The source of an advertising agency’s income:
A manufacturer who operates out of a small and unpretentious office is often impressed (sometimes unfavorably!) by the obviously furnishings in the offices of some advertising agencies. Paying for part of the agency’s overhead, rent, payroll, etc. is naturally going to use up some of the money he spends for advertising. Should he spend his money through an agency, or should he spend that money direct and thus save the cost of the agency’s services?
Questions like these are good questions, but the answer to them is often not as clear or simple as it seems. In order to answer them, attention must be focused not on the total costs of advertising agency service but on the additional costs, if any which the use of an advertising agency will involve as against the expenditure of the same number of advertising dollars on a direct basis without agency participation in the expenditure. The difference is a vital one, because of the nature of historically established advertising agency compensation methods.
An advertising agency traditionally derives its basic income from “agency commissions”. Those commissions, for the most part, are paid to the advertising agency by various advertising media (e.g., newspapers, magazines, radio or televisions stations or networks, etc). Agency commissions is usually established at or near the level of 15 per cent of the “card” or “list” price of the space, time or other facility purchased.
To be sure you understand how the commission is derived, let’s use a specific example is previously mentioned, a full-page four-colour advertisement in LIFE cost $39,500. if you as an advertiser brought a one-page four-colour single insertion in LIFE direct from the publisher you would be billed the full published rate of $39,000. However, if you had the ad prepared for you by an advertising agency which placed the ad with the publisher of LIFE, the agency would be billed for the rate of $39,000 less 15% agency commission. That commission of $5,925 would represent the agency’s gross income on the creation and placement of that single ad. From your viewpoint as an advertiser, the effect of this compensation method is clear. It would cost you no more dollars out of your total advertising budget (or appropriation, as it is called), for advertising space if you used an advertising agency that would if you did not.
You may well ask: Why should advertising media pay my advertising agency for services performed by the agency for me, the advertiser? The answer is buried in the historical development of the advertising agency, and would require more space here than its relevance to the subject of this report warrants. What you should remember is that, illogical or not, that is the basis of most advertising agency compensation generally.
For a more complete picture of the compensation question, we might note a few exceptions, which introduce added costs to the use of an agency. Some advertising media (the large direct-mail house, for example), do not grant advertising-agency commission. If your places some of your advertising through non-commissionable media, the invoice which you receive from your agency for such advertising is likely to consist of two items, each identified. The first is the base cost which represent the sum, which the agency paid out of its corporate pocket to the media. The second is an additional figure, representing agency commission. In that way the agency receives the same relative gross income from the advertising it places, as it would have received if the media granted commissions to agencies. It is customary also to add agency commission to various other non-commissionable expenditures made by the agency for its advertiser-client, such as the cost of the engravings used in advertisements (purchased by the agency from a photo-engraving house), and the cost of the finished artwork from which those engravings were made.
Some advertisers tend to resist and resent the practice of agencies’ adding an agency commission to non-commissionable items. For example, the agency may buy artwork, engravings or typographic composition, or prepare a portfolio for the use of your salesman. Any activity of that type costs the agency money, in terms of the time and overhead associated with the activities of skilled and experienced people in performing such specialized tasks. Agencies pass along the costs involved by adding an agency commission to the cost incurred, or by charging a special fee for the service. You should be alert to the possibility that the fee or commission may be out of the line with the agency’s costs. You should not, however, expect the agency to provide such service – on which there is no commission from a media, nor any other income for the agency to use to offset its costs – without charge. Such charges are an established trade practice.
Not the vital importance of paying agency commission on all non-commissionable media. If such expenditures were not commissionable, the agency would often be in the position of having to choose between two or more media, with significant difference in the agency’s own income as one influence on the decision. Since all media expenditure carry the same commission, whether it is the policy of the media to pay an agency commission or not, the agency’s decision is influenced only by its judgment as to what contributes the soundest media approach to achieving the planned objectives sought by its client.
Agency commission represents gross income, within which a profit-provision must be made:
It is important to remember that the agency commission, whether paid to the agency by a media or whether added to the client’s invoice and paid by the client in the case of non-commissionable media or non-media advertising expenses, constitutes the gross income and not the net income of the advertising agency. Out of that gross income, all of the expenses of operating an agency is typically its payroll account. In addition to salaries, which often represent as much as half of total agency expenses, such other items as rent, heat, light, telephone and telegraph, postage, and travel and entertainment costs must be paid. There is, in addition, a further “cost” which should be recognized.
