Your Costs Are None of Your Client’s Business

Transparency Not for PricingCan 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, bu
t 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 ha
e 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.

A strange aberration: pricing professional services

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?

The very definition of no-win

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.


Tim Williams leads Ignition Consulting Group, a U.S.-based consultancy that advises advertising agencies and other professional services firms in the areas of business strategy and pricing practices.  He is the author several books, including “Positioning for Professionals: How Professional Knowledge Firms Can Differentiate Their Way to Success.

Twitter: @TimWilliamsICG


  1. Peter Dunkelberger says:

    Now I see from where VeraSage is really coming. It is pricing by whatever the traffic will bear. Which is ok, but one runs into savvy clients occasionally, who are as smart as we CPAs and don’t want to overpay for their product.

    I thought for awhile that perhaps VeraSage, truth and wisdom, had something going for it. But I see it is business not as I would not wish to conduct it: pricing based on what I think the client will pay. VeraSage is not on to anything new, it is the 1800s robber barons all over again.

  2. I support the VeraSage quest and premise that we need to move away from hourly billing. However, Mr. Williams, you have chosen to defend your position using a BMW 7 series as a comparative “product” to professional services. This has the flaw of comparing a consumer product to that of a business to business product to support your position. I agree that it would be very rear for a consumer to question the cost of a hard good, though they are most certainly calculating the value (price vs. cost) on some level. However, in a business to business setting there is a much greater chance (70+% of the time in my experience) that the customer is going to question your cost basis, if not calculate (100% of the time) his interpretation of your cost basis. This is particularly true in the manufacturing sector were I was a buyer and a seller.

    In the end all that truly matters is did the customer receive value for the price paid and did the vendor receive fair value for the product provided – that is the measuring stick for ALL commerce transactions. Any imbalance in this equation will doom the relationship…..

  3. Peter, pricing based on “what the traffic will bear” is the very nature of pricing as practiced by pricing professionals in virtually every industry. If you ate dinner at a restaurant lately, I can guarantee this is how your entree was priced. The same is true for hotel rooms, airline seats, and movie tickets. Pricing products and services based on subjective and contextual factors isn’t unethical — it’s capitalism.

    • Peter Dunkelberger says:

      Yes and no, Tim. You have some good examples at the ends of the spectrum, but for the guy or firm doing the meat and potatoes work, cost is very important, and, while the clients might not know the cost, they are watching the clock and know how long it takes to get something done, and they price (and time) shop. And yes, if you smile and can hold the client’s hand in a good way, you might be able to charge a little more for the commodity work that we do.
      But “what the traffic will bear” can be the result of taking advantage of client ignorance and fear. The internet has eliminated a lot of that, especially for goods and somewhat for services. As information sources grow, fewer and fewer firms will be able to take advantage of the knowledge disparity.

      And capitalism has many forms of application. Like democracy, it is quite different in the Democratic Peoples Republic of Korea, Russia and the US.

    • Cesar Dulong says:

      Great explanation. That is the reason because customer payed so much to flight in a Concorde from Paris to New York , speed to reach his destination no how many hours the flight took.
      I think that much of the problem is seller is not capable to built value in $$ term and cost of delay for customer, then purchasing areas can delay decision and look apples vs. orange comparison as the same product.

  4. Alan, thanks for your comment and support of the Verasage mission. I would argue that because the customers of professional service firms aren’t buying “ingredients” or inputs, but rather solutions and outputs, the actual costs are even less relevant. What does it matter that a public affairs professional is able to make a 5-minute phone call to his friend in the mayor’s office and achieve an important result for his client? The client seeks — and is paying for — a result. If this same client had hired a much less experienced, less connected public affairs professional, should he pay more because it will take longer to achieve the same result?

  5. Wow, I have never heard of that. That’s crazy. I would not feel it was the business of anyone what my costs were. They either take the deal I offer or not.

