0 Overhead and the Truth about Efficiency Metrics

1 Why This Topic Matters Cost based compensation agreements are still the norm with clients and agencies. Confusion exists about what can be determined from an agency’s overhead rate. Many people incorrectly believe overhead rates are indicators of efficiency. We have to provide simple and effective ways of correcting the misperceptions if we are to have production negotiations.

2 The Fundamental Myth Efficiency can not be determined from Overhead Rates High overhead ≠ inefficient Low overhead ≠ efficient There are no benchmarks of standard overhead rates

3 Where Did Overhead Rates Come From? Circa 1990,when moving from media commissions…. Clients wanted to pay the agency so it could earn a reasonable profit without any windfalls - or losses. The agency’s internal cost accounting reports were the source of the agency’s overhead rate.

4 An understanding of overhead rates is essential to correcting the misperceptions that surround the marketing industry. Where to Start

5 Cost Total (000) Client Time (“Direct’) Overhead (“Indirect”) TOTAL Cost Total (000) Client Time (“Direct’) Overhead (“Indirect”) 1. Senior Person 2. Junior Person 3. Support Sub Total Rent, Utilities IT, Office Supplies Travel, New Biz, Other Sub Total TOTAL Cost Total (000) Client Time (“Direct’) Overhead (“Indirect”) 1. Senior Person Junior Person75 3. Support25 Sub Total Rent, Utilities IT, Office Supplies Travel, New Biz, Other Sub Total TOTAL Cost Total (000) Client Time (“Direct’) Overhead (“Indirect”) 1. Senior Person Junior Person75 3. Support25 Sub Total200 Rent, Utilities50 IT, Office Supplies50 Travel, New Biz, Other50 Sub Total150 TOTAL350 Cost Total (000) Client Time (“Direct’) Overhead (“Indirect”) 1. Senior Person Junior Person75 3. Support25 Sub Total Rent, Utilities50 IT, Office Supplies50 Travel, New Biz, Other50 Sub Total150 TOTAL Cost Total (000) Client Time (“Direct’) Overhead (“Indirect”) 1. Senior Person Junior Person75 3. Support25 Sub Total Rent, Utilities50 IT, Office Supplies50 Travel, New Biz, Other50 Sub Total150 TOTAL Direct staff costs are “marked up” to adequately recover all the other agency expenses Cost Total (000) Client Time (“Direct’) Overhead (“Indirect”) 1. Senior Person Junior Person75 3. Support25 Sub Total Rent, Utilities50 IT, Office Supplies50 Travel, New Biz, Other50 Sub Total150 TOTAL Overhead = indirect direct × 100 Overhead = 175 × 100 Overhead = 100% Simplified Overhead Calculation: 3-person Agency

6 How Real Life Overhead Calculations Differ Calculating the overhead rate for a 3 person, 30 person or a 300 person office follows the same process as this example. The only difference between these examples and real life is this: For each client facing employee, the time spent on non- client time is treated as overhead (Indirect) and not as a Direct cost.

7 Four examples of how high (and low) overhead rates are misinterpreted

8 We’ll explore four different agencies, each of them a simple 3-person shop, with similar services, space and infrastructure. Our starting point: this 3-person agency, with a 100% overhead rate, is the baseline for comparison to the next four agency examples.

9 Agency 1: 3-Person Agency (baseline) Cost Total (000) Client Time (“Direct’) Overhead (“Indirect”) 1. Senior Person Junior Person75 3. Support25 Sub Total Rent, Utilities50 IT, Office Supplies50 Travel, New Biz, Other50 Sub Total150 TOTAL Overhead = indirect direct × 100 Overhead = 175 × 100 Overhead = 100%

10 This is what this exercise will show 2. An agency with a lower overhead rate than our baseline is more expensive. 3. An agency with a higher overhead rate than our baseline is less expensive. 4. A decision to be more efficient, by reducing staff costs creates a higher overhead rate. 5. Faster growing markets – like India - with lower staff costs, have extremely high overhead rates - but still have lower fees.

11 Agency #2: Pays its employees 10% more, on average, than our baseline agency, and the overhead rate goes down.

12 Cost Total (000) Client Time (“Direct’) Overhead (“Indirect”) 1. Senior Person Junior Person83 3. Support28 Sub Total Rent, Utilities50 IT, Office Supplies50 Travel, New Biz, Other50 Sub Total150 TOTAL Overhead = indirect direct × 100 Overhead = × 100 Overhead = 92% Agency 2: 10% Higher Staff Costs Overhead is reduced to 92% - but there is no implicit improvement in efficiency

13 Agency #3: Pays it’s employees 10% less, on average, than our baseline agency, and the overhead rate goes up

14 Cost Total (000) Client Time (“Direct’) Overhead (“Indirect”) 1. Senior Person90 2. Junior Person68 3. Support22 Sub Total Rent, Utilities50 IT, Office Supplies50 Travel, New Biz, Other50 Sub Total150 TOTAL Overhead = indirect direct × 100 Overhead = × 100 Overhead = 109% Agency 3: 10% Lower Staff Costs Overhead is increased to 109% - but there is no implicit decline in efficiency

