If Mad Men advertising hotshot Don Draper was operating on Madison Avenue today, he would find competition coming from more than just other ad firms.
A recent study by Harvard Business School professor emeritus Alvin J. Silk and colleagues finds that more companies than previously thought are developing in-house advertising capabilities, especially in technology-oriented and creative industries. Working with Silk on the study were Sharon Horsky of Bar-Ilan University and Steven C. Michael (HBS PhDBE '93) of the University of Illinois at Urbana-Champaign.
The study found that almost half of U.S. advertisers large and small operated some form of in-house advertising unit in the 1990s, a trend apparently on the increase. In this decade, Procter & Gamble, Google, and Condé Nast Media Group all introduced internal advertising units.
Why the increase in vertical integration? Potential reasons include structural changes in the advertising industry such as the unbundling of agency services, and improved communication tools that make it easier and more cost efficient for firms to manage some aspect of their own advertising campaigns.
Taken together, "this is an opportune time for managers to give serious consideration to the internalization of at least some advertising and marketing services," Silk says in this Q&A.
Sarah Jane Gilbert: Can you explain the concept of vertical integration?
Alvin Silk: Vertical integration is about a firm deciding which products and services to "make" internally as opposed to what it buys in the marketplace.
A firm may integrate "forward" into the channels used to distribute its output to customers, or "backward" into the supply chain that provides inputs the firm requires to produce and/or market its output. An in-house advertising agency is a case of backward vertical integration. Advertising services may be fully integrated in the sense that an in-house agency provides full service (e.g., strategy and creative development, ad production, and media placement).
Alternatively, a firm's advertising services may be partially integrated in the sense that the in-house agency provides only a limited range of services—say, ad production and media placement—and an independent or outside agency is relied on for other services—say, strategy and creative development.
Q: What are the advantages and disadvantages of establishing an in-house advertising resource?
A: The make or buy decision relating to advertising services is a complex one. The primary considerations involve issues of cost and control. The make or buy decision calls for a comparative analysis of two types of costs.
Can an advertiser operate an in-house agency that produces a specific set of services at a lower cost than the compensation required to retain an outside agency?
In addition, there are transaction costs. How do the costs of planning, adapting, and monitoring the development and implementation of an advertising campaign compare when the tasks are performed internally rather than by an independent outside agency?
Ownership of an in-house agency rests with the advertiser and allows the advertiser greater control over matters such as the assignment of personnel and the scheduling and coordinating of tasks than what may be obtained when working with an independent agency that serves numerous clients.
A long-standing issue is whether an in-house agency can attract and retain creative personnel as effectively as an independent agency.
Q: At what point does it make sense for a firm to bring advertising services in-house? Are there cost benefits, and do they depend on size?
A: Previous research has shown that advertising agency operations are subject to economies of scale, and hence the advertiser faces a major tradeoff in choosing between an in-house and an outside agency.
If an advertiser "buys," the compensation paid to the outside agency includes markups on its creative, production, and media costs. When an advertiser "makes," it avoids payment of the outside agency's markups, but the in-house unit may fail to achieve minimum efficient scale, thereby suffering a cost penalty.
Thus, if the firm's advertising budget is not sufficiently large to allow its in-house unit to operate at or beyond minimum efficient scale, the advertiser may sacrifice size-related economies realized by an independent agency serving numerous clients. Moreover, when negotiating compensation agreements with outside agencies, large advertisers are in a stronger bargaining position than are smaller advertisers to capture the size-related economies available to independent agencies.
Consistent with this line of reasoning, our empirical studies indicate that the likelihood of a firm internalizing advertising services decreases as the size of its advertising expenditures increases.
Q: How long does it take for an organization to establish a fully functioning in-house advertising agency?
A: The length of time required to establish an in-house unit is not a subject that has been addressed in the literature I have seen. Obviously, it will depend on the range of services to be delivered and the nature of capabilities a firm already possesses.
Q: Your research covered several different industries. Did your findings vary by industry?
A: Our study covered 69 broadly defined industries. The proportion of firms with at least some in-house advertising services varied widely across industries, ranging from about a sixth to three-quarters. Two sectors in particular exhibited a higher level of internalization of advertising services than could be accounted for by other factors: technological industries (e.g., electronics, instruments) and creative industries (e.g., publishing, motion pictures).
Q: Your study covered two years, 1991 and 1999. What do you think the findings would be now, a decade later?
A: It has sometimes been suggested that use of in-house agencies is sensitive to the business cycle, and we chose to study 1991 and 1999 because those years bracket a full business cycle in the U.S. economy.
With the passage of almost another decade, how much reliance is currently placed on in-house agencies? The Association of National Advertisers (ANA) has just released the preliminary findings from a survey on this subject conducted among members that are large national advertisers. The survey found that 42 percent of ANA member firms have established internal advertising units. Cost efficiencies and savings were reported as the major reasons for pursuing the in-house route.
In line with our finding that internalization of advertising services tends to decrease as the size of a firm's advertising outlays increases, the ANA study reports that full-service in-house agencies are a rarity among their sample of member firms that tend to expend substantial amounts on advertising. Most of the in-house units performed specialized or limited functions, such as those related to the development of direct mail, online, and promotional materials.
Q: What can managers learn from your research?
A: First, I would hope our study will serve as reminder that the choice of make or buy with respect to an advertising agency is not a case where one size fits all. The decision should be based on a careful economic analysis. Our study provides some basic insights into when an in-house agency is likely to be efficient and when it is not.
Secondly, this is an opportune time for managers to give serious consideration to the internalization of at least some advertising and marketing services. Advertisers presently face the challenge of coordinating a vast array of independent communication services and suppliers, and concerns have often been expressed about the costs and inefficiencies surrounding existing arrangements for accomplishing this. With widespread abandonment of commission-based agency compensation and the unbundling of agency services, barriers that once discouraged the establishment of in-house agencies have long since fallen away.
The present environment surrounding agency-client relations is one characterized by heightened cost-consciousness and accountability. The advertising industry is currently undergoing a major transformation as it absorbs new information and communication technologies that not only offer new media for reaching customers but also bring new tools for managing advertising campaigns. These technological changes are likely to result in shifts in production and transaction cost, and thus existing patterns of advertising agency-client relations may well undergo further changes.