Perverse Incentives
A perverse incentive is a structure built to align two parties that instead rewards the opposite of what one of them wants. A client sets up an arrangement expecting it to pull a vendor toward the client's growth, and the same arrangement pays the vendor most when the client's costs climb. Marketing has many of these structures because so much of it is bought on spend-linked terms.
How it actually works
The standard arrangement is spend-linked. Most agencies charge a percentage of ad spend or a retainer that scales with the scope of work, so the agency earns more as the client spends more. Software is often sold per seat, and cloud and token vendors bill by storage and consumption. Each of these can be a fair way to price a service.
The arrangement fails when it is assumed to align the vendor's earnings with the client's profit. Under a percentage-of-spend fee, the vendor's revenue rises with the client's spend whether or not the client's profit rises with it.
The effects compound over time. Spend-linked advice tends toward more budget, more channels, and more campaigns, independent of whether the current ones drive profit. Once a budget is growing, no one questions it. And when the firm running the analysis also sells the media or the creative, reporting that something does not work reduces that firm's own revenue. The alignment test is mechanical: a fee is aligned when it is a function of the client's profit or a fixed scope, and misaligned when it is a function of the client's cost base, because a vendor paid on the cost base earns more as the cost base grows. The test has an observable symptom: a spend-linked vendor whose recommendations never include cutting anything is supplying evidence of the misalignment, since some share of any budget is always cuttable.
In practice
At a large insurance brand, the incumbent agency both sold the ads and reported on their performance, and its first three-month test showed a lower acquisition cost. A $7 million renewal rested on that result, and for the brand the renewal meant a 20% increase in ad spend. An independent review with control of experiment design, measuring net new acquisitions, found the reported gain came from a seasonal rise in demand. Acquisition costs rose in every treatment where the ads ran, and the renewal did not happen. The agency's fee structure had rewarded the spend the test was justifying. The mechanism has a documented history. The Beech-Nut Packing Company wanted to sell more bacon, so Edward Bernays got 4,500 doctors to confirm that a hearty breakfast was healthier than a light one, then published the results in newspapers across the country (Tye, The Father of Spin: Edward L. Bernays and the Birth of Public Relations, 1998). In Propaganda (1928), Bernays outlined how to sell pianos without asking anyone to buy a piano: convince architects to include music rooms in their home designs. Industry narratives still walk that line, which is why the question worth asking of any handed conclusion is who wins if you believe it ([manufactured industry narratives](/insights/why-your-vendors-win#manufactured-industry-narratives)). The counter-structure is a fee that cannot move with your spend: our engagements are flat, scoped up front, and not tied to budget, so the advice is free to point at cutting a cost.
Where we come in
We scope every engagement up front, as fixed-scope, fixed-bid work that is not tied to client spend, so the return is planned from the start and our advice can point at cutting a cost. On the Potbelly turnaround, that alignment came first; efficiency was proven at level budget before scaling, and we have run the same go-to-market work with Digital Realty and Equinix.
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Related terms
- Principal-agent problem
- The gap that opens when the hired party, the agent, has goals that diverge from the hiring party, the principal, and holds information the principal does not.
- Agency fee models
- Percentage-of-spend ties the fee to a share of the media budget; a scaling retainer ties it to the scope of work. Both rise as spend rises.
- Usage-based pricing
- Billing set by consumption, such as seats, storage, or tokens, so the vendor earns more as usage grows.
- Contingency vs fixed fee
- Contingency ties payment to spend or another moving variable; a fixed, scoped fee is set up front and does not move with the budget.