  6. Great post and excellent comparison! When I ponder this phenomenon I can’t help but consider what we do as knowledge professionals that contributes to this social more. For example, when we place emphasis on the time something takes us to complete, or markup discussions, or hourly rates – in a way we invite a discussion about these topics. Customers wouldn’t feel comfortable asking if they weren’t used to including that as part of the discussion!
    The major difference with the BMW example- the auto industry has not trained us as consumers to think about the effort it took to produce. Consider this: when was the last time you went car shopping and the salesman talked only about efforts to produce the vehicle? Of course they didn’t talk about that! What do they focus on? Value! Performance, benefits, results!
    Before we can expect the public to treat us differently, we must DO something different to “re-train” them. Since I’ve implemented value pricing in my first over the last decade, there really are no discussions or arguments about price. Once the client is clear on the results I will deliver – it becomes a simple choice: do you want to car or not?
    I’ve noticed many knowledge professionals trying to make the change to VP while still talking about their inputs as a way to justify their cost. When the client asks about billable hours, they are surprised and assume the method doesn’t work.
    Change begins with us. We have to speak differently about what we do if we want the public to see what we do as being different.

  7. First, let me express my appreciation for your well-articulated view on how to value professional services (and acknowledge that I’m looking at a subset of that category specific to the advertising and marketing industry being agency compensation). And, to remind readers of what I’m sure you already know, there are always two sides to any story.

    Let me start with you’re example of the shiny new BMW 7 Series, likely what all professional service providers strive to be. I agree, I’m not aware of anyone who has even attempted to figure out what a Beamer actually costs to manufacture, much less been successful at it. We don’t know how many hours the skilled professionals spend on the assembly line, spent designing the robots that help with construction, and so on. And, as you state, the quality of the product, the reputation of the brand, all affect our purchase decision. So far, we are on the same page.

    With that said, I don’t suspect anyone has walked into a BMW dealership and plopped down the sticker price of $141,000 for his or her new BMW750i sedan. If there is such a person, then likely he or she is so wealthy that money doesn’t really matter. But for the rest of us, we’re actually a lot more careful. We do benchmark the car in various ways. We likely benchmark the car (using Consumer Reports, Car & Driver, etc.) to see how the car stacks against competitors in quality, reliability and re-sale value. Much the same way clients benchmark the quality and reliability of their advertising agency. Further, we are most assuredly going to benchmark the cost (using Kelly Blue Book, Car Fax, etc.) to see what other buyers have paid for the very same car. We don’t want to end up paying the $141,000 sticker price if most others paid, let’s say, only $126,000 for the very same car. When buying a car, just like when hiring an agency, it is important to benchmark costs.

    Let me focus in on advertising and marketing agency compensation, the real topic here. Smart clients will send out an RFP when searching for a new agency. They will measure not only the quality, fit and reputation of the agency; they will also measure the costs in order to build a cost/value relationship. (I may pine the BMW750i but can only afford a Honda Civic.)

    When comparing and contrasting agencies, clients need to understand what they are getting and what they will be paying for it. Not only is it required to be fiscally responsible; it’s also a must for budget purposes. Many times proposed agency staffing plans (what you are buying) include things like: “Art Director-TBD” or “Art Director-TBH” (meaning the art director is “to be determined” or “to be hired”). That means the agency hasn’t even decide whom the art director is, much less the value of him or her. Will he or she have 3 years experience, or 8? Will it be the same art director you liked from last year, or someone new?

    While measuring time (hours) and effort (skill levels) in determining fair agency compensation is admittedly not perfect, it is the best measurement tool we have and certainly beats the alternative of simply having the car salesman decide unilaterally what fair compensation is.

    Further, if agencies are to sell only outputs, then is the client able to say they are not completely satisfied with the output and not pay for it? Kind of like, if you’re not completely satisfied with the Beamer, the buyer has the option of taking a pass and going to another car manufacturer. With that said, out-put (deliverables) pricing is certainly an acceptable compensation methodology and is used by many leading advertisers. But, benchmarking the price of the deliverables is equally as essential.

    Sound financial responsibility drives the need for the long-standing practice of assessing and benchmarking agency compensation. For help in what is fair to ask from your agency, I suggest you read both the 2002 and 2006 “best practices” guidelines jointly negotiated by the Association of National Advertisers (ANA, the client-side industry advocate) and the American Association of Advertising Agencies (4A’s, the agency-side industry advocate). Appropriate levels of agency transparency and compensation methodologies are well documented in these easy-to-read best practices guides.

