Advertising agencies use two methods to bill their clients: the labor-based fee system and the media commission system. Under the fee system, an agency bills for compensation based on the precise number of employee hours worked on behalf of a client. Under the media commission system, the agency keeps 15% of the gross ad rate set by the medium in which the client runs an ad.
Until the late 1950s, the media commission system was the dominant form of advertising agency compensation. The fee system, however, has been used since the early 20th century by agencies with accounts that were either very labor intensive or generated insufficient media commissions to compensate the agency adequately. Agencies handling clients needing multiple ads, usually in small-circulation trade publications and professional journals, have long used the fee system.
The fee method's strength lies in the direct correlation of agency service costs with the number of service hours provided by the agency. Fee compensation arrangements also provide advertisers with detailed knowledge of and control over the actual cost of agency service. On the other hand, the fee method tends to be complex and difficult to administer, requiring elaborate record-keeping and continuous dialogue regarding costs and work hours required to provide satisfactory service.
In addition, when using the fee method, the advertiser often intrudes into the agency's management and accounting practices. The routine discussion of agency costs and their components may tempt a client to impose its own precepts upon the agency, steering both away from advertising and toward accounting and managerial issues instead. Ironically, the advertiser may, in the process, preempt the managerial prerogatives of the agency that it hired precisely for its management expertise.
Although a wide variety of fee compensation systems are in use, no two are alike. The basic labor-based fee is composed of five common elements. The first is direct labor cost, or the salaries of agency personnel working on the account. Since agency employees typically work on more than one account at a time, direct labor costs usually are expressed as hourly rates. Agency employees generally keep detailed records of the number of hours spent working on individual accounts; the hourly rate is then used to convert hours worked into direct labor cost.
The second component of most fee-based systems is employee benefit costs, which correlate with direct labor costs. These include payroll taxes such as FICA and unemployment taxes and employee benefit plans such as health, life and long-term disability insurance.
Third are overhead costs, which include the costs of occupancy of an office (rent, heat, light, power, cleaning and trash removal), communications, security and the costs of agency personnel such as receptionists, accounting personnel, human resources and agency management, which cannot be charged directly to specific client accounts.
The fourth and fifth factors, respectively, are agency out-of-pocket costs associated with servicing the account and the agency's profit.
Several questions must be answered when developing a labor-based fee structure: Is the direct labor cost purely salary or does it also include the cost of taxes and benefits that follow salaries? How is the agency's overhead allocated among its accounts and what constitutes an excessive level of agency overhead? How many hours make up an employee work year? How are hourly direct labor costs adjusted when an employee works hours in excess of the defined work year? How are agency costs allocated to a client's multiple brands? What is a fair agency profit?
Beginning around 1960, when only about 5% of advertisers used fee compensation, some industry leaders began arguing for a more general adoption of the fee system. This was partially the result of a consent decree at the time, which ended the monopoly ad agencies earlier had enjoyed on media purchased at discounted prices. When media became available to all buyers at a net discounted price, some felt the commission system would be impractical. Among the most prominent was David Ogilvy, whose agency won the large Shell Oil account in 1961 on a fee basis.
By the 1980s and 1990s, however, the fee system had made significant gains. According to figures from the U.S. Association of National Advertisers, nearly one-third of American agencies were using some version of fee compensation by 1985, and by 2000, that had increased to 68%.
By the late 20th century, an increasing proportion of U.S. advertisers preferred this system, and most agencies remained flexible.