As a digital agency leader, having precise, consistent data is essential for making crucial decisions without added stress. But, if you’re here, you’re probably aware that getting there is easier said than done.
Simplifying the process of measuring and improving agency profitability is the focus of this post, providing key insights to help you and your agency plan for the future.
I’ll get you the formulas and benchmarks you’ll need to do this at your own agency, and I’ll also hold your hand through an example step-by-step.
If you've ever felt frustrated trying to measure key metrics in your agency, keep reading.
Step 1 - Getting your Finances in Order
How profitable is your agency?
Typically, agency owners will look to their P&L for these insights. There is nothing wrong with looking for them there, but whether or not you’re seeing the correct numbers is another story.
If you’re thinking “Well, I need to see my profit”, you’re only partly right. You also need visibility on other numbers. Here is everything you need to see:
Revenue
Agency Gross Income (AGI)
Delivery Margin
Overhead Spending
Profit
That’s it. Let’s expand on that:
Revenue
You’re going to need to see how much money is coming into your business, in other words, the Revenue for the company.
While this is standard in all accounting practices, the catch is that some don’t differentiate between Revenue and Other Revenue.
Anything coming into your business that isn’t revenue that your team has earned (so things like interest on investments, rent from the building you own, or revenue from the tech startup you’re incubating on the side should be isolated in “other revenue”).
By basing these calculations on Revenue, you’ll be using cleaner inputs, leading to more accurate representations of profitability.
Isolating the revenue attributed specifically to the core function of that business is an important first step.
AGI (Agency Gross Income)
The next step is to calculate your Agency Gross Income (AGI). This is your Revenue, minus any Pass-Through Expenses.
You’ll want to remove other income that you’re getting but passing on to external vendors, like a white-labeled service, ad spend, print budgets, materials, etc.
The primary purpose of identifying AGI is to clarify the amount of revenue that your agency is responsible for earning in order to properly measure and benchmark other metrics.
If you don’t remove this income, you might start to think you’re bringing in a lot more cash than you actually are.
This isn’t to say that there is anything wrong with white-labeling services – I’ve seen it work many times.
What truly matters is how your margins look on your end, which leads us to the next metric you need to see on your P&L, Delivery Margin.
Delivery Margin
With your Agency Gross Income clear, now you’ll need to figure out how much of that AGI you’re keeping after you provide the work.
I call this Delivery Margin - the ratio of each dollar your agency retains. You may think of this as “Contribution Margin” or “Gross Margin” if you have an accounting background.
This metric is calculated by using the following formula:
AGI - Delivery Costs / AGI
Note: A Delivery Cost is really what it costs you to deliver work. It’s mostly the cost of your delivery team, but also can include Shared Delivery Expenses which are applicable to your Delivery work as a whole, but not necessarily one particular project (like an Adobe Creative Cloud Subscription for your Delivery Team).
The big unlock here is that by isolating Delivery-only costs, AKA the cost of your Delivery Team members and the tools they use, you’ll know this margin without the numbers being skewed by other department salaries (internal sales, marketing, administration, etc.) or any of the other tools they use or expenses they have.
It’s critically important to isolate the portion of your payroll, software and other costs related to delivery so you can identify the true margin of your service offerings.
A healthy target for your Delivery Margin number (on your P&L) is 50%+.
Overhead Spending
Now, let’s account for, well, the Non-Delivery expenses that I’m sure you’ll have plenty of. You can group your Overhead Expenses however you like, but make sure to keep it within 20-30% of your AGI to keep it in check.
I break this out into:
Admin (internal bookkeeping/accounting, legal, executive assistants, etc.)
Sales & Marketing (sales for your agency, internal marketing like your website, content, etc).
Facilities (rent, utilities, equipment, etc.)
General guidelines are to target spending in the range of 8-14% on Admin, and the same on Sales & Marketing. Then, 4-6% of AGI on Facilities.
I’ve come to notice that cutting Overhead Costs is one of the first alarm bells a digital agency owner will ring when profit starts dwindling.
You can make small sacrifices here and there, and you’ll notice slightly improved numbers. Often, it will appear that your overhead spending is too high relative to AGI, but the problem is often that the AGI you’re earning with your team is too low relative to their cost.
Where the true unlock lies is in your Delivery Margin. I’ll show you later how to improve that number.
Profit
At the end of it all, you have profit left over. That’s your Revenue, take away Delivery Costs (shared or not), Overhead, and Pass-Through Expenses. The benchmark to aim for here is above 20% of AGI. 30% is great performance, 40% is world-class.
Finances Example
Let’s go through an example of what these numbers could look like for a small marketing agency using all of the above terms.