    Advice to clients: Be sure to select the agency right for your business, but also demand appropriate transparency in determining agency compensation. Benchmark costs against industry standards. Advice to agencies: Do not equate agency compensation transparency with lower compensation or value… if you’re a great agency and doing great work, be transparent and let clients know you expect a higher profit margin for your superior work… in 20+ years on the financial side of the advertising industry, I have yet to come across a client who will not pay more for better work.

    Bob Cauley,
    Co-Founding Partner
    Beekman Associates, LLC

  8. Bob,
    Let’s begin where we agree: The BMW example, and how no consumer cares about what it costs BMW to produce. Your example of benchmarking the BMW is one of price/value comparison, not actual cost benchmarking (there seems to be confusion in your comment between the terms cost and price).

    Of course consumers and companies compare prices, but do they really compare internal costs of their suppliers? Do you know how much Apple spends to produce your iPhone, or a pharmaceutical company spends to produce your prescription drugs? Would you even be able to compute it? Is tracking hours an accurate representation of costs, or merely one way among many to allocate costs?

    I posit to you that buyers care about the baby, not the labor pains. Hourly billing measures the labor pains.

    The principal problem is with the theory compensation consultants seem to hold that value can be measured by labor. This dates back centuries, but was given credence by the writings of Karl Marx from the 1860s. It’s been totally falsified and discredited by empirical evidence, and a superior theory of value, known as the subjective theory of value, has replaced it.

    If you start with the wrong theory, you will use the wrong measurement, and get the wrong result, even though it will be precise. You even admit, “measuring time (hours) and effort (skill levels) in determining fair agency compensation is admittedly not perfect, it is the best measurement tool we have and certainly beats the alternative…”

    Really? So it’s better to be precisely wrong rather than approximately right?

    Labor hours and efforts do not measure value. It’s the equivalent of plunging a ruler into an oven to determine its temperature. If it were true, no business would ever go bankrupt, since you don’t need to be a CPA to put a price above your costs.

    Value, like beauty, is in the eye of the beholder. You can benchmark prior prices (and historical costs) all you want, but that will never reveal the value of specific time and place economic decisions. It’s why, for example, you don’t pay the same air fare as the person sitting next to you. It’s also why accountants book “goodwill,” a word they use to describe their ignorance when it comes to value.

    What I find fascinating is why the compensation consulting business even exists. It’s as if advertising agencies are regulated utilities, and should only be allowed to earn a certain return on investment (or, worse, return on costs). It doesn’t even work well for utilities, but it’s an insane practice in a free, competitive market. Try telling Google, Apple, Oracle, or SAP that they can only earn a certain margin.

    I challenge any compensation consultant to walk into a Big 4 accounting firm, or a major Wall Street law firm, or a consultancy firm, such as Accenture, Bain or McKinsey, and ask them to fill out spreadsheets listing their overhead costs for their benchmarking reports. They’d be laughed out of town.

    The compensation consulting business exists because of the conflict of interest that is inherently built into the billable hour (what the agency wants more of, the client wants less of). This conflict creates a lack of trust between the client and the agency, similar to the legal profession, which is also in the process of leaving the billable hour behind.

    This systemic conflict of interest in hourly billing and measurement is why progressive marketers like P&G and Coca-Cola have implemented their own versions of Value Pricing. They got tired of dictating, auditing, and capping costs and margins. After all, they are far more interested in building brands.

    For years we’ve been studying the literature published by the major trade associations in this sector, and it’s all based on the same incorrect theory of value. There’s no new evidence in any of these “best compensation practices” documents; it’s all been refuted when the labor theory of value was, back in 1871-74. There’s no good way to implement a bad theory.

    By the way, we advocate all agencies offer a money-back guarantee on their work, or at least a portion of it. Not only is it the ethical and moral thing to do, it makes excellent business sense, and comports to the subjective theory of value.

