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When New York State Lottery executives threw their account into review earlier this year, they were hoping for something more than a stunning ad campaign. They wanted premium service at a value price.

They apparently got what they wanted. Grey Advertising, New York, which won the $28 million account last month over incumbent and front-runner DDB Needham Worldwide, reportedly sliced its fees to a mere 5% of billings.

In a statement announcing the decision, Lottery officials boasted that the move from DDB Needham to Grey would save "$2.4 million over three years."

It's a dog-eat-agency world out there. Advertisers in search of greater savings are pitting agencies against one another for a more competitive price. The result: Some agencies are cutting their rates by as much as 10%, while quietly grumbling about being treated as commodities. Others are changing the way they're compensated, eliminating the traditional commission-based structure (originally 15% of a client's media expenditure) and adopting performance-based or labor-based ones.

While no advertiser is ready to say it will make marketing decisions based strictly on price, most admit it's a growing factor in their final negotiations with an ad agency or media-buying shop.


Compensation "is going to be very important when it comes down to the finalists," said Tom DeNardin, VP-marketing at Thrifty Car Rental, whose $13 million account is currently in review.

It's a feeling shared by other advertisers. Even if they're not ready to commit to the cheapest bidder just yet, they are holding out for lower prices.

Insiders say the review for the account also had an unusually strong emphasis on costs. Barnes & Noble officials deny that agency compensation played a major role in who received the account. But executives close to the negotiations said TBWA Chiat/Day, New York -- which was awarded the $38 million business -- accepted a fee at least $1 million lower than competing agencies.

In the ever-competitive world of account reviews, charges of lowballing are now as common as second-guessing the winning creative. And it's more than just sour grapes.

There are a number of reasons why agencies cut their own compensation: to bulk up a fledgling office, bolster an overall poor new-business record or to add a marquee client name to their roster.

In the summer of 1997, for example, some people in the industry argued that demands by Wall Street to bolster profits led Young & Rubicam to chisel its fee structure to the 5% range to nab the consolidated $850 million account of Citicorp. Y&R, the critics argued, wanted a large win to signal growth momentum to potential investors in the company's initial public stock offering.


Peter Georgescu, CEO of Young & Rubicam, dismissed the talk as a "stupid argument." He said Y&R's profit margin has risen this year even while the agency has been servicing the mammoth bank account.

Mr. Georgescu has been one of the industry's biggest proponents of shifting agency compensation to a performance-based system, which he said best aligns the interests of both client and agency.

Marketers are demanding different kinds of work from their agencies -- more integrated efforts between general advertising and marketing services such as event sponsorships, as well as a greater variety of media -- which can't be adequately compensated under billings-based commissions.

Yet, the new fee structures aren't a total loss for agencies. Some shops say they are more profitable under performance- and labor-based compensation formulas than when clients paid a traditional commission.

Even Grey, which reportedly lowered its fees to snag the Lottery, said it gives the client a fair price while still earning a profit.

"You don't win these things on price, you win on quality," said Bob Berenson, U.S. president.


The average profit margin for agencies with $600 million or more in billings grew to almost 19% last year from 13% in 1983, according to an analysis by Morgan Anderson Consulting, which specializes in compensation. What's more, the percentage of marketers who compensate agencies based on billings dropped to 35% in 1997 from 71% 15 years ago.

Arthur Anderson, a principal of Morgan Anderson, argues that labor-based pay -- charges for the number of hours worked for a client plus a profit for the agency -- are propitious for both agency and client. Fifty-eight percent of advertisers now pay agencies based on labor. The agency benefits because it's fairly paid for the amount of work it does on a campaign while the advertiser pays for the work done instead of media that's been bought, Mr. Anderson said.

Under the traditional commission structure, an agency can end up getting paid far less if the advertiser pulls back media spending.

The 15% commission is "virtually extinct," said Mr. Anderson. Yet even when it was the rule, it was just an ideal, he said.

For example in 1984, only 52% of agencies that received media commissions were paid 15%. The rest were paid lesser amounts, according to Morgan Anderson's research.

Philip Guarascio, VP-general manager, marketing and advertising of General Motors Corp.'s North American Operations, said marketers will only go with the cheapest agency if they don't see the value an agency can bring.


"If you see agencies as commodities, which we don't, then you pick the one with the lowest price. The least sophisticated people seem to be doing this," he said.

Still, executives insist that some agencies will try to undercut others in the negotiation phase of a review just to win business.

"It happens. It exists," said one agency executive. "Desperate agencies do desperate things."

The agency business of 15 years ago was a much simpler one, still led by traditional advertising that lent itself better to commission-based compensation, said Brendan Ryan, chairman-CEO of Foote, Cone & Belding. But the offerings of ad agencies have become more complex, and integrated marketing is a complicated thing to price.

The past year also brought a turning point on the client side, when two giant marketers -- Procter & Gamble Co. and Unilever -- revealed they were both reviewing their agency pay structures. Last week, Ford Motor Co. became the latest marketer to shift compensation setups (see story, this page).

P&G, known as the last of the large package-goods marketers to pay 15% commission, is exploring several models, such as fee-based and performance-incentive pay, a spokeswoman said.

The explosion of publicly traded agencies and holding-company ownership in the 1990's hasn't been a factor, observers said. Despite investors' overriding emphasis on revenue growth, public agencies are no more likely to lowball their pay than privately owned shops, insiders report.


Agency executives say investors don't care about media billings as long as profit margins are up.

"Whether it is private or public, [an agency has] to make money," said Philip H. Geier Jr., chairman-CEO of Interpublic Group of Cos.

In the future, issues facing agencies and their clients will be just how to compute compensation -- factoring in the hourly work and acceptable profit margin -- and how the agency/client relationship can make these new structures work.

Mr. Anderson said advertisers are beginning to demand more disclosure from agencies about how they compute the hours and costs they include in labor-based compensation, and they're negotiating more thoroughly the profit margins factored into their agreements.

The downside of labor-based compensation for the agency, said Mr. Georgescu, is that clients will see the hourly rate as a fixed cost to be controlled, not an investment.

"The natural tendency is to screw the costs down," he said.

Industry leaders say a good client will understand that an agency needs to show a profit, and agencies have to be willing to walk away from a client that doesn't.

"Is negotiating part of it? Absolutely," said Deutsch Partner and Exec VP-Business Development Director Peter Drakoulias. "But price shouldn't be part of your agency's USP."

Contributing: Laura Petrecca, Jack Neff, Jean Halliday.

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