When an advertising agency places an ad for a client, the medium (e.g., newspaper, TV, radio) pays a commission to the agency. If, for example, the commission rate is 15% and an advertisement costs $1,000, the advertiser pays $1,000 to the ad agency. The agency remits $850 to the medium and retains the remaining $150 as its commission. Thus, the commissions that an agency receives pay for the services it provides to the advertiser.
In addition to media commissions, ad agencies also usually mark up the cost of physically producing advertisements in a form acceptable to the media. If the media commission is 15%, for example, agencies will typically mark up production bills by a commission rate of 17.65%; that amount equals a return to the agency of 15% of the combined total of production expenses and agency commission. For example, if a production bill is $100 and the agency markup is 17.65%, the total paid by the advertiser is $117.65 and the agency commission ($17.65) is equal to 15% of $117.65.
In the jargon of the industry, media bills represent "gross" costs?that is, media rates including the agency commission. Production bills represent "net" costs, as they do not include commission and must be marked up (or "grossed up") to include the agency commission.
Around 1920, the rate for agency commissions granted by the media settled at 15%. The establishment of the level of commission at 15% reflected an accommodation between the media and agencies for the creative services the agencies provided to advertisers. The system was a subject of great controversy within the industry, pitting advertiser against agency, but ultimately it survived. The commission was allowed only to ad agencies. If advertisers bought space (or later time) directly from the media, they were charged at the gross or undiscounted rate.
The 15% commission system served as a basis for agency compensation in the U.S. until 1956, when the U.S. Department of Justice issued a consent decree that effectively abolished the system. Under this decree, all media were required to sell space and time at the net price to all buyers, instead of charging advertisers that bought space or time directly from the media the gross rate. Advertisers in the U.S. were now free to buy media at net rates and negotiate agency compensation on their own. The result was vigorous growth of alternative systems of ad agency compensation.
Today, few, if any, agency compensation arrangements are exactly alike, but three major alternatives to the traditional 15% media commission system have evolved:
- Flat-rate commissions at less than 15%.
- Downward-sliding scale commissions, in which an advertiser might, for example, pay the agency 14% on the first $10 million in media billings, 12.5% on the next $10 million of media billings and 10% on all billings in excess of $20 million.
- Labor-based fees, calculated from the actual cost of the labor assigned to an ad account, plus allocated agency overhead and agency profit at a stated percentage of revenues.
The greatest advantage of commission systems of agency compensation?even complex downward-sliding scales?is that they are simple to administer. The greatest weakness of commission systems is that the basis of agency compensation (media space/time) has no relation to either the quantity or the quality of the creative work and other services that are provided to the advertiser client by its ad agency.