    As long as compensation consultants, clients, and agencies stay focused on costs, efforts, inputs, and hours, they are all keeping their limited executive attention off of what really matters: value, results, and outcomes, which Tim so eloquently argued in his post.

    Our advice to agencies and clients: If you adopt the subjective theory of value, along with normal pricing practices that exist in other industries, get rid of the billable hour, timesheets and time tracking, offer your clients options, and a value guarantee, the business of compensation consulting would become superfluous, like taxis in an Uber world. That’s our side of the story.

    • Again, thank you for your perspective on agency compensation and for the point of view that value should drive price rather than costs. While I do not disagree in all circumstances, there are many times when that simply won’t work.

      First, let’s look at the comparisons being made. Taking the BMW example (or the Apple iPhone, etc.) shows why the comparison is actually apples and oranges. When a client is shopping for a car, as you so well indicate, he or she can kick the tires and even take it out for a test drive; see if he or she actually likes it before buying it. With advertising, that’s not the case. When a client buys, for example, a 30-second TV spot the client cannot take it out for a test drive (or market test it) because there is no 30-second TV spot created yet. The client is simply buying a promise to make a 30-second TV spot and can only hope that when it’s done it’s a good one. With a 30-second TV spot one doesn’t even know the color, the look, the shape, the model, the result and so on; they are going in on “a hope and a prayer”, with fingers crossed. Okay, perhaps that’s a bit (or more than a bit) overstated as both client and agency work in hard in tandem to strive for the best result while sharing the risks of success. But, I think my point is made, the comparison is not apples-to-apples: buying a finished product is a lot different than buying a yet-to-be-completed service. I suggest throwing those comparisons away; they’re not valid. Let’s not forget John Wanamaker’s famous quote on advertising value: “Half the money I spend on advertising is wasted; the trouble is I don’t know which half.”

      So what is the right answer? I suggest that one size does not fit all, and each compensation arrangement between a client and its agency should be customized to fit their mutual purposes and goals.

      When a client can be very specific on a scope-of-work one can reasonably benchmark the output, place a value on it, and determine what a fair price might be. For example, if going into the year the client knows it will need 5 TV spots, 10 print ads and a website landing page; one can benchmark the output (and therefor value) by benchmarking it against other like deliverables. The industry considers this output-based (or a variation thereof of, value pricing) compensation and this methodology may work well for certain clients who can be specific on output requirements. This methodology can also work well if hiring your agency on a project-by-project basis with a well defined scope-of-work. The need to benchmark these outputs is still very much there but, likely can be benchmarked on an output (value) basis rather than on hours, rates and associated costs.

      Most clients do not fit that mold. Because advertising is such a moving target with many bumps and curves in the road, most clients cannot identify specifically what they will need in the coming year and opt instead to buy a certain level of agency resources. Rather than identifying the number of TV spots or print ads, they prefer to buy an annual staffing plan (including a certain number and level of account people, creative people, production people, etc.). We cannot value the outputs because we don’t know what they are and they haven’t even been created yet. The real question here is how to put a place a “value” on staffing plans. Clients (and the industry overall) have found it most useful to determine value using industry comparisons based on sound benchmarking in order to “set the bar” and then adjust accordingly to fit the particular situation and value perceived. Benchmarking the agency costs assists in setting that bar and offers a reference point to make sound, fact-based decisions.

      Contrary to your reference above, using costs as a tool to help one in determining value does not make one a Marxist. Hours, costs and benchmarking alone are not the sole solution to determining value, but sure are a great measuring tool to assist in the elusive endeavor.

      Bob Cauley,
      Co-Founding Partner
      Beekman Associates, LLC

  9. Bob,
    Thank you for your response.

    Value does drive price, in ALL circumstances. Otherwise, no business would ever go bankrupt (please deal with this point, it’s profound and irrefutable). To believe otherwise might not make you a Marxist, but it does mean you are practicing and subscribe to his most famous economic theory, which has been absolutely refuted by empirical evidence.

    I concede your point on apples and oranges comparison of the BMW and iPhone examples. However, that doesn’t mean comparisons are not relevant. What you are defining with agency services are “credence services”: These have attributes buyers cannot confidently evaluate, even after one or more purchases. Thus, buyers tend to rely on the reputation of the brand, testimonials, service quality, guarantees, price, etc.

