by Tim Williams
During the 16-hour flight from Los Angeles to Sydney, 90 percent of the activity in the cockpit is ensuring the plane is staying its course with the help of automated navigation systems. But the other 10 percent — the takeoff/ascent and approach/landing — is where a pilot’s skill and experience are essential. It’s during these two brief periods that pilots really earn their money.
The same could be said for the majority of assignments undertaken by professional services firms. It’s at the front end and the back end of the program where agencies provide the most value to their clients.
This phenomenon is effectively illustrated by the “Smile Curve,” first developed by Stan Shih. The tips of the smile represent the work that carries the highest value. The perceived value dips in the trough of the smile. Using the work of an advertising agency as an example, this model could be visualized as follows:
In the initial stages of an assignment, an ad agency deploys expertise that most client organizations are hard-pressed to duplicate in-house. Agencies have the requisite talent, competencies, and objectivity to uncover useful customer insights, craft powerful communications strategies, and develop inventive solutions to solve marketing problems.
However, as the assignment enters the production/execution phase, the perceived value goes decidedly downward. That’s not to say this type of work isn’t important. To the contrary, production work must be done well with zero defects. It’s just that the resources for this type of work are standardized and widely available, often in lower-cost geographies. It’s the type of work that many clients are capable of doing themselves, which explains the rise of in-house agencies and production departments. The Association of National Advertisers in the U.S. reports that close to 70 percent of major marketers have significant internal capabilities in this area. Moreover, because technology has enabled high-speed, low-cost production of everything from digital banner ads to website videos, few marketers are inclined to compensate their agencies at the same rate for the dip of the curve as the tips.
The value of agency outputs increases again at the end of the curve as the team engages in measurement, analytics, and optimization. The best agencies possess sophisticated tools and technologies to help marketers assess how well their campaigns are performing. The firm can then recommend ways to optimize the effectiveness of the work in future deployments.
The smile as a frown
The problem with the Smile Curve is that most firms turn it into a frown when it comes to remuneration. Ad agencies famously give away the high-value work on the front end in the form of spec presentations requested by prospective clients. And they chronically underprice the back end of the curve by applying the badly flawed “blended hourly rate,” which only serves to assign an average value to every point on the curve.
In effect, agencies give away the high-value work in order to get the low-value work.
Not a brilliant business strategy. Because the services in the dip of the curve must be done at low cost, it’s almost always low-margin work for agencies. To make matters worse, the low-value work constitutes up to 80 percent of the volume of many firms. It’s no wonder agency profits have been on a steady 25-year decline.
Broadly speaking, there are two basic solutions to this economic dilemma. The first is to decide to get out of the low-value business altogether, which some (but not many) agencies have done. The effects of this decision are lower revenues but higher profits.
The second approach is to “decouple” the work of the firm, ideally into two different business units; one staffed for the high-value work, and one equipped to do the lower-value work. For this model to be effective, each unit must not only have a distinctive pricing structure but a different cost structure as well. To profitably provide the services in the dip of the curve, it’s simply not viable to run the low-cost, high-volume business from a skyscraper in midtown Manhattan.
But this approach also requires a change in business practices to capture much more value from the tips of the curve, because this is where your real margins live. Specifically:
- Discontinue the destructive practice of funding the development of comprehensive speculative work for the purposes of new business. In cases where speculative work is “required,” your firm must insist on fair compensation, not just a symbolic stipend or honorarium. This will not put you out of business. Many exceptional ad agencies built their reputation this way. By standing firm, you stand out.
- Protect the firm’s intellectual property. Prospective clients should not expect to own or use any of the ideas shared during new business presentations unless the firm receives fair and adequate compensation. Even work and ideas developed for current clients should not always default to a “work for hire” arrangement. Consider the industries that generate most of their revenues from ownership and licensing of IP (film, music, publishing, photography, etc.)
- Enhance the value of your offerings by converting the firm’s bullet point list of services into benefit-oriented solution sets. Instead of billing for the time spent delivering the service (research, brand planning, analytics, etc.), package up these services as programs that can be individually priced, client by client.
- Institute “fixed-price for fixed-scope” pricing in place of time-based billing. This by itself will allow your firm to benefit from its expertise and ability to solve problems faster and better. Beyond that, implement a variety of modern pricing approaches such as usage-based, subscription-based, output-based, etc. This diversification of your remuneration portfolio can produce both an immediate and long-term improvement in your margins.
In the days of Mad Men, marketers were heavily dependent on outside providers of marketing services — their agencies — to provide every single competency on the Smile Curve and were willing to pay well for it. The disintermediation of business services has changed all that. Your firm might not be able to stay ahead of the Smile Curve, but you can bend it to your profitable advantage.