Strategy but for Agencies: The Five Forces of Agencyland
How profitable can marketing agencies be?
Michael Porter’s Five Forces framework for analysing industry profitability has stood the test of time. As with many frameworks, it’s essentially a comprehensive checklist in diagrammatic form, separated out along a particular dimension – in this case, the variety of ways that industry characteristics cause the industry to share profit with other players.
These forces vary widely from industry to industry. Porter suggested that all business strategy can be described as choices in how to deal with the particular five forces of a given industry. As an illustration, I thought I might look at an industry which more often does the analysing rather than being analysed – marketing agencies.
Supplier Power
For agencies, by far the biggest input is labour. There are other costs to doing business, to be sure – office space, technology, subscriptions, etc. But agencies essentially buy time from skilled workers, combine their efforts in a particular way, and charge their customers a mark-up on that time. (Either explicitly in a rate card or implicitly in project fees.)
Typically in examining supplier power, one of the first things we consider is how concentrated the industry is compared to the suppliers. That is, if there are only a handful of businesses in the industry, suppliers don’t have a lot of choices in whom to sell to, and those businesses can demand preferential prices.
Another first thing we consider is how large a portion of business costs the supply represents. You might think suppliers are advantaged when their product is a relatively large cost for the industry, but the size of the cost incentivises the industry to negotiate harder, research more, etc., to keep that large cost under control.
And then there’s the question of the substitutability of any given supplier’s offering – in other words, are industry needs differentiated or commoditised? A cutting-edge PC manufacturer might need only the very best graphics chips, giving a lot of power to the few suppliers of the very best chips. But a shoe company is probably not over a barrel when it comes to buying shoelaces.
Finally, there are switching costs – how costly is it to switch from one supplier to another?
All of these boil down to two things – how price-sensitive are industry participants and how much leverage do the parties have in bargaining?
How does agency labour hold up as suppliers to the industry?
Supplier power varies with different kinds of roles and seniority.
There are many agencies, but there are also many aspiring agency employees.
Senior high-skill workers are scarce relative to the number of agencies, differentiated in value, though broadly substitutable amongst themselves.
For more junior lower-skill workers, there is typically a large number relative even to the large number of agencies, and they’re more or less substitutable among them.
There is no unionisation in agencyland.
Switching costs are relatively low, though labour regulations and on-boarding costs aren’t negligible. Once someone has a job, you can’t just swap them out for some marginal improvement, and even if you could, at the very least it would be terrible for morale.
The result is a mix for the industry. Juniors have to settle for relatively low pay as they compete with each other for roles and are broadly as valuable as each other. But the scarcer seniors can demand high pay as they bring with them valuable portfolios of past work, awards won, networks of sales leads, the promise of otherwise difficult-to-achieve quality of work, and often even personal brand (as press releases about big hires are sure to emphasise).
Supplier power in agencyland: medium (a mix of high and low).
And it’s all downhill from there.
Buyer Power
If you thought negotiating pay for senior suppliers was bad, wait ‘til you get a load of buyers. Buyer power is a mirror image of supplier power, so the same kinds of considerations apply: relative concentration, relative proportion of cost (price sensitivity), differentiated needs, switching costs.
You might think that relative concentration isn’t so bad. There are many more businesses which need marketing services than there are marketing agencies. But think of it instead in terms of the concentration of demand and supply. The relative size of most businesses’ marketing budgets, combined with the effects of three other forces on margins (new entrants, substitutes, internal rivalry), ensure the dynamics work against agencies’ favour. That is, for all intents and purposes, there is not enough client spend to go around, agencies need clients more than the other way around, and clients are therefore able to play agencies off against each other. The bargaining power sits with the clients.
In terms of price sensitivity, while marketing is not typically as large a cost to clients as labour is to agencies, the budgets are definitely big enough that clients are eager to keep those costs down. (How much more so when belts are tightened and there’s pressure on marketing teams to reduce costs.)
Switching costs aren’t insignificant. It can be a pretty big deal for a client to switch from one agency to another – they lose relationships; built-up internal expertise on the brand, company and client industry; efficient ways of working that took time to iron out the kinks, etc. In fact, the spectre of switching costs can indeed keep clients in relationships with agencies they might otherwise think about ditching, though this tends to take its toll on agencies in less direct ways. And many agencies are familiar with the sting of an established client going out to pitch, making the agency battle again with competitors to hold on to the work.
And finally, differentiation. This may be controversial, but I’m going to say that marketing agencies are highly commoditised in comparison with many other categories. I’ll add one qualifier, though: they’re commoditised within strategic groups. I’ll talk more about that in later posts, but for now, I’m suggesting that in many cases, for the purposes of clients, it’s often true that one agency is roughly as good as another.
What does all of this add up to? In general, buyers of the agency industry are both price-sensitive and have a lot of bargaining power, mitigated to some degree by switching costs.
Few things exemplify this more than the phenomenon of competitive pitching. Clients can literally ask five agencies to do tens of thousands of dollars of free work in the hopes of winning billable business. I’ve been in one pitch with an estimated $100,000 of labour was invested. Did we win? Uh… That’s irrelevant.
Buyer power in agencyland: high.