Consider you’re a full-service marketing agency that did $1M in Revenue last year. This revenue is coming from delivering your services (and not interest gained from investments, or other income). Then, consider that your agency provides all marketing agency services except for SEO. You white label that out to a vendor, and pass on that expense to the client. Let’s say last year this totaled $20,000. Therefore, your AGI is going to be:
AGI = $1,000,000 - $20,000
AGI = $980,000
Let’s also suppose that your Delivery Costs (the cost of your Delivery team, along with some Shared Delivery Expenses) amount to $490,000 for the year. Therefore, your Delivery Margin will be:
Delivery Margin = ($980,000 - $490,000) / $980,000
Delivery Margin = 50%
Delivery Profit = $490,000
Next, let’s assume Overhead Spending to be at $300,000 for the year. That would be your Admin, internal S&M and Facilities costs summated.
The Profit leftover from that is simply your Delivery Profit minus any Overhead Expenses:
Profit: $490,000 - 300,000
Profit: $190,000
Leaving us with a profit margin of around 20%.
This number is decent but could be better. Most clients I work with jump to cut Overhead Spending to improve profitability.
While there may be room for slight improvements there, the real opportunity to move the needle is in the highlighted area - around your AGI, Delivery Costs, and Delivery Margin.
Revenue | $1,000,000 |
AGI | $980,000 |
Delivery Costs | $490,000 |
Delivery Margin/Profit | 50% / $490,000 |
Overhead Spending | $300,000 |
Profit $ | $190,000 |
Profit % | 20% |
By focusing on your operational data and digging into what is behind these numbers on the P&L, you’ll be able to notice more potential upside in your profitability (not to mention it’s easier to calculate).
Let’s take you through that!
Step 2 - Using your Operational Levers
To move your AGI or Delivery Costs (in other words, to achieve a higher Delivery Margin) you have three main levers to focus on. They are to increase your Average Billable Rate, increase your Utilization, or decrease your Average Cost Per Hour.
Lever 1 - Average Billable Rate
Your Average Billable Rate (ABR) is a measure of how efficiently your team earns their revenue.
It’s the amount of revenue earned per hour your team works on a client project. If your team worked two hours on a project that you were paid $200 for, their ABR is $100/hr.
The formula for ABR is as follows:
ABR = AGI / Delivery Hours
You’ll already know your AGI figure, which is the cost of a project or group of projects minus any associated Pass-Through Expenses, and Delivery Hours are any time your team spent on delivering a client project or group of projects.
Don’t confuse this with Billable hours - it doesn’t matter how many hours your team billed to the client. What matters here is how many hours they worked on it.
Knowing the formula above helps with showing you the two ways to impact your ABR:
Increase your AGI figure (sell and deliver the same service offering for a higher price
Usually done through optimizing your pricing model
Project | AGI | Delivery Hours Spent | ABR |
Project A | $10,000 | 60 | $166 |
Project B | $12,000 | 60 | $200 |
Decrease your Delivery Hours (deliver the same project for the same AGI but in fewer hours from your team).
Usually done through effective processes and system creation. Invest in templates, training, and tools for your team to lean on when delivering client work.
Project | AGI | Delivery Hours Spent | ABR |
Project A | $10,000 | 60 | $166 |
Project B | $10,000 | 50 | $200 |
Applying to the Baseline Scenario
Here is our baseline scenario again, with our 20% profit margin.
AGI | $980,000 |
Delivery Costs | $490,000 |
Delivery Margin/Profit | 50% / $490,000 |
Overhead Spending | $300,000 |
Profit $ | $190,000 |
Profit % | 20% |
Let’s now consider that with an optimized pricing model (potentially value-based pricing?), you were able to charge a little bit more for your services, and your team is a bit better at delivering those services because of your investments in processes. This has allowed your team to take on a few more projects each year, boosting your AGI from $980,000 to $1,050,000.
AGI | $1,050,000 |
Delivery Costs | $490,000 |
Delivery Margin/Profit | 53% / $560,000 |
Overhead Spending | $300,000 |
Profit $ | $260,000 |
Profit % | 25% |
Lever 2 - Utilization
The next lever available to you to impact your Delivery Margin is Utilization.
Utilization is a measure of how much of your team’s time is being used to earn revenue (directly) for the agency.
Generally speaking, the more time your team spends on client work, the more revenue they’re contributing towards earning revenue.
Note: this calculator will help you figure out what your team’s utilization is.
This metric’s formula is:
Delivery Hours / Capacity
Delivery Hours will be the same as above - time that is spent on delivering your services to your customers.
Capacity will be all of the time that your team members have available (that includes coffee breaks and vacations) which for a typical 9-5 employee will be 2080 hours a year.
To use this lever to impact Delivery Margin, you again have two options as you view the above formula. Either:
Ramp up the sales to increase your team members' delivery hours so that they’re contributing more of their capacity towards revenue-earning activities (and therefore less time on internal projects to fill up the week):
Team Member | Capacity | Delivery Hours | Utilization |
Sarah (before) | 2080 | 1040 | 50% |
Sarah (after) | 2080 | 1240 | 59% |
Decrease the total capacity that these team members have (which in turn would increase Utilization):
Team Member | Capacity | Delivery Hours | Utilization |
Sarah (before) | 2080 | 1040 | 50% |
Sarah (after) | 1780 | 1040 | 56% |
Applying to the Baseline Scenario
With an increase in Utilization, you can assume that this is going to directly impact your AGI number.
