Creative Agency Operations: An epidemic failure of understanding what is really happening
I’ve started this a few times to try and fully capture the historic context, ideas and actions for holistic agency operations solutions, but have failed to really do it justice. I’m scrapping what I’ve done and taking a far more casual approach to this.
My starting point is that, from a business perspective, agencies are still in the 1980s. The fundamental assumptions they run on were developed then, and persist today. Decades back, agency operations drove a system that resulted in “a firehose of money pouring into the foyer for a decade” (an actual quote from a long-time senior agency person). That money gave rise to large-scale complacency and false assumptions by the people that benefitted and rose through the ranks based on them. In turn, they passed their “knowledge” down to the next generation, and so on. As that was happening, technology changed, expectations from clients changed, the media landscape changed, the power dynamics within business changed… and agencies stayed largely the same.
Unit Economics Of An Agency
For those that are unfamiliar, unit economics is a way of analysing a product's cost to its revenue based on its most basic unit. In the case of creative agencies, this would be an hour of time.
Each hour has a buy and sell side — we buy the hour at a salary plus overheads rate, and then sell it to a client at a slightly higher rate. Those are our parameters to work with. There are other pricing models, but the industry largely works on this.
The more hours in the system and sold to clients, the more money gets made. The decision-making framework for an agency is all about how to move the hours off the agency ledger, and onto a client ledger, at the highest cost.
To break down the calculation for an agency on what the charge rate to clients should be, the agency has the salary (plus superannuation and any other government-mandated elements), and they decide how many chargeable hours a year they should divide the salary by. In Australia, we have 48 working weeks, and if you said a team member could do 1,600 billable hours, that would be 33 hours a week charged to the clients. The total fluctuates depending on the demands of the agency and procurement — I’ve seen it as high as 1,900, which is unreasonable.
So, we have salary divided by ~1,600 hours. Then we need to cover the rent, admin team, beer in the fridge, creative awards, etc. A great rule of thumb is that covering all these elements will cost 100% of your salary bill. So if you have a salary of $100,000, you need to bring in the salary plus another $100,000 to cover your costs of running.
Then there’s your profit. That percentage varies by agency, and the big holding companies set the target yearly. This means most agency businesses must return between 2.1 to 2.5 times the salary bill to have a sustainable business that is turning out a profit.
Some agencies work to lower multiples through different tactics, but they largely just rely on work volume to generate a profit that’s worth the effort.
If the above all makes sense, then you can understand that hours volume matters a lot. Agencies have focussed on maximising the required hours to complete a task. They did this through layers of staff hierarchy. Three layers of creatives, three layers of accounts, two layers of producers, strategists, design directors and more. Some of these activities added huge value to the work, and some just padded out the hours.
Over time, the drive for financial results really pushed more of the latter, and you had situations where meetings had 12 people in them, ten of which had nothing to contribute, but all added it to their timesheets.
Poor Outcomes Through Misaligned Incentives
Imagine you’re an agency CEO. In the push to win business and increase revenue, you have dropped your multiple and margin on a few new clients, your average is down, and you know this is all going to be seen by the board / holding company / partners and is a reflection of your performance. You have few levers to pull to try and make the numbers work, but one of the easiest is increasing the billable hours by existing staff. You don’t have to pay anything more, the overheads on the additional hours are almost nil, but the unit revenue stays high.
From a cultural perspective, agencies have historically done a great job selling employees on the need for overtime to complete work. The CD saying “keep going” to the creatives working on a campaign, the late changes to roll-out happening at 5 pm means the design team must stay late. All these things normalised a world where the average creative agency employee was working ~10 hours a day, not the 7.5 hours contracted (where I’m based). Not to mention weekends.
If you’re running an agency, those additional hours were once a bonus. They made the numbers look great. But over time, as hourly charge rates dropped, they have become more essential to just hitting the targets.
Now we have a scenario where the internal staff are working punishing hours, the clients are paying for inefficiency that benefits the agency revenue, and it’s all just to keep the agency above water.
The result of a system that sells hours ends in a scenario where, as a client, you pay more for an average designer to spend six days doing an average logo than you would for a great designer doing a great logo in 30 mins. Not great.
Bleak Tactics
Last I heard, the industry average creative agency margin within a major Australian city was 13% (pre-covid and against a target range of 17% to 22%). In the ’90s, it was easily 30%+. Today, for technology-based service businesses (implementors, systems maintenance, martech builds, etc.), it can be over 50%. But I know of creative agencies that have a margin at or below 4% — I can get a savings account that will perform better than that.
Those results have driven more and more bleak tactics and a loss of focus. Creative advertising, brand building, and strategic communications — making ads — was no longer enough. We needed new service lines and to claim we can “do anything” in each pitch to try and reinforce the crumbling infrastructure. And agencies currently do all kinds of things they shouldn’t. They do it badly, make huge mistakes and lose focus on the real value they provide.
In addition, the internal conditions decline as demands on the team grow, especially for more hours. Then there’s the loss of trust at a client level because agencies aren’t rigorous on their timesheets (euphemism there), add layers and fees, and retain team members at over 100%.
