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Advertising Agency Overhead 

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This position paper addresses the issue of whether to include agency contributions to retirement plans and new business costs when calculating agency overhead. The AAAA’s position is that these necessary costs should be included in overhead when calculating agency fees even though some advertisers and agency search consultants disagree.


I. Background

Some agency compensation arrangements with clients, particularly those taking a “cost plus” approach, delve into the various elements of the agency’s fee or hourly billing rate structure. These elements typically include such items as the direct salary costs of agency personnel working on the client’s business, the agency’s overhead as a percentage of the direct salary cost, and the agency’s profit factor or margin.

Many agency and client professionals find these types of fee arrangements frustrating for the following reasons:

  • They are time consuming for both agency and client to administer and they provide unnecessary opportunities for friction between both parties.
  • Negotiations should be over agency fees, not the elements making up the fees (the same as is done with lawyers, consultants, CPAs, etc.)
  • They do not lend themselves to “value pricing.”

Still, these types of compensation arrangements are favored by some clients and search consultants. AAAA members maintain that in calculating an overhead rate for such contracts, some advertisers and consultants take the position that certain legitimate agency operating expenses should not be included in overhead.

The purpose of this paper is to identify those expense items and explain why they should be included as part of agency overhead.


II. Expense Items in Question

In the typical agency, the following agency operating expense categories are considered legitimate items of agency overhead and should be included in overhead calculations despite contrary positions taken by some advertisers and agency search consultants:

Contributions to Retirement Plans
Some consultants and advertisers contend that 401(k) matches and contributions to qualified profit sharing plans should be excluded from overhead because they are discretionary (defined contribution
rather than defined benefit) agency expenses, and are therefore an allocation of profits rather than regular operating expenses. But this viewpoint has never been valid for agencies that consistently make contributions to retirement plans for employees, regardless of what they are called and whether or not the annual contribution is discretionary.

  • It is even less so now, when the trend for virtually all employers is away from fixed benefit pension plans and more toward 401(k) plans, which often assume employer matches. A 401(k) plan also is important when it comes to recruiting. It is an employee benefit that prospects generally assume will be in place, so advertisers should regard its inclusion as an operating expense.
  • A qualified profit-sharing plan falls under ERISA, with maximum vesting requirements, contribution limitations, etc., just as qualified pension plans do. The government treats it as a retirement plan. So should clients.

It should be noted that many agencies include their payroll-related costs (payroll taxes, group insurance, workers’ compensation, retirement contributions, etc.) in direct salaries. In these cases, that portion of the retirement contribution attributable to client time will be in direct salaries, and that portion related to indirect time will be in overhead. Regardless of whether it is split in that way, or entirely in overhead as would be the case where only base salary is included in direct salaries, it remains a legitimate operating
expense.

When an agency has a track record of consistent contributions to these qualified plans, the costs should logically be included in the agency’s operating expense for determining both direct salaries and overhead. However, in those rare instances where an agency has one of these plans, but rarely contributes to it, and then only in an unusually high-profit year, the arguments against inclusion as an operating expense may have some merit.

New Business Expense
Some argue to exclude these costs from agency overhead on the grounds that they do not benefit the current client. Not true. New business expense is a necessary operating expense that benefits all agency clients by:

  • Bringing in additional business over which the agency can allocate its fixed cost commitments, e.g., lease for office space, investments in training and technology, etc., thus keeping its ongoing overhead rate at a reasonable level.
  • Replacing lost business to accomplish the same goal. It is a fact that client turnover is occurring at an increasingly rapid rate, frequently due to circumstances that have little or nothing to do with the agency’s performance.

Since agencies do not sell product off the shelf, or cannot represent competing products, they must constantly seek new clients. These expenses are the equivalent of the client’s marketing expense. As such, they are a legitimate operating expense.

The expansion of the agency’s operating base, and the prevention of its erosion, benefit both agency and client.


III. Summary

In negotiations between an agency and client, there is no “one best way” to arrive at agreement on agency compensation. Fee amounts should be developed through case by case negotiation. However, if
the negotiation includes an overhead element, then strong reasons suggest that all contributions to retirement plans and new business expenses should be included in the agency’s overhead.

Adopted by AAAA Board of Directors, September 19, 2000.

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