Threat of New Entrants
This force is about how easily new businesses can enter the industry and suck up demand when the market grows. It’s affected by structural barriers to entry. The more difficult it is to feasibly enter the industry, the more existing members of the industry can hold on to profits. For a simple example, consider how difficult it is to start a pharmaceutical company – both regulatory barriers and the capital required to do potentially years of R&D before a saleable product is created. (Some of these barriers are now being lowered by industry innovation, but you see my point.)
Agencyland has practically no barriers to entry. Register a company, buy a domain name, throw together a website, email a few freelancers, start trading.
Threat of new entrants to agencyland: high.
Threat of Substitutes
What counts as a substitute rather than a competitor is a question of industry definition, which is a hotly debated topic but often ends up not particularly mattering. However you draw the lines around the industry you’re analysing, players end up in the category of either internal rivalry or substitution. For our purposes here, I’d consider in-housing the main substitute for agencies.
In-house agencies are on the rise, and even for businesses who wouldn’t describe themselves as having an in-house agency, the option is there for many of them to do their own marketing – their own strategy, creative, design, etc., even if they’re bringing in individual contractors for particular tasks.
Admittedly, for those clients who have not built the full capabilities of an agency internally, the quality of the work may be lower than what could be offered by the typical agency. But given the aforementioned price sensitivity, “good enough” advertising work from a team being paid salaries may appear preferable to award-winning work by an agency which charges several times the labour cost of the inputs, let alone the additional cost of account management, etc.
Substitutes are often of a lower quality than the industry overall, but they put caps on the prices the industry can charge for its products and services. If the whole industry is generally too expensive, the substitute becomes preferable despite the compromise on quality.
And plenty of in-house agencies don’t compromise on quality at all. They benefit further from tight relationships and smooth communication within the business, among other advantages.
Why haven’t I included AI as a substitute? The impact of AI will be mediated through multiple forces – reducing supplier power, lowering barriers to entry, increasing the appeal of substitution.
Threat of substitutes to agencyland: high.
Internal Rivalry
And finally, internal rivalry. Typically internal rivalry lowers the profitability of an industry by forcing participants to spend money on marketing and compete on price.
In my last post, I talked about excess share of voice as a theoretical causal factor in growing market share. That is, if every participant in a market doubles their advertising budget while spending proportionately to their market share, no one’s market share grows. In essence, the industry as a whole wastes those resources and, unless the cost is passed on to customers, everyone’s profit declines. But if some competitors start increasing their spend, everyone has to follow suit to hold on to their share.
That doesn’t come into play much in agencyland. Agencies don’t typically market themselves with anything like the aggression we see in many categories. But that doesn’t mean there aren’t significant costs in agencies competing with each other. As mentioned above, competitive pitching is a huge cost to the industry. In a pitch with five participants and each investing an average of $50,000 of billable head hours, the only thing we can know for certain is that about $200,000 of industry effort disappears into the ether. Multiply that by many times, and many millions of dollars are shaved off the profitability of the industry as a whole.
Another aspect of the cost of agency competition is the role of awards. Awards are valuable to agencies, but are often costly to win for several reasons. To win awards, agencies will often compromise on price – for example, doing work for a non-profit which is billed at, or even below, cost. Or if a potentially award-winning opportunity for a client is identified, the agency will over-invest in that work, erasing already small margins to ensure the finished product has the best chances of winning. And after the work is done, while entry fees are relatively negligible, there is a labour cost attached to the time it takes to craft a good award-winning entry.
The other side of internal rivalry is competing on price. As I’ve suggested above, within strategic groups, agencies are often more or less interchangeable. They don’t want to believe it, but the fact is that an agency whose fees are significantly higher than competitors will struggle to justify that premium in comparison with the other options. Agencies get squeezed on agreed rate cards, promised deliverables in retainers, etc., all in the name of winning (or keeping) business.
Finally, I mentioned entry barriers above. Related to internal rivalry, however, are exit barriers. If it is costly to shut up shop, businesses in an industry may stick around through unprofitable times simply because it’s less expensive to keep going than it is to die. As an example, consider an industry with expensive and highly specialised equipment which would be worthless to most buyers. Why does this matter? Because they keep operating and competing with other industry participants, further diluting the profit.
Agencies don’t typically have a lot of material assets – compared to many industries, it’s as easy for an agency to shut up shop as it is to start. However, there is another kind of exit barrier which is more common in agencyland: emotional attachment. That is, many agency founders are more interested in keeping their agency going than in making the most profitable choices with their lives or capital. Irrational but understandable, this may keep the profit pool more dilute than low profits would in some other industries.
Internal rivalry in agencyland: medium-high.
So those are the five forces affecting industry profitability for marketing agencies, and they paint a grim picture. From every angle, agency profitability is squeezed. There may be a bunch of factors that haven’t occurred to me, but in broad strokes, I think the biggest drivers are there.
But industry profitability does not automatically equate to business profitability. As Porter says, business strategy is about making choices to create a sustainable competitive advantage in light of those five forces. Some agencies can and do consistently return outsized profits within this environment – by behaving differently from the others.
So if you’ve read any of the above and been itching to say, “Hey, that one doesn’t apply to us!”, great news – you’re probably doing something that I’ll cover in the next few articles as I look at strategies for agency profitability in the airless hellscape that is the agencyland industry.