Advertising Agency Compensation: An Agency Theory Explanation.

Advertising agency compensation may change dramatically in coming years as advertisers put pressure on agencies to reduce commissions and tie compensation to performance resulting from advertising campaigns. Drawing on agency theory from the economics discipline, the authors develop and test several hypotheses to address the advertising agency compensation decision. Their study provides the first comprehensive look at the prevalence of outcome-based compensation tied to performance and other compensation systems currently used among U.S. advertisers.

Much has been written about advertising agency compensation and the changes currently occurring in the advertising industry. One industry observer comments: "The way agencies are compensated for their purchases of advertising promises to change dramatically" (Zbar 1994, p. S-24). Calls have been made for agencies to "work harder to customize their compensation structures and find new ways of redefining their role in brand building" (Selinger 1995, p. 3). As a result, advertising agencies have witnessed a steady erosion of client budgets, indicative of client opinion that full-service agencies are too costly for the impact they deliver (LaBahn 1996). In effect, though studies by the Association of National Advertisers (Gleason 1996) show that a majority of advertisers (59% in 1995 vs. 61% in 1992) have been paying their agencies in commissions, more than three quarters of the agencies were paid reduced-rate commissions in 1995 compared with less than half in 1992. Further, in addition to lower agency compensa tion advertisers are demanding greater agency accountability.

The pressure on advertising agencies to enhance their performance and deliver value is the result of several events: the Total Quality Management revolution of the 1980s to improve quality, now extended to include supplier performance; the increased pressure on marketing budgets resulting in calls to justify expenditures; and a competitive environment wherein market prices are stable or declining, forcing profit growth to come from other sources such as volume generated by advertising. For the advertiser, the message is clear. Advertising, like any other activity, must be managed better to obtain superior results at a lower cost. Agency compensation is critical to that objective, but what guidance can theory offer to the advertising manager?