In our article, ‘Agency Remuneration Models Explained part I’ we discussed two of the most common models that advertising and digital marketing agencies use: monthly retainers and fixed fees. This article will take a look at two alternative models: value-based pricing and performance-based pricing.
Agencies of any size and experience level can use retainers and fixed-price fees. They are well-known and straightforward so it doesn’t take much to justify those fees. To result in a more successful engaging and efficient manner with the clients the above-mentioned methods are used. Clients are happy to agree to them so long as they receive the service required. This ensures the validity of a client avoids scams and creates a reliable image of the service provider.
So if they’re easy to agree to and are versatile, why consider the value and performance-based pricing? Hubspot found that only 12% of digital marketing agencies used value-based pricing, whereas 22% used fixed fees. Using value-based pricing results in better performance as it determines a fixed price for the product. This prevents the loss of a company as the products are driven by consumer demand. Both of the models that were discussed in our previous article place value on the time, effort, and materials used towards the product. It focuses on recovering these expenditures while making them profitable for the business or the company.
Agencies with a stronger reputation, larger income, and more experience have a better understanding of their value and demand. They can charge beyond recovering the cost of providing the service; they can add to their price from the value and outcome of their service. This is because they have branded their products making them more desirable and thus is worth more than their original value. It is harder to put a number on these but it creates the potential for greater profit margins.
However, implementing value and performance-based models requires a lot of research and carefully calculated decisions, which is probably why they aren’t as popular as retainers and fixed fees. It isn’t a simple formula of determining the monthly cash flow to run the business and hit the target profits. Value and performance-based models need to put a number on qualitative things such as reputation, customer loyalty, satisfaction, and willingness to pay. When used correctly and successfully, these models can bring higher profits to agencies and more security to the client.
Value-Based Pricing (VBP)
When agencies charge according to how valuable their product is to the client and with how much difficulty the client would be able to find an alternative, it is a value-based price. It is a model that is implemented after a lot of market research and careful calculation; it is not a vague or a random desired value. This makes it a client-centered model because it is the position of the client that determines the price more than the agency’s position. This is because the value of the product is directly based on the need of the consumers.
Benefits of VBP
The greatest benefit of this model is the greater profit margins for agencies. With hourly charges, for example, the agency prices according to overheads, employee pay, software subscriptions, effort, and market value. When an agency chooses a value-based model, they can also add their reputation, difficulty to find alternatives for the client, and lifetime benefits of the service they provide. The higher each of these factors is, the higher the profit margin is for the agency.
A business would only agree to such a model if they have studied the agency’s history and found great success. It is hard for small and new organizations to put value-based pricing to use as, without the right marketing, not much profit can be generated. The client also has to be confident that the price isn’t just an expense, but an investment that they will recover quickly because of the efficiency of the service. This adds on a responsibility on the agency to provide ideal assistance to the customers. For example, an agency that creates YouTube videos that can bring in ad revenue long after they have been posted have a long life and keep recovering costs back to the business. This means clients benefit from the fact that the agency will continue to serve them even after their partnership is over, which fully justified any expensive fees.
Overcoming the Challenges of Value-Based Pricing
‘Value’ is not a tangible figure. There is no formula to put a number on how important the agency’s service will be to a customer. This model can bring a lot of profits for an agency that has a lot of specialization and many years of experience, but it is difficult to implement. The model itself requires an expenditure of resources and funds towards extensive market research. It also requires adequate resources and a specific amount of investment capital.
Sometimes this value can actually be negative. If competitors have undervalued their services, clients will not be convinced to pay higher fees to agencies. Sole traders tend to be the greatest culprits of this: a Payoneer report on freelancers found that the average freelancer makes $19/hour, a very low rate compared to what agencies charge. If the average market value of a certain service is only $19/hour, and the providers are able to deliver a high quality of these services, then agencies don’t stand a chance to charge the actual value of the services. This makes it hard for the agencies to flourish.
This is especially difficult for services that can be commoditized, for instance copywriting and graphic design and that lone freelancer can deliver at exceptional quality and the market value is quite low. There is a skill and time that is required to provide such services. Many of Upwork’s top copywriters charge as low as $10/hour. This would make VBP detrimental for copywriting agencies as the perceived value of their service isn’t high and therefore cannot bring higher profits.
For agencies that provide more sophisticated services like video creation and event marketing, they have an edge for value-based pricing. They can easily convince clients that their products and services are elite. They are difficult to replicate for sole traders, so have a lower risk of being undervalued in the market.