These are bleak signals that the agencies haven’t got a profitable operating model that works.
The future is already there for us to see too. Engineering (Civil and Oil/Gas) is further along this path than advertising is. Hours, productivity and output are measured through technology to an insane level of accuracy in those businesses. Contracts are awarded on a fixed fee basis, and companies compete to win revenue… Not profit. Revenue.
Conflict Contracts
The last point I have on hours here is around signing contracts with our clients that have conflicting objectives. We know that agencies are battling a decline in value for each hour they have to sell, driven in part by the client’s willingness to pay. To understand that willingness to pay, we need to look at our agreements. Agencies enter into agreements with their client that have two different objectives:
- Clients want the best work, as fast and efficiently as possible, because hours equate to money.
- Agencies want to create the best work as slowly as possible, with as many people and layers as possible, because hours equate to money.
An excellent starting point for a new “partnership”, right? Two completely opposing objectives in the premise.
We can agree we both want the best work. And let’s agree that the best work delivers value to the brand employing the agency (profit, not creative awards in the south of France).
We both agree that hours equate to money in the current context. And within this, we have no incentive for agencies to invest in efficient processes, technologies and IP, which can deliver the best work faster. That would mean working harder for less money. Equally, the clients have no incentive to give us timelines that might equate to the best work, because that could mean greater cost for no additional revenue for them… trust is low in this relationship.
A Part of The Solution
Alignment of objectives between the agency, staff and clients is going to be key to a sustainable future for creative agencies. The current model will kill the industry. At the pace of business change now, we’re talking years not decades.
To my mind, a key starting point is how we measure performance in an agency. Right now, we look at revenue and margin mostly, creative awards too. But the evolution of our environment and how we approach work means that agencies have a counterintuitive approach to creating their product.
Most other businesses look to reduce the cost and time required to create a product while maintaining their price point, thereby increasing their margin. Working this way incentivises the investment in IP and processes that create a more efficient and higher quality outcome for clients at a lower cost of creation and potentially higher margin, or more competitive pricing, thereby attracting more clients.
As discussed above, agencies aren’t incentivised to be more efficient or invest in real technology and improvements that could help create the product faster. They need more hours in the system. The evolution of procurement, downward price pressure and increasing wages has meant agencies demanding more time from their staff to make up for those losses.
This results in catastrophic work culture, push factors driving great talent out, an eye-watering average industry churn rate, and recruitment costs. How can we measure performance to incentivise the right internal actions?
Yield Per Hour
I will advocate for measuring your agency's performance on a yield-per-hour basis. The formula is straightforward:
Total Monthly Revenue / Total Hours Worked = Yield Per Hour.
Your revenue total is just the recognised revenue for the month. For example, if you’ve completed 50% of a $10k job by the close of the month, you recognise $5k in that month.
Total hours worked is EVERYONE. Reception, EAs, traffic and more. They ALL need to timesheet and be accurate about it. If they lie on their timesheets, they hurt the business and the whole team. This is really important.
The beauty of this measure is that it penalises over-investment of time without a corresponding financial gain, and incentivises the agency to be as efficient as humanly possible.
It means that dedicating time to the exploration of ideas, pitches and more is a harder decision because you’ll drive down your yield. People will push harder for one right concept, not three, where two will be binned. That should mean creative concepts are treated as scarce, finite resources that should be valued.
And hopefully, that equates to leadership being more careful with their team's personal time, too, which changes an agency's culture and work conditions.
Ultimately what this does is align clients, staff and leadership in the value chain. We need to maximise revenue and minimise effort. More value, less cost. And so the investment in technology, systems, processes and care for people's time becomes a part of the culture in the agency and ensures that there are aligned decision-making and an understanding that when overtime is required… there must be a good reason for it.
In my mind, the Yield Per Hour measure should be public in the agency and shared each month so that people understand the performance of the business as well.
Using Yield Per Hour To Generate Greater Margin
The above metric aligns us with the clients and staff on the approach to creating the product. The next step is the pricing of the product. I think everyone agrees that hours are a stupid way to price it. I see a lot of people exploring value-based pricing, but I’m yet to meet a client that likes that idea. I’d suggest here that an extensive shopping cart that flat prices assets, concepts, etc. is the way to go. And then using the Yield incentive to reduce the effort required to generate the campaign.
The client gets faster results at a predictable price. The agency has the ability to win more profit by being efficient. I know there are going to be elements that need bespoke pricing and campaigns that will blow out. But if you’re experienced and disciplined in the approach, the learning curve should be low and the losses contained before you see an improvement in the numbers.
Where to?
The solution here is lightweight. It’s implementable immediately, but will it ultimately solve the problems an agency has? No.
I’m going to dig into a few ideas over the coming weeks to try and explain my thinking and ideas for other areas that can improve an agency business.
This is a base to work from in the ideas that flow from here, which will cover the organisational structure of agencies, how to shape the roles within an agency, what the leadership of an agency really should be, and more.
I’m huge on direct, candid feedback and would love to engage with anyone thinking about these topics. Feel free to contact me if you ever want to chat: dave.keating@operative.agency