Brian O’Kelley of AppNexus wrote an interesting article last week in ClickZ affirming the ad networks’ rightful place on the agency media plan. He encouraged ad agencies to worry less about about the ad networks’ business — i.e., those tantalizing 70% margins reported in SEC filings — and more about their client’s business. After all, if you are able to do a better job for your client, who cares if it causes someone else to make more profit? This is good rational advice, but its not the way humans ordinarily think.
Take the Ultimatum Game, a psychology experiment that examines decision-making processes. Here’s a quick summary that I found on Ars Technica:
The basic rules of the Ultimatum Game are simple. One person is given a stack of cash, and told to divide it between themselves and a second party. That second party is then given the chance to accept or reject the offer; if it’s rejected, neither of them get any money. Clearly, any of this free money should be better than nothing, so under assumptions of strictly rational behavior, you might expect all offers to be accepted.
They’re not. Things in the neighborhood of a 50/50 split are accepted, but as the proportions shift to where the person issuing the ultimatum tries to keep seventy percent of the total, rejections increase. By the time they hit an 80/20 split, nearly 70 percent of the offers are rejected, even though that 20 percent of the total cash would leave the recipient better off than where they started.
Some agencies fall into the same trap, leaving 20 cents of client value on the table because they can’t stomach another supplier taking 80 cents.
If you’re focused on buying marketing inputs (e.g. impressions) as cheaply as possible and you demonstrate value by referencing the savings you’ve generated, then you’re a procurement officer and you create value by hammering away on your suppliers’ margins. If you’re focused on delivering marketing outcomes (e.g. consumer engagements, a few points in brand lift, sales) by properly pricing marketing inputs, then you’re a strategic partner and you create value by building your clients business. I know this seems a bit polarizing, but I do believe these are distinct mindsets and people are usually operating in one or the other.
We’re at a transformative moment in the media business. The advertising value chain is playing a game of musical chairs and, for better or worse, you’re going to be sitting in a different chair a few years from now. The question is: what chair do you want to land in? The mindset you take today will decide your role in the future.
[...] Greg Hills references the "Ultimatum Game" and looks at how the game plays out between a vendor (any type of vendor) focused on margin versus one focused on being a strategic partner. For the second outcome, Hills outlines, "You’re focused on delivering marketing outcomes (e.g. consumer engagements, a few points in brand lift, sales) by properly pricing marketing inputs, then you’re a strategic partner and you create value by building your clients business." Hills thinks you will be one or the other. [...]
What are you if you create BUSINESS outcomes? Or marketing outcomes that *lead to* business outcomes? What are you if you don't run from accountability but embrace it?
What are you if you design marketing to discover and capture demand?
No, you're not a salesman. You're a money-maker, not a money spender. You're a marketing professional unlike most. You're a leader.
Hi Greg,
The logic you present only works in a single-play game. If there's an expectation that the game will be repeated, it is rational to hold out for a 50/50 split (a “tit-for-tat” strategy in game theory).
I think people are socially conditioned to believe that they'll have repeat interactions with their professional network. In this case, economic self-interest drives them to understand more about (and eventually try to capture) the big margins…
http://en.wikipedia.org/wiki/Repeated_game#Repe...
Graham.
You're right, it makes sense to consider iteration if I'm referencing Game Theory.
To respond within the confines of my hypothetical Ultimatum game — for true iteration, you'd need the agency actor saying yay-nay the first game to play as the vendor in the 2nd game and set the split.
Interestingly, there isn't much of a revolving door between buy-side and sell-side in advertising, as there is with lobbyists and politicians in government. So the iteration dynamics aren't as strong as they might be.
I think the fact that there isn't much of a revolving door reinforces my point that the two are distinct mindsets.
i wish we had 70% margins. we have 10% bottom line margins. you can check our filings…
i like the game theory example but i think its over simplified because there are marketing outcomes associated with every campaign and
it has more to do than the number of turns each player has. What we have invested in provides a much more effective outcome than what any of the trading desks can do themselves. so the example above doesnt take into account what i could do with my % and what you can do with your % and the utility we could each derive.
imagine if someone asked us to split a million dollars…if we each live in new york city, thats going to affect my decision very differently than if i live in kansas city where i would be willing to take a much smaller % and still derive equal utility.
its the right thought just a bit over simplified.