    Many services fall into this category: health care, legal, accounting, consulting, insurance, etc. Hollywood studios might be the best comparison, since making a movie is also fraught with tremendous risk and uncertainty.

    So what? Can we please stop whining about risk, including the hoary Wanamaker quote? Risk is where all profits are derived! Are agencies and their clients not subject to the same laws of economics as these other services? It gets very tiring listening to the same argument that “our industry is different.” Nonsense.

    Your “hope and a prayer” comment is why we advocate agencies offer a money-back guarantee. Competent professionals who understand their value can do this.

    We also agree that one size does not fit all. We advocate pricing the customer, not the services. This is the trend in all pricing.

    You write: “The need to benchmark these outputs is still very much there but, likely can be benchmarked on an output (value) basis rather than on hours, rates and associated costs.” But if value is subjective, how do you propose benchmarking outputs and value? It varies by time, place, circumstance, client, and myriad other factors, as you noted. Any benchmarking measurement will miss the most dynamic and important elements of value, including risk and uncertainty at the time of decision.

    Logically, if you say A, you must say B. You cannot say value is not driven by costs, and then argue that value can be benchmarked by a “fair price.” What’s fair? Who determines fairness? This is capitalist acts between consenting adults.

    Was Facebook’s purchase of WhatsApp for $19 billion fair? How was it benchmarked? By looking at costs? Hours? Number of employees? I know you’re thinking, no, it was based on expected future profits. Exactly. And it’s not guaranteed. In other words, it’s risky.

    You further the error when you write, “The real question here is how to place a ‘value’ on staffing plans. Clients (and the industry overall) have found it most useful to determine value using industry comparisons based on sound benchmarking in order to ‘set the bar’ and then adjust accordingly to fit the particular situation and value perceived. Benchmarking the agency costs assists in setting that bar and offers a reference point to make sound, fact-based decisions.”

    This, too, is nonsense, as you are going back to costs to determine value. Staffing plans aren’t much different than having a lawyer on retainer, or a concierge doctor, all priced upfront, with options. It’s done all the time.

    Finally, you write, “Hours, costs and benchmarking alone are not the sole solution to determining value, but sure are a great measuring tool to assist in the elusive endeavor.”

    Why is value elusive? Because it’s subjective and spiritual, meaning it cannot be measured at all, let alone by hours and costs. It’s very much like the world’s most valuable brands. How would suggest these are valued? Adding up costs and hours?

    Do you not agree that a brilliant idea can be produced in 10 minutes that creates millions of dollars of value (like Merv Griffin’s writing of the theme song for Jeopardy), or that 1,000 plodding hours (and costs) can be spent and be completely worthless? Are you suggesting that Jonas Salk’s polio vaccine’s value is measured by the time and costs it took him to develop? If so, Marx would agree. He’d also be wrong.

    Moreover, you’ve ignored all of the major points in my first comment: Treating agencies like regulated utilities, why compensation consultants exist at all, the systemic conflict of interest and mistrust that this form of benchmarking creates, and why can’t you get cost data from an accounting, law, or consulting firm. If this benchmarking is so useful, why is there so much disenchantment with the agency/client relationship? One major reason is the perverse incentives created by billable hours, FTEs, timesheets, benchmarking costs, and dictating profit margins, rather than focus on long-term value creation.

    You haven’t made one argument that I have not absolutely refuted in my books, Pricing on Purpose, and Implementing Value Pricing. These works are grounded in economic reality and empirical evidence, which is why we will continue to advocate for them across all professional firms. It’s a far more effective way to run an agency, price its services, and create more value its customers.

    The purpose of a business is to create wealth outside of itself, and that cannot be done if it’s focused on costs, hours, efforts, and efficiency. Benchmarking is, by definition, about the past, whereas innovation, risk taking, and uncertainty are about the future, and the source of all dynamism and wealth creation. Yes, even in the advertising business.

  10. Thank you, Bob. I agree, and may the best ideas win in the marketplace.

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