15 Agency #4: Invests in productivity tools and replaces the junior person with someone less expensive, the overhead rate goes up. 15

16 Cost Total (000) Client Time (“Direct’) Overhead (“Indirect”) 1. Senior Person Junior Person50 3. Support25 Sub Total Rent, Utilities50 IT, Office Supplies60 Travel, New Biz, Other50 Sub Total TOTAL Overhead = indirect direct × 100 Overhead = × 100 Overhead = 123% Agency 4: Invest in Productivity Tools Productivity tools to reduce staff costs with a minimal increase in IT costs cause an increase in the Overhead rate

17 In Mumbai, rent is more expensive than New York. Expenses such as phones, computers, office equipment and IT are no less expensive. Salaries paid to employees are dramatically lower leading to a significantly higher overhead rate. 17

18 Agency 5: Developing Market - Mumbai Cost Total (000) Client Time (“Direct’) Overhead (“Indirect”) 1. Senior Person40 2. Junior Person20 3. Support10 Sub Total Rent, Utilities50 IT, Office Supplies50 Travel, New Biz, Other50 Sub Total150 TOTAL Developing markets have extremely high Overhead rates, but are not considered inefficient Overhead = indirect direct × 100 Overhead = × 100 Overhead = 267%

19 Overhead, Fee and Hourly Rate Summary 19 Agency Overhead Rate Agency Cost (000) Fee (000) 20% Profit Hourly Rate (1,800 year) Agency 1 (Baseline) 100%350438$122 Agency 2 (10% increase) 92%371464$129 Agency 3 (10% decrease) 109%330413$115 Agency 4 (Productivity) 123%335419$116 Agency 5 (Mumbai) 267%220275$76

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21 Sample Overhead Rates for US Agencies Office Size - Headcount Overhead % Sample Creative / PR / Media Agencies 2012 data - % based on salary and all related staff costs - Assumes 75% direct / total staff cost ratio Many data points, no benchmarks

22 If overhead recovery rates can’t be benchmarked, what can? 1. Total fee relative to service provided 2. Total fee per person 3. Blended hourly billing rate across a team 4. Hourly billing rate by function

23 In Conclusion Overhead rates are not efficiency metrics and do not imply high or low cost of agency services. Assorted data points should not be confused as benchmarks. Benchmarks of actual overhead can not be calculated.

24 Overhead and the Truth about Efficiency Metrics Thank you

25 1. Benefits as Employment Cost: Common Method Cost Total (000) Client Time (“Direct’) Overhead (“Indirect”) 1. Senior Person Junior Person75 3. Support25 Sub Total Rent, Utilities50 IT, Office Supplies50 Travel, New Biz, Other50 Sub Total150 TOTAL Overhead = indirect direct × 100 Overhead = 175 × 100 Overhead = 100% Social taxes and benefits are costs of employment and are included in the ‘Direct Costs’ allocation

26 Cost Total (000) Client Time (“Direct’) Overhead (“Indirect”) 1. Senior Person85 2. Junior Person65 3. Support20 Sub Total Social taxes, benefits30 Rent, Utilities50 IT, Office Supplies50 Travel, New Biz, Other50 Sub Total TOTAL Overhead = indirect direct × 100 Overhead = × 100 Overhead = 133% 2. Benefits in Overhead: The less common calculation When social taxes and benefits are moved into the Indirect column, the calculated overhead rate is higher

27 Cost Total (000) Client Time (“Direct’) Overhead (“Indirect”) TOTAL Cost Total (000) Client Time (“Direct’) Overhead (“Indirect”) 1. Senior Person 2. Junior Person 3. Support Sub Total Rent, Utilities IT, Office Supplies Travel, New Biz, Other Sub Total TOTAL Cost Total (000) Client Time (“Direct’) Overhead (“Indirect”) 1. Senior Person Junior Person75 3. Support25 Sub Total Rent, Utilities IT, Office Supplies Travel, New Biz, Other Sub Total TOTAL Cost Total (000) Client Time (“Direct’) Overhead (“Indirect”) 1. Senior Person Junior Person75 3. Support25 Sub Total200 Rent, Utilities50 IT, Office Supplies50 Travel, New Biz, Other50 Sub Total150 TOTAL350 Cost Total (000) Client Time (“Direct’) Overhead (“Indirect”) 1. Senior Person Junior Person75 3. Support25 Sub Total Rent, Utilities50 IT, Office Supplies50 Travel, New Biz, Other50 Sub Total150 TOTAL Cost Total (000) Client Time (“Direct’) Overhead (“Indirect”) 1. Senior Person Junior Person75 3. Support25 Sub Total Rent, Utilities50 IT, Office Supplies50 Travel, New Biz, Other50 Sub Total150 TOTAL Direct staff costs are “marked up” to adequately recover all the other agency expenses Cost Total (000) Client Time (“Direct’) Overhead (“Indirect”) 1. Senior Person Junior Person75 3. Support25 Sub Total Rent, Utilities50 IT, Office Supplies50 Travel, New Biz, Other50 Sub Total150 TOTAL Overhead = indirect direct × 100 Overhead = 175 × 100 Overhead = 100% Simplified Overhead Calculation: 3-person Agency