Pricing Methodologies 101: Pricing projects profitably

by Barry on August 24, 2010

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Is it best to price that new project on a Fixed Fee or a Time and Materials basis? Perhaps we should structure it on a Cost Plus basis, a Revenue Sharing model, or maybe Commission based? What are the advantages of each to an agency? From a client perspective, what are the pros and cons of each?

There are many factors in determining which pricing methodology to use such as client preferences, agency preferences, campaign objectives, and scope details. This article describes each methodology, focusing on the pros and cons from both the client and agency point of views.

Fixed Fee
Client pays a flat rate that is agreed to in-advance based on a pre-determined scope.  This is also known as Flat Rate pricing. The price is based solely on the budgeted cost. The client pays the same amount, regardless of how much work it took the agency to complete the project.

Client POV (point of view): The upside of a fixed fee contract is that the costs are locked in and cannot change without client approval. Also scope (that is, the work) that they are getting in-return is locked. The downside is that if the agreed scope changes, then the client can expect a Change Order for additional monies.

Agency POV: The upside of a fixed fee arrangement is that if the agency can bring in the project under-budget, then the underage amount is added to the agency’s profitability.  However the downside is that if the project goes over budget, then the overage goes against the agency’s profitability (possibly resulting in a loss). It is crucial that the project is priced correctly, preferably using bottom-up pricing and from looking at historicals.  The Statement of Work needs to have enough details to protect the agency if the scope changes; it is important to include both what is and what is not included. Thus the agency is responsible for the monetary risk.

Time and Materials (T&M)
Client pays based on the actual time spent, usually based on an hourly, daily or weekly rate card. For example, if the agency works 10 hours, then the client pays them 10 hours. If they work 50 hours, then the client pays them for 50 hours, and so forth.

Client POV: Open-ended Time and Materials contracts are quite risky to clients since there are no caps to the costs. To control this, it is important to include “do not exceed” caps, either on a project or monthly-basis. With a T&M structure, the clients should request weekly cost management reports that provide the estimated variance at compliance. This numbers tells if the project is projected to come in under- or over-budget, and is equal to the estimate at completion (which is equal to the actual costs incurred to-date plus the estimated to completion costs) compared against the budget at completion.

Agency POV: For close-ended T&M projects, it is important that the “do not exceed” number is not too low, otherwise it becomes a losing proposition for the agency since with a Fixed Fee with a cap contract, the agency carries all of the risk but they have no upside.

For T&M contracts, the rate card can be a source of many issues. The rate card needs to be developed from a cost-plus basis so that it reflects your resource costs (including benefits) + overhead + profit. There are many types of rate cards. The rate card may be role-based (each role, e.g., Art Director, has a specific rate), tiered (roles are bundled into groups by seniority, e.g., directors, and each group has a specific rate) or blended rates (a single flat rate that is applied to all resources, regardless of cost).  The rate card needs to be updated every year based on your real costs, or it can quickly become out-of-date. This can become a problem for legacy, multi-year clients who want to control (and frequently lower) their costs. It is recommended that you build into long-term contracts a clause that allows you to update your rate card based on certain parameters. Otherwise you will find yourself locked into rates from 1998.

Cost Plus
For cost plus projects, the fee is based your expected costs for the specific assigned resources. The cost is derived from taking the resource costs (the actual salaries) of your team + overhead + profit. Cost Plus pricing is usually based on a Fixed Fee but it can be structured into as a Time or Materials contract.

Client POV: cost plus fees can be complex as there is no defined public rate card. The client should ensure that the agency is not pricing the project using senior resources (and senior rates) and swapping in junior staff without adjusting the rate card. This is solved by obtaining a list of specific resources assigned to the project, so that the agency cannot easily swap out resources later on with more junior staff.

Agency POV: The cost plus relationship removes much of the rate card risk from pricing projects since the fees are based on the actual resource costs. As a comparison, T&M rate cards are based on an approximated resource cost since salaries are not the same across each title (e.g., even though Art Directors all share the same title, they are paid different salaries). The downside is that the cost plus rate card requires a much greater level of security and it needs to be kept confidential since the rate card can be used to calculate actual salaries. This makes tracking actual costs more difficult. It is also important to develop a cohesive strategy for how your organization will determine cost plus pricing so that there is consistency. For example, you need to ensure that you have standard overhead percentages and that your profitability targets deals with variables such as using full time versus freelance staff.

Revenue Sharing
The Revenue Sharing model is that the agency is paid based on the brand’s actual revenue. While it may seem simpler, it is actually much more difficult to implement.

Client POV: the client needs to ensure that the agency is working across all of the client’s brands as driven by the client, and not just the most profitability ones. Also the contract terms should be structured so that the agency is compensated based on campaign results, and not just the brand’s pulling power especially since a well-known brand will generate a certain amount of revenue, regardless of any campaigns that are in-market.

Agency POV: Sales can take a hit for a number of reasons, regardless of how effective a campaign is, which can have severe revenue impacts. For example, there could be a recession that kills the economy, production issues that limit inventory and subsequently sales, recalls, and bad press (e.g., Toyota’s pedal acceleration issues from November 2009 – July 2010). Also agencies will tend to avoid unproven mediums or those where the ROI is hard to measure. This can limit the brand’s exposure to newer forms of advertising such as Mobile, Facebook and Twitter.

Commission Based (Percentage of Ad Spend)
The percentage of ad spend pricing is a commission model where the agency is compensated based on the total ad spend. The range varies slightly, typically from 12-15%.

Client POV: Commission based pricing controls costs and is very similar to the fix fee structure. The downside is that the client needs to ensure that the campaigns are effective as it can be too easy for the agencies to minimize their spend and under-deliver. The agency may not put their “A” team on your campaign. This is because the agency fees are limited, which means that budgets are constrained, as opposed to a bottom-up costing approach where you develop costs based on expected work. Commission based pricing does not work with newer forms of advertising where the ad spend is very small (or non-existent) but the cost to develop and maintain the campaign can be expensive (e.g., Facebook applications).

Agency POV: since the fees are capped, it can be difficult meeting the campaign objectives within the price range. This works best for the “bread and butter” accounts that are not pushing the creative edge. The agency will also look for ways to be as economical as possible. It may mean developing fewer concepts, or re-using executions from previous campaigns.

What about retainers?
Retainers are the holy-grail for agencies. Most agencies strive for long-term retainers where the revenue is projectable over a long period (the longer, the better). This is the dream of any COO. Retainers bring financial stability and everything that comes with that including greater independence from holding companies, ability to hire, ability to free up money for training, parties and perks, ability to win awards, and ability to attract the best people and other clients.

The opposite of a retainer are small, stand-alone projects, each of which has to be pitched and won. This can be expensive, time consuming, and is hard to predict.

To clients, the main benefit that retainers provide is preferential pricing and consistent staffing on their accounts.

When structuring the retainer, it needs to include provisions for how to reconcile hours, the frequency of reconciliations, and if there are underages or overages, how will those be dealt with (e.g., do you rollover underages and can be overages be billed?).

All of the pricing methodologies mentioned earlier can be structured under a retainer.

Would love to hear about what works and more importantly, what does not work for you.

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