0 overhead and the truth about efficiency metrics

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Overhead and the Truth

about Efficiency

Metrics

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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.

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The Fundamental Myth

Efficiency can not be determined from Overhead RatesHigh overhead ≠ inefficient

Low overhead ≠ efficient

There are no benchmarks of standard overhead rates

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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.

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

Where to Start

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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 100

2. Junior Person 75

3. Support 25

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 100

2. Junior Person 75

3. Support 25

Sub Total 200

Rent, Utilities 50

IT, Office Supplies 50

Travel, New Biz, Other 50

Sub Total 150

TOTAL 350

Cost Total (000)

Client Time(“Direct’)

Overhead (“Indirect”)

1. Senior Person 100 100

2. Junior Person 75 75

3. Support 25

Sub Total 200 175

Rent, Utilities 50

IT, Office Supplies 50

Travel, New Biz, Other 50

Sub Total 150

TOTAL 350 175

Cost Total (000)

Client Time(“Direct’)

Overhead (“Indirect”)

1. Senior Person 100 100

2. Junior Person 75 75

3. Support 25 25

Sub Total 200 175 25

Rent, Utilities 50

IT, Office Supplies 50

Travel, New Biz, Other 50

Sub Total 150

TOTAL 350 175

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 100 100

2. Junior Person 75 75

3. Support 25 25

Sub Total 200 175 25

Rent, Utilities 50 50

IT, Office Supplies 50 50

Travel, New Biz, Other 50 50

Sub Total 150 150

TOTAL 350 175 175

Overhead = indirectdirect

× 100

Overhead = 175175

× 100

Overhead = 100%

Simplified Overhead Calculation: 3-person Agency

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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.

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

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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.

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Agency 1: 3-Person Agency (baseline)Cost Total

(000)Client Time

(“Direct’)Overhead

(“Indirect”)

1. Senior Person 100 100

2. Junior Person 75 75

3. Support 25 25

Sub Total 200 175 25

Rent, Utilities 50 50

IT, Office Supplies 50 50

Travel, New Biz, Other 50 50

Sub Total 150 150

TOTAL 350 175 175

Overhead = indirectdirect

× 100

Overhead = 175175

× 100

Overhead = 100%

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This is what this exercise will show2. 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.

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Agency #2:

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

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Cost Total (000)

Client Time(“Direct’)

Overhead (“Indirect”)

1. Senior Person 110 110

2. Junior Person 83 83

3. Support 28 28

Sub Total 221 193 28

Rent, Utilities 50 50

IT, Office Supplies 50 50

Travel, New Biz, Other 50 50

Sub Total 150 150

TOTAL 371 193 178

Overhead = indirectdirect

× 100

Overhead = 178193

× 100

Overhead = 92%

Agency 2: 10% Higher Staff Costs

Overhead is reduced to 92% - but there is no implicit

improvement in efficiency

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Agency #3:

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

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Cost Total (000)

Client Time(“Direct’)

Overhead (“Indirect”)

1. Senior Person 90 90

2. Junior Person 68 68

3. Support 22 22

Sub Total 180 158 22

Rent, Utilities 50 50

IT, Office Supplies 50 50

Travel, New Biz, Other 50 50

Sub Total 150 150

TOTAL 330 158 172

Overhead = indirectdirect

× 100

Overhead = 172158

× 100

Overhead = 109%

Agency 3: 10% Lower Staff Costs

Overhead is increased to 109% - but there is no implicit

decline in efficiency

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Agency #4:

Invests in productivity tools and replaces the junior person with someone less expensive, the overhead rate goes up.

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Cost Total (000)

Client Time(“Direct’)

Overhead (“Indirect”)

1. Senior Person 100 100

2. Junior Person 50 50

3. Support 25 25

Sub Total 175 150 25

Rent, Utilities 50 50

IT, Office Supplies 60 60

Travel, New Biz, Other 50 50

Sub Total 150 160

TOTAL 335 150 185

Overhead = indirectdirect

× 100

Overhead = 185150

× 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

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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.

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Agency 5: Developing Market - MumbaiCost Total

(000)Client Time

(“Direct’)Overhead

(“Indirect”)

1. Senior Person 40 40

2. Junior Person 20 20

3. Support 10 10

Sub Total 70 60 10

Rent, Utilities 50 50

IT, Office Supplies 50 50

Travel, New Biz, Other 50 50

Sub Total 150 150

TOTAL 220 60 160

Developing markets have extremely high Overhead

rates, but are not considered inefficient

Overhead = indirectdirect

× 100

Overhead = 16060

× 100

Overhead = 267%

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Overhead, Fee and Hourly Rate Summary

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AgencyOverhead

RateAgency Cost

(000)Fee (000) 20%

ProfitHourly Rate

(1,800 year)

Agency 1(Baseline) 100% 350 438 $122

Agency 2(10% increase) 92% 371 464 $129

Agency 3(10% decrease) 109% 330 413 $115

Agency 4(Productivity) 123% 335 419 $116

Agency 5(Mumbai) 267% 220 275 $76

2121

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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

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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

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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.

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Overhead and the Truth

about Efficiency

Metrics

Thank you

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1. Benefits as Employment Cost: Common Method

Cost Total (000)

Client Time(“Direct’)

Overhead (“Indirect”)

1. Senior Person 100 100

2. Junior Person 75 75

3. Support 25 25

Sub Total 200 175 25

Rent, Utilities 50 50

IT, Office Supplies 50 50

Travel, New Biz, Other 50 50

Sub Total 150 150

TOTAL 350 175 175

Overhead = indirectdirect

× 100

Overhead = 175175

× 100

Overhead = 100%

Social taxes and benefits are costs of employment and are included in

the ‘Direct Costs’ allocation

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Cost Total (000)

Client Time(“Direct’)

Overhead (“Indirect”)

1. Senior Person 85 85

2. Junior Person 65 65

3. Support 20 20

Sub Total 170 150 20

Social taxes, benefits 30 30

Rent, Utilities 50 50

IT, Office Supplies 50 50

Travel, New Biz, Other 50 50

Sub Total 180 200

TOTAL 350 150 200

Overhead = indirectdirect

× 100

Overhead = 200150

× 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