Moral Hazard in Outsourced Marketing Contracts

When an organisation outsources its marketing function to a brand activation agency, a traditional principal-agent relationship exists between the client and the agency. Moral hazard arises because the principal cannot fully observe the agency's level of effort or the efficiency with which it manages the marketing budget. Because of information asymmetry and misaligned incentives, there is an opportunity for cost inefficiency within the relationship between a client and its agency.

According to a study by the Association of National Advertisers, 35% of marketers on the client side believe that their agencies have conflicting incentives to meet their business objectives. In addition, the ANA's report on media transparency showed that undisclosed rebates and lack of transparency in trading practices cost US advertisers approximately $3-4 billion per year. While not all of these costs can be attributed solely to moral hazard, they illustrate the economic consequences of opaque contractual arrangements and incentive misalignment.

The Nature of the Incentive Structure and Its Limitations

Two of the most common forms of outsourced marketing contracts are retainer-based contracts and percentage-of-spend agreements. Both of these types of agreements encourage agencies to behave in a way that is contrary to the expected outcome. For example, an agency compensated through a time-based or retainer agreement will not be rewarded based upon the number of clients satisfied or the amount of revenue generated. In addition, the percentage-of-expenditure model is a model that is still commonly used for the purchase of media, and it creates incentives for agencies to encourage clients to spend money, regardless of whether the additional dollar generates a return on investment. Agencies that operate according to a fee structure based on a percentage of media spend are incentivised to spend as much as possible on advertising to maximise their commission. For example, if an agency acts as the representative for a client with a £15 million media spend, the agency would receive £300,000 in commissions from this campaign, and if the client increased their media spend to £20 million, the commissions would increase to £375,000 (an increase of £75,000), even if the additional £5 million generated diminishing marginal returns. Since the client does not have access to the media marketplace in real-time, attribution data, or the agency's relationships with media suppliers, they are at a structural disadvantage in identifying this behaviour. Economists describe this problem as one of hidden action, a form of moral hazard arising because the client cannot perfectly observe the agency's behaviour.

The emergence of performance contracts with advertising agencies has offered clients some relief, but has also introduced distortions into the marketplace. Performance contracts generally include a payment structure based on measures such as "cost per acquisition" or "return on ad spend." Most agencies operating on a performance basis tend to focus on optimising the most easily measurable performance metrics (i.e., click-through rates, conversions) to the detriment of building a brand over the long term through brand awareness and brand-building tactics. A brand activation agency with a pure performance-oriented brief may over-emphasise conversion opportunity initiatives and under-emphasise experiential and awareness-building investment initiatives.

Volkswagen's recent agency consolidation exercise is a real-world example of the above dynamics. In 2023, Volkswagen embarked on a process to consolidate its roster of global agencies. One of the drivers of this consolidation was the revelation through internal audits that across its multiple agency relationships, Volkswagen was paying substantially different prices for functionally identical services that were delivered by agencies that were representing themselves as direct competitors.

A similar example is provided by Procter & Gamble's 2017 agency cull, which reduced the number of agencies supporting P&G from approximately 6,000 to fewer than 2,500. Jon Moeller, then CFO of Procter & Gamble, stated that the reason for this decision was to reduce inefficiencies and lack of accountability across the spend ecosystem, and Procter & Gamble has publicly stated that it reduced its agency and production costs by $750 million in a single fiscal year as a result of eliminating unnecessary agency relationships, suggesting that prior to the decision to reduce its agency roster, Procter & Gamble was spending an amount equal to or greater than that amount due to an inefficient fee structure.

To mitigate the effects of the information asymmetry created by agency-client relationships, clients have begun to use several different contractual mechanisms to require increased transparency from their agency partners. Some of the contractual provisions that have been implemented include open-book accounting provisions that require agencies to share the actual costs and markups on their media services. Independent third-parties, such as Ebiquity and FirmDecisions, offer independent auditing services to provide clients with accurate verification of their agency billing practices and are able to identify discrepancies between what clients expect to pay and what they are billed.

Though these new mechanisms have narrowed the gap between agency-client relationships, none of them are capable of fully closing the gap. There will continue to be situations in which agencies possess a greater degree of information than their clients do, specifically in the areas of programmatic trading and establishing fair market rates for influencer pricing. As the overall complexity of marketing continues to increase, so too will the potential for moral hazard, as a direct correlation exists between the complexities of a business and the potential opportunities for moral hazards arising from a lack of transparency and lack of ability for one party in a transaction to observe the actions of the other party.