With more AGI coming in, since your team is spending more of their total time on revenue-earning activities, you’ll see a bump in profitability.
Team Members | Total Capacity | Utilization | Delivery Capacity | ABR | AGI |
6 | 13,066 | 50% | 6,533 | $150 | $980,000 |
6 | 13,066 | 55% | 7,186 | $150 | $1,077,945 |
With an increase of 5% utilization for your team, your agency will be (in this scenario) bringing in ~$98k more in AGI. Here is this number relative to our baseline scenario.
Baseline:
AGI | $980,000 |
Delivery Costs | $490,000 |
Delivery Margin/Profit | 50% / $490,000 |
Overhead Spending | $300,000 |
Profit $ | $190,000 |
Profit % | 20% |
With Utilization Increase:
AGI | $1,077,945 |
Delivery Costs | $490,000 |
Delivery Margin/Profit | 54% / $588,000 |
Overhead Spending | $300,000 |
Profit $ | $287,000 |
Profit % | 27% |
You can go deeper on the Utilization lever here.
Lever 3 - Average Cost Per Hour
Finally, the last way that you can impact your Delivery Margin is to focus not on improving your AGI like in the previous two scenarios, but on lowering your Delivery Costs by decreasing your hourly costs -- Average Cost Per Hour (ACPH).
ACPH is simply how much your team’s time costs you per hour. You can calculate this number for your team using this resource.
If your ACPH for your team currently looks like this:
Name | Role | Total Annual Comp | Total Annual Capacity | ACPH |
Brian | Jr. Designer | $50,000 | 2080 | $24 |
Betty | Sr. Designer | $75,000 | 2080 | $36 |
Ben | Creative Director | $100,000 | 2080 | $48 |
|
|
|
| $36 avg |
Then how can you decrease that number?
You’re going to want to have your junior members (those who cost less) take larger portions of the project on.
If you are able to create detailed processes at every stage of the project, you’ll be able to create templates, systems and workflows that allow less expensive work to complete more of the job, leading to lower ACPH across your team.
This will cause a shift in your Delivery Costs number.
Here is what your new team could look like:
Name | Role | Total Annual Comp | Total Annual Capacity | ACPH |
Brian | Jr. Designer | $50,000 | 2080 | $24 |
Britt | Jr. Designer | $50,000 | 2080 | $24 |
Ben | Creative Director | $100,000 | 2080 | $48 |
|
|
|
| $32 avg |
Applying to the Baseline Scenario
Here is what a decrease in ACPH could do to your Delivery Costs number, and impact overall profitability:
Baseline:
AGI | $980,000 |
Delivery Costs | $490,000 |
Delivery Margin/Profit | 50% / $490,000 |
Overhead Spending | $300,000 |
Profit $ | $190,000 |
Profit % | 20% |
With ACPH Decrease:
AGI | $980,000 |
Delivery Costs | $450,000 |
Delivery Margin/Profit | 54% / $530,000 |
Overhead Spending | $300,000 |
Profit $ | $230,000 |
Profit % | 25% |
A Combined Effort
It’s unlikely that you’re going to be able to successfully increase your Utilization rate by 40% or ABR by more than $100/hr.
Being realistic, what’s most likely to have a positive impact on your profitability is a combination of all three levers, as small as the tweaks may be.
Let’s look at our baseline scenario, and see how it can be impacted:
Baseline:
AGI | $980,000 |
Delivery Costs | $490,000 |
Delivery Margin/Profit | 50% / $490,000 |
Overhead Spending | $300,000 |
Profit $ | $190,000 |
Profit % | 20% |
Now let’s assume that with improvements in ABR, you were able to increase your AGI to $1,050,000.
Then, with improvements to your Utilization rate, AGI moves up another 50k on the year, taking it to $1,100,000.
Finally, a decrease in your ACPH lowers your Delivery Costs by another $25,000 on the year.
Here is what that scenario will look like now, with Combined Improvements:
AGI | $1,100,000 |
Delivery Costs | $465,000 |
Delivery Margin/Profit | 57% / $635,000 |
Overhead Spending | $300,000 |
Profit $ | $335,000 |
Profit % | 30% |
And the best part is that you didn’t need to touch your overhead expenses to make this happen.
Conclusion
In conclusion, improving agency profitability is achievable through a real time data-driven approach.
Focus on critical metrics like Revenue, AGI, Delivery Margin, Overhead Spending, and Profit.
Use levers like Average Billable Rate, Utilization Rate, and Average Cost Per Hour to measure performance and identify areas for improvement.
Optimize pricing models, invest in processes and systems to increase AGI and Delivery Margin, and streamline workflows to reduce Average Cost Per Hour and Delivery Costs.
With these efforts, your agency can achieve greater success and profitability.
