The other day I was on a flight from Chicago to Minneapolis. I sat next to a dentist who worked in the Chicago suburbs and was visiting family in Minneapolis. We traded backgrounds and then got into a conversation about healthcare.  I’ll spare you the full details of our conversation, but I do want to touch on one interesting point.  Let’s talk about two dentists:

• Dentists A: Has a practice right on Michigan Avenue in the heart of Gold Coast
• Dentist B: Has a practice in the suburbs of Naperville
• Both Dentists graduated from the same schools, with the same GPA, during the same year, have the same equipment, the same number of people on their staff, offer the same services, and accept the same insurance

In this situation, you’ll pay more to see the dentist in Gold Coast than you will to see the dentist in Naperville. The simple reason…the one single variable is overhead in the form of rent.  The rent in downtown Chicago on Michigan Avenue is substantially higher than it is in Naperville.  This makes sense, right?  Ok, so if you lived equi-distant between the two dentists wouldn’t it make logical sense to visit the one in Naperville?

If only it were that easy…that black and white.  While the above makes for a clean comparison, the reality is that the location in Chicago will offer different services (ones that cater to the surrounding audience), employ a different type of staff configuration, contain more cutting edge equipment and the physical environment will deliver on creating a certain emotion (cucumber water while you wait?).  That’s a how a business creates a point of difference when they offer the same services…they change/enhance everything else surrounding the core services.  Car dealers are notorious for this.  My BMW dealer in Minneapolis is heads and shoulders above the dealers I’ve worked with in Chicago.  From environment, to staff, to services the two dealers I’ve worked with in the Chicago area just can’t compete.

Ok, so we covered dentists and car dealers.  Let’s shift gears and talk about ad agencies.  I’ve worked for agencies and managed them from the client side.  Here’s a few things I’ve seen, managed, planned and learned when it comes to pricing:

1. Location and real estate has the biggest impact on what you’re paying an agency.  At ConAgra Foods, where I managed digital across all brands, there was roughly a 60% blended rate difference between midwest agencies and West Coast agencies.  This aligns perfectly with how expensive real estate is on the West Coast and how relatively inexpensive it is in the midwest.
2. The cost of talent is insane.  Forgetting things like salaries and benefits, the cost of keeping employees happy and replacing them should they leave is significant.  Part of what you pay for to keep an employee happy is the physical environment (Herman Miller chairs, really cool conference rooms, beer on site, etc.), training (aka conferences), variable compensation and of course the work they get to work on.
3. Everyone wants to move away from pricing based on hourly rates and towards something that’s more aligned with value pricing.  Simply put, value pricing is where the client and the agency agree that the value of the services/deliverables is X.  Different clients will value the same service differently.  Factors like how quickly you need the service will change the value of the deliverables.  Of course, with procurement teams trying to squeeze every vendor, agreeing on a a value pricing model is nearly impossible.  This keeps all parties working in a time and materials world, where the client asks for some service, the agency outlines the roles, people, rates and the hours needed for each to deliver on the client’s request.  So you’ll end up with something like Creative Director, John Smith, $300.00, 20 and $6,000.
4. Hourly rates contain 3 different dimensions.  They contain the cost to pay for the employee (their salary), the cost to pay for overhead (hardware, software, rent, benefits, etc.) and the agencies margin.  Smart folks who wanted to see their worth and how much they could ask for in terms of a raise would simply take the hourly rate X 35 (hours a week) X 50 (weeks less 2 weeks for vacation)/3 (salary is one third of the billable rate).  So in simple terms a person being billed out at $100.00 can’t be paid more than $58,333.33 a year without the agency needing to decrease their margin on that employee or cutting overhead.  Keep in mind every agency uses a “unique” formula specific to their company…but it accounts for those 3 dimensions.  The formula above is a simple way to make sense of it all.

You can see how I must be a pain for agencies to work with I really try not to be. If anything I usually understand their POV, because I’ve lived it…and I lived it a level where I was responsible for revenue reporting to our CEO.  But, just because I can understand where they’re coming from, doesn’t mean I simply accept a proposal at face value.  The question I often ask myself is “what am I paying for.”  Am I paying for an expertise we don’t have? Speed we can’t deliver on? Smarts greater than our own? Etc.  When you understand what you’re paying for you can put the proposal into the right context.

Companies are masters of creating the right buying experience.  Well, succesfull ones are.  Have you ever just window shopped in a Tiffany & Co.’s?  It’s a fundamentally different buying experience than Kay Jewelers.  But, you pay for that experience.  The cost of silver is a fixed commodity.  Yet, we pay more for less silver weight in grams at a Tiffany & Co. than we do at a Target, Kay, or Macy’s.  We tell ourselves it’s the design of the piece. That may be true.  But, the shopping experience is also more inviting. You don’t feel bad about the perceived over paying because you believe the value is appropriate.  Agencies, have been creating a buying experience like no other for years.  From the retro looking/feeling loft to the artfully adorned lobby to the 80″ Plasmas and state of the art “conference” rooms, agencies have been making it easy and comfortable to buy for years. Just remember, when you decide to work with that agency, you’re paying for all of that.  Your fees are covering the rent, the lighting, the heat, the complimentary bottled water, the lunch brought in, the talent inside the walls and the investment into the organization.

