applied to the question of how agencies get paid for what they do.

Estimating mistakes

Now more than ever, agencies are struggling to keep their margins. Many agency managers believe that a big part of the problem is their agency’s tendency to chronically exceed estimated time on client relationships and assignments. So many agency organizations are feverishly trying to improve their estimating system while at the same time pressing their accounting departments for increasingly detailed analyses of how agency time is spent. They are on a quest to improve their time-based billing practices.

The problem isn’t just the practices; it’s the paradigm.

Paradigms drive practices

In the middle ages, the paradigm guiding medical practices was bloodletting – the belief that diseases were carried in the blood, and that you could rid the body of sickness by simply draining out the blood.

If that’s your paradigm, then your practices would be around becoming better at bloodletting. You would read books about how to improve your cutting techniques, constantly seek to improve your understanding of how much blood is enough, and send your people to seminars to learn about the latest in bloodletting techniques. You would be improving the practice of bloodletting, but it would all be based on the wrong paradigm.

Similarly, what agencies need to improve their profitability isn’t a better time keeping system, a better accounting package, or a better approach to estimating and billing their time. What’s needed is a new paradigm.

External value vs. internal costs

The correct paradigm for a professional knowledge firm like an agency is that you’re selling business results, not time. Clients don’t buy your efforts; they buy the outcomes the efforts produce. Your internal costs have nothing to do with the external value you create for your clients.

Based on this paradigm, agencies can apply the same creativity to compensation as they apply to their clients’ business. They can begin to develop practices that result in proactive pricing based on value rather than reactive estimating based on costs.

The old cost-based paradigm assumes agency professionals are hourly-wage laborers from the Industrial Age. The value-based paradigm considers agency professionals to be knowledge workers from the Information Age, capable of creating incredible wealth and value for their clients – irrespective of hours worked.

It’s no coincidence that the agencies that are making the biggest mark on our business are the ones that have changed their paradigm about how they get paid. Their compensation practices are different because their paradigm is different. It’s also no coincidence that they tend to be much more profitable that the average agency – sometimes by a factor of two or three.

Finally, consider this: you don’t have to wait for the entire industry to change its paradigm about agency compensation. You only have to change yours.

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For a more detailed overview of value-based compensation, download a recent article by Tim Williams and Ron Baker in the October 2007 issue of The Advertiser, published by the Association of National Advertisers.