OK, yeah that was really lazy of me to parrot a number like that. Maybe I can redeem myself by shedding some light on something that isn't perfectly understood by many, including myself. I took Intro to Accounting & Finance and you're the president of a publicly traded company, so I'm going to depend on you to correct me here
In conversations with agency executives, I've heard of fee structures where the client is charged a % of media fees in the low to mid single digits. So a few cents of every client dollar spent in media billings goes to the agency. This represents the agency's revenue. The agency deducts its costs, mostly rent and labor which are fairly variable but easy to accurately forecast. I'm not familiar with these costs personally and since the holding companies generally don't break out net income by agency, I can't learn it through the filings.
The network, by contrast, offers goods to clients on a non-transparent gross margin. It is significantly higher than the agency's gross margin, nearing 50% in some cases. However, this is to be expected since the network put capital at risk by taking media risk and investing heavily in inherently speculative technology development. All else being equal, as you rely more on technology rather than media/data tonnage to drive the same performance, your gross margin will increase even though your net income stays the same. That's the magic of accounting.
This difference in cost structure — networks having lower variable costs dragging down their gross margin but at the same time making long term investments in technology that have an offsetting effect on net income — means that a network has assets to make the same dollar go farther. So, per your comment, you can't just reshuffle the value chain while ignoring that.
I think a lot of the confusion comes from the fact that since agency net income isn't public, people compare networks and agencies on the level of gross margin which is a flawed comparison for the reasons I describe above.
OK, yeah that was really lazy of me to parrot a number like that. Maybe I can redeem myself by shedding some light on something that isn't perfectly understood by many, including myself. I took Intro to Accounting & Finance and you're the president of a publicly traded company, so I'm going to depend on you to correct me here
In conversations with agency executives, I've heard of fee structures where the client is charged a % of media fees in the low to mid single digits. So a few cents of every client dollar spent in media billings goes to the agency. This represents the agency's revenue. The agency deducts its costs, mostly rent and labor which are fairly variable but easy to accurately forecast. I'm not familiar with these costs personally and since the holding companies generally don't break out net income by agency, I can't learn it through the filings.
The network, by contrast, offers goods to clients on a non-transparent gross margin. It is significantly higher than the agency's gross margin, nearing 50% in some cases. However, this is to be expected since the network put capital at risk by taking media risk and investing heavily in inherently speculative technology development. All else being equal, as you rely more on technology rather than media/data tonnage to drive the same performance, your gross margin will increase even though your net income stays the same. That's the magic of accounting.
This difference in cost structure — networks having lower variable costs dragging down their gross margin but at the same time making long term investments in technology that have an offsetting effect on net income — means that a network has assets to make the same dollar go farther. So, per your comment, you can't just reshuffle the value chain while ignoring that.
I think a lot of the confusion comes from the fact that since agency net income isn't public, people compare networks and agencies on the level of gross margin which is a flawed comparison for the reasons I describe above.
OK, yeah that was really lazy of me to parrot a number like that. Maybe I can redeem myself by shedding some light on something that isn’t perfectly understood by many, including myself. I took Intro to Accounting & Finance and you’re the president of a publicly traded company, so I’m going to depend on you to correct me here
In conversations with agency executives, I’ve heard of fee structures where the client is charged a % of media fees in the low to mid single digits. So a few cents of every client dollar spent in media billings goes to the agency. This represents the agency’s revenue. The agency deducts its costs, mostly rent and labor which are fairly variable but easy to accurately forecast. I’m not familiar with these costs personally and since the holding companies generally don’t break out net income by agency, I can’t learn it through the filings.
The network, by contrast, offers goods to clients on a non-transparent gross margin. It is significantly higher than the agency’s gross margin, nearing 50% in some cases. However, this is to be expected since the network put capital at risk by taking media risk and investing heavily in inherently speculative technology development. All else being equal, as you rely more on technology rather than media/data tonnage to drive the same performance, your gross margin will increase even though your net income stays the same. That’s the magic of accounting.
This difference in cost structure — networks having lower variable costs dragging down their gross margin but at the same time making long term investments in technology that have an offsetting effect on net income — means that a network has assets to make the same dollar go farther. So, per your comment, you can’t just reshuffle the value chain while ignoring that.
I think a lot of the confusion comes from the fact that since agency net income isn’t public, people compare networks and agencies on the level of gross margin which is a flawed comparison for the reasons I describe above.
trust me, im no accounting guru either.
Yeah agreed, the models are just very different, and its tough to say one is deserving of more or less when its an apples to oranges comparison of business models. Agencies are vendor managers at their core with strategic capabilities layered on but essentially it’s a services model. Were operate a supply chain model…your math is right (i think), I think your point is right as well. Its like people comparing a CPG company’s margin with a retailers margin, like comparing J&J’s margin to Walmart’s…
My only issue was the example. You needed to take into account utility.
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