Value-based pricing has often some similarities with consultancy services as it is understood as an investment and the services provided tend to have a high price point but that value can be perceived inexperience and time of execution by the agency.
A PBP model pays the agency according to what exte0nt they fulfill the client’s marketing goals. Often there is a fixed fee with additional bonuses on top based on the performance of the campaign or outcome that the agency produces. For example, an event marketing agency may charge according to sign-ups or the number of attendees to a workshop as a bonus, with a flat fee for creating the workshop in the first place. Other agencies charge only for the performance without a flat fee.
Benefits of PBP
This model, if done right, might as well be the best model because both of the parties benefit. This is necessary for the agency to be successful in its field and produce better results for the clients. It is a complete win-win: the client is fully insured that they will pay for success only and the agency can get a good deal out of this confidence deal. It is the only model that directly incentivizes results. Hourly charges incentivize time, retainers incentivize doing just enough (not excelling) and fixed price projects incentivize quickest results (not necessarily the best results).
PBP is quite similar to VBP when it comes to the non-monetary benefits. While the agency can charge high, the client is confident about making that investment because they won’t suffer losses if the arrangement doesn’t work out. Putting forward a bid for PBP also shows the agency’s confidence in delivering exceptional quality work, something that would drive the client to shake hands on the deal.
Overcoming the Challenges of PBP
What ‘performance’ is being paid for?
There are several metrics to measure. In other pricing models, this is a straightforward question because while the agency has to show results, they don’t directly depend on them for their cash flow. An agency being paid hourly usually reports on KPI improvement as a result of their hourly efforts.
But when a client has to put their money on these numbers, things change. Each lead isn’t equal anymore. The agency charges per measurable outcome, for example per lead, per click, or per a certain amount of impressions-whichever indicates to both sides of the agreement that progress is happening.
An agency has to bring performance at any cost; otherwise, they will lose a lot of money. Their performance is the major thing that they are getting paid for. Even if there is no performance to show, they are still paying for hours, overheads, and resources that go into the process. A lot of time and legal work goes into determining what counts as a ‘performance’ and what metrics can go towards payment. Not each lead is qualified and the client has to separate the leads generated from their own efforts from the leads generated by the agency’s efforts.
Putting a system in place that differentiates and tracks these KPIs may take additional costs. For other models, tracking systems are there to show overall progress and results. When money is involved, the tracking system has to be more sophisticated and precise.
How will this be tracked?
Chances are that the client already has a system in place tracking the open rates of their emails. The agency will also have their own system for tracking its own success. This could be done through monthly comparisons of profits and losses of the agency. They may have to invest in software to differentiate the efforts of the agency from the client’s previous efforts. Online websites are available to track the success of the programs.
How will both parties deal with downfalls?
In other types of agency and client contracts, the agency seldom needs to shoulder the burden of downfalls on the client’s part. However, if poor marketing or sales decisions from the clients impact their brand or marketing campaign, it will lead to fewer results generated from the agency’s marketing efforts. Since the agency is paid by performance, their cash flow will suffer and this could cause disputes.
In rare cases, a client may be involved in a scandal. Or, their business hits a rut. In this case, leads and conversion will fall short but this wouldn’t be the Agency’s fault. This is where the legal work gets tricky when it comes to deciding who shoulders the blame for what, and how the agency will be compensated when leads are toppling at the hands of the client. The agency depends on the financial and reputational security of the client to keep an income coming in as long as the agency does its part. This ensures that the client won’t be manipulated but his/her reputation would be maintained, with simultaneously not affecting the reputation of the agency itself.
Both value-based and performance-based have a focus on the outcome. However, they tend to be higher in cost because a low-cost service says ‘low value’ or ‘low performance’.
Both of these give agencies the ability to sell their services as products and packages. Our report on Marketing Agencies in 2021 revealed that agency owners want to lean toward selling their services in the same fashion as products for better consistency and administration.
These are challenging models to implement but are still used because of their efficiency in delivering a client-focused outcome. There is more accountability on each side of the party to accept the consequences of their mishappenings. The relationships have more trust and more potential for long-term work than with hourly or project-based pricing. Long-term work gives agencies more security, stability and helps improve their reputation. So, when set up and implemented correctly, VBP and PBP can be an excellent strategy for agencies to scale and earn more.