Unless you’re a non profit, you are in the business of turning a profit.  A free market allows one company to value agency X as a bargain and another company to value that same agency as over-priced.  A good relationship between client and agency often exists when both parties believe they are getting mutual value.

Things like salaries, benefits, lights, printing fees and other traditional operating expenses are easily understood.  But, often, agencies don’t do themselves any favors with making their clients feel like they’re paying for the right value.  I could wax on about this topic (and how it works both ways), but let me focus on one area: The SXSW Conference.  Here’s a post that covered the attendance by agencies at last year’s SXSW. conference. There are 3 things that jump out at me:

1. Leo Burnett sent 65 people to SXSW. Let me say that again 65.
2. If you look at the Vivaki model (Digitas, Zenith, Razorfish and Stacrom) and combine all the attendees from those 4 companies, Vivaki sent 175+ people to SXSW.
3. Noticeably absent from the list is an agency like TBWA…and other leading creative agencies like Goodby,KBS+P, Big Spaceship, Droga5, etc. sent less than 10.

If you think that list is scary, you should see the list for Cannes.

When I ask myself what am I paying for…when you ask yourself what are you paying for…it’s hard not to look at the reckless spending lines.  In a world that includes email, texting, tweeting, blogging, live video casting, internal social networks and more, doesn’t it seem like a 175 person (roughly the size of most mid-size agencies in total) cast is a just a tiny bit irresponsible?  Keep in mind the cost of the flights, hotels, meals, and event passes are being absorbed by the agency and then ultimately passed on to you in the form of billable rates.

With an economy that’s still stuck in a rut, agencies laying people off left and right, a renewed focus on being operationally lean, will we see the same turnout from agencies at this years big events like SXSW?  If we do, wouldn’t it make you scratch your head and ask, “what am I paying for?”

I’m out on blogger vacation this week. The keys to TheKmiecs.com have been turned over to a few, select, awesome guest writers. The following has not been edited by me and is the work and effort of the original author. I appreciate the time and thinking that went into this post and hope you will too. Enjoy!

It is a ridiculous notion that social media is some paradigm-shifting phenomenon whose waters can only be successfully navigated by people with the word “guru” in their LinkedIn profile. Here’s a bit of honest-true reality. Social media is nothing new — take it from somebody who has been blogging since 1997.

People haven’t changed. It’s only the tools that they—-and we-—have at our disposal that have evolved.

Before we spoke to one another at the water cooler. Today we communicate together on Twitter.

Before we listened to our customers in focus groups to develop insights. Today we listen with Google Alerts, Twilerts and ListenLogic to develop insights.

Before people responded to incentives like coupons. Today people respond to incentives like recognition, self-validation, utility—-and coupons.

Before we tried to get audiences to “click here.” Today we try to get them to “comment here.”

Big agencies and the status quo
Then why is the marketing universe freaking out? Why are big agencies completely unprepared to deal?

The answer to the first question is easy. They’re freaking out precisely because they’ve relied for so long on those big agencies who are completely unprepared to deal.

The second answer became clear to me at the iMedia Agency Summit where I saw the other Adam K. a few weeks back. A question was put to the audience during a participatory session on social media: “What does media mean today?”

My table consisted of very “new media” group: the CEO of Six Apart, the lead evangelist from Eyeblaster, a couple of women from AdFusion content network and me. We talked about media being not just new streams of communication flowing out of corporations, but ones flowing back in as well. Fairly thoughtful stuff if you ask me.

When responses from the audience were taken someone from one of those big agencies grabbed the mike a few tables over.

“Media is anything you can buy.”

Therein lies the rub. There was a great deal of talk at the Agency Summit about the “monetization” of social media. Big agencies make most of their money buying media and charging a substantial commission for it. In their eyes, media has to be limited to what they can pay someone else to place in order for it to fit into their model.

Sadly for them, those eyes are attached to their head. Which is buried in the sand. It’s too hard to change their model, so they ignore it and cling to how things have always been done.

Small agencies positioned to win
Meanwhile, smaller, nimble agencies are there to pick up the pieces. Because we are nimble, adapting our model to changing times isn’t as onerous. Because we are smaller, we can provide valuable consultation and management services that contribute to the bottom line in a meaningful way.

For instance, I believe that there is an inherent flaw in the media commission model. Whenever an agency has a financial incentive to provide one service over another, they are motivated to act out of self-interest rather than the best interest of their client.

Try telling that to an agency exec earning 11% on a $200 million media buy.

Adam Kleinberg is the CEO of Traction, a creative agency with a digital core on the California Street cable car line in San Francisco. Traction has designed cross-channel brand experiences for some of the world’s greatest brands, including Apple, Virgin Mobile, Adobe, Bank of America, Walmart.com, Norton, Alibaba.com, CamelBak and Clos du Bois. They were named BtoB Magazine’s 2009 Interactive Agency of the Year.