An advertising agency, like a manufacturing organization, is in business to make a profit. An agency can realize a profit only if the total of all its gross income. The management of an advertisement agency typically plans for achievement of a planned-for profit margin by the process of reserving a portion of anticipated income from a given client (on account) for profit, and budgeting the remainder over various expense items involved in serving the account. This tendency, to take a “slice off the top” of total income from an account as profit, differs from the profit-planning approach of some manufacturing organization. It is rather general in advertising-agency management.
The amount and quality of advertising service which you as an advertiser can expect from an agency depends directly on the size of your total expenditure ;-
Now to arrive at accurate perspective on what you as an advertiser can expect, in the way of service, from an advertising agency you hire, let’s mentally transpose ourselves to the agency’s side of the desk. Assume that you are the president of an advertisement agency, considering an account-present or perspective – in terms of how important that account is to you or would be if you had it, and of how much service you could afford to give the account if it wore “in the shop”. What criteria do you use? A very simple one – a rough estimate of the potential gross and net profit the account would provide.
Suppose that the account in question has a total appropriation, you estimate, of $100,000. That represents gross income of $15,000. What would it represent to you in real profit – that is, in net income? Assume that your agency does its profit – that is, in net income? Assume that your agency does its profit – planning in the expectation that it will retain as profit after taxes, 2 per cent of its expenditure. In order to have 2 per cent after taxes, however, you need about 4 per cent before taxes. Note that is 4 per cent out of the total of 15 per cent you receive as commission in other words a little more than on –quarter of the total amount you receive as commissions you plan (or hope!) to retain as before-tax profits in order to have about one-eighths of that income as your after-tax profits. (There are two wide variations in the earnings ratios of different types of advertising agencies and of different sizes of advertising agencies. The 4 per cent before taxes – per cent after taxes figures used are reasonable figures for any agency in the moderate size range – that is, with total billings in an area from 5 million to 9 million, and with gross income at about 15 per cent of total billings.).
The purpose of this relatively long example is to make an extremely vital point. You as an advertiser approach an agency, and discuss with the principals of that agency the possibility that they may be appointed to handle your account, which you estimate will total $100,000 a year. If you appoint them, you will be creating for yourself, in effect, a “service bank account” in the amount of $11,000 a year. (The $11,000 represents gross income of $15,000 reduced by profit provision of a $4,000 before-tax sum.)
You are entitled to know just how much in the way of what kind of service you will receive for that $11,000. the agency will (or should) tell you. You should be on guard against being “over sold” – against being promised $20,000 or $30,000 in service. You know from the above figures that the only way an agency can deliver that much service on an account your size, is for the agency to lose a substantial sum of money in serving you.
As a minor exception to the above comment, we might note that some agencies – perhaps most agencies – realize little or not profit in the first year or two that they handle an account. There are substantial non-recurring costs involved in acquainting the agency team with the particular problems of the advertiser and his industry. Particularly on an account, which is estimated to have substantial growth potential, a deliberate policy of “investment spending” (i.e., spending in service and in direct costs a sum in excess of commission income) is not unusual. But mark this well: it is a very different thing for an agency to have a planned policy of investing in new accounts in the first year or two of serving them, and for an agency to promise continually to provide more service than the commissions and/or fees involved can pay for.
While commission income represents the major source of agency compensation, there is an additional method of working out the agency’s income from an account, which warrants mention. In some cases, the cost of preparing a client’s advertising would be far in excess of the commission income involved. Such a pattern is not usual in the case of advertisers with multiple product-lines, using a variety of different specialized business publications. Such publications reach selective audiences. The circulation of each is far smaller than the multimillion copy circulation of some consumer publications. The cost of a page of space (and, therefore, the commission on a page of space) is correspondingly small. On that type of operation, it is not unusual for the advertiser and the agency to agree upon a service for handling the account. Often commissions earned on advertising placed by the agency are credited against and hence reduce the net fee the advertiser must pay. The point to note here is that the advertising agency, like the advertiser, is in business to make profit and is entitled to do so when soundly managed. If the amount of expense involved in handling a particular advertiser’s account (including time salaried personnel, overhead items, etc.) is in excess of the commissions which would be generated by the amount of advertising in question, the agency is enlisted to and will typically insist upon a fee in addition to commission sufficient to reimburse it for its costs and leave a profit for the agency’s management.
Against the background of these general comments about the nature of the advertising agency, it would be logical now to move into a consideration of specific agency types and of factors involved in the selection of an agency. Before you as an advertiser can discuss intelligently with an advertising agency whether you are or are not interested in their services or whether they are or should be interested in handling your account, it is necessary for you to have in mind at least an approximate dollar figure which represents a preliminary estimate of the size of your advertising account.