P&G, Reckitt Production Changes Threaten Volume Discounts for Agencies

Procter & Gamble and Reckitt Benckiser will force their ad agencies to choose commercial production vendors from a pre-approved shortlist of providers, according to Brandweek. The vendors would then have to agree to fixed prices for two years. The move will affect Reckitt agency Euro RSCG and P&G's Saatchi & Saatchi, Grey Group and BBDO.

The news sounds dull -- please, tell me more about the agency billing process! I hear you cry -- but is in fact fascinating once you understand what is going on behind the scenes. Here's the crucial line from Andy McMains' story:

As one source put it, "The agencies are on board with these plans because they have to be. But they hate it."

Think carefully about that statement. If vendor production expenses are simply billed back to the client, via the agency, at cost, why would an agency "hate" restrictions on vendors or their bills?

Brandweek's story suggests that agencies feel passionately about this because it restricts their artistic choices. P&G has banned expensive 35mm film, for instance. But are agencies really angry because they believe that an image of a box of Tide will somehow suffer if it isn't captured in the medium of Truffaut?

Of course not. Agencies are angry because greater client control of vendor costs threatens to end a revenue stream that agencies have long enjoyed, especially in Europe: The "volume discount rebate" or "override."

(BNET would like to make it clear that none of P&G or Reckitt's agencies have been accused of retaining volume discounts.) Here's how volume discount rebates work. The agency chooses a production vendor, a printer or TV commercial director, for instance. The agency then bills the client for the cost of the vendor's services. At the end of the year, however, the vendor may thank the agency for the business -- especially if there is a lot of it, and it's ongoing -- by returning to the agency a "volume discount," perhaps 10 percent.

At this point, the agency faces a dilemma. Modern client contracts usually contain language that requires bills to be expensed at net, not gross, or that discounts must be returned to the client. But if the agency books the rebate separately from the client's account, it will look like an unrelated revenue stream that the agency can keep. As clients do not normally get the right to audit an agency's entire books (just their own account), the chances of a client finding that rebate are slim.

Keeping the money, however, is fraught with danger. If a client contract is strictly worded, it amounts to outright fraud. At the very least, it is the type of ethical conflict of interest good agencies ought to avoid.

It was at one time a common and accepted business practice in the U.K. to keep a client's volume discount rebate. But internationally, the practice led to controversy:

Leo Burnett settled with the U.S. Army in January 2009 for $15.5 million a case in which it was accused, in part, of marking up bills for pass-through expenses that were supposed to be billed without profit.
The former head of Aegis Media in Germany stood trial in October 2008 for allegedly diverting â‚¬51 million in air-time that TV stations had given him, and selling them via his own private company.
In February 2008, GroupM CEO Irwin Gotlieb proposed in BusinessWeek that his agency be allowed to keep rebates earned by his media buys, which total $60 billion annually. Gotlieb said clients would be fully informed of the practice if they agreed to it.
In 2005, IPG gave back $250 million to its clients in so called "Agency Volume Bonification" monies â€" rebates that the agency initially kept but eventually returned when an accounting scandal forced the agency network to restate its financial numbers. That practice was made illegal in France in 1993.

What is surprising about P&G's move is that it didn't occur earlier. It is also surprising that the new procurement rules leave in place the potential for abuse. Brandweek:

P&G and Reckitt, whose global ad spend last year is estimated at $1.3 billion, still expect their creative shops to manage the production partners, including the processing of their bills, according to sources.

If the agencies are still managing the vendor choices, even under new restrictions, then those vendors that make the cut are still in the position to offer volume discount rebates. The advantage for clients seems only to be that with prices fixed, the margin for abuse has been narrowed rather than abolished completely.

Image by Flickr user happyeclair, CC.

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