3 Common Profitability Leaks Within Agencies
Managing an agency isn’t like running any other business. There are unique daily challenges agency leadership must overcome, while also meeting the needs of their clients’ expectations. So when you finally start to see your hard work pay off and your business begins to scale, you expect to see clear results.
Agencies need clear goals to work toward to understand if scaling operations are hitting these benchmarks. Increasing profitability is commonly the first expectation after a business has grown. Why else would you put in all that hard work? However, some agency owners find the opposite occurs, and their profitability decreases.
It’s an odd circumstance that happens more frequently than you might think. The added levels of complexity and inefficiency when adding more revenue, and thus team members, can sometimes do the opposite of what you’re trying to achieve.
Top Agency Revenue Bleeders
In WeConsult’s experience with helping agencies, we’ve found three common mistakes that occur within their operational management that contribute to profitability leaks. You can find those mistakes below and how to fix them.
Underutilization
Agencies are service-based businesses that rely on their team’s time and talents to generate revenue. Utilization is a metric that starts with tracking time and refers to the total amount of time available to your team. To calculate your agency's utilization rate, you will divide your team's total workable hours by their billable hours. Here's an example:
Full time employee available hours in a year = 2080
Note that some calculations will reduce this amount to reflect company holidays and time off. For this calculation, we’ll keep things super simple.
Billable hours the employee works in a year = 1400
Utilization rate = 1400/2800 x 100 = 67%
In most cases, the higher the utilization, the more revenue generating hours your team is working on. However, there is a huge caveat: the client receives a bill for all of your team's working hours.
It’s best practice for firms to track utilization across all billable team members and then also look at the average rate across the entire agency.
Underutilization refers to the percentage of billable time being lower than what their team is capable of billing. This lowers overall profitability had employees been working on billable work therefore generating more revenue. If you need some help with time tracking, head to How Time Tracking Will Help Your Bottom Line.
Ways Underutilization Occurs
Underutilization of the team can occur in a variety of ways. Here are three common culprits.
Billable team members’ utilization rates are not being monitored on a monthly basis and their low utilization is slipping through the cracks.
There is not enough billable work, meaning you have too many "resources" and insufficient client work to fill them.
Too many non-billable team members are bringing the firm's overall average down. Since salaries are an agency's most considerable expense, one symptom you see that reflects this is when the project gross margins are healthy but overall company profitability is not. Overall you want to aim for your payroll and benefits to be about 50-60% of your adjusted gross income (revenue minus cost of goods). Any higher than this and you’re going to be bleeding profits.
Solutions to Underutilization
Every agency is different and there isn’t one fix-all recipe to underutilization. However, here are some suggestions that WeConsult often offers its clients.
Make sure the team is tracking time so you can get insights into this critical business metric. To get people on board, educate the team on how the agency makes a profit and why that profit is essential.
Ensure each department's leaders know that one of their responsibilities includes making sure each team member is appropriately utilized and aiming for the targets.
Focus on tightening up resourcing. You can do this by utilizing resourcing tools such as Harvest Forecast or hiring a role solely dedicated to resource management. The latter being a solution for larger studios since it’s a non-billable resource.
Unfortunately, if there's not enough work and too many people on the team, you may have to make a difficult decision to do some restructuring of your team. Many agencies are filling in the gaps as needed through contractors and fractional support.
Scope Creep
You're likely familiar with this term, but if you aren't, scope creep is when a project's scope (i.e., the work required to complete a project) keeps growing without adequately addressing the impact. The impacts are things like project budget, timeline, or necessary resources needed to complete the project.
How Scope Creep Occurs
The name for this profit-leaching goblin is apt. That's because you often don't know it's even happening because it crept in silently. Scope creep can occur in many ways, but here are some common scenarios.
A client requests an additional feature outside the original scope of work.
The client failed to disclose information that would create more work for the delivery team.
Your team delivers work beyond the usually allocated amount in a given month in a subscription-based or retainer model, and you do not charge the client for the additional effort.
No matter how this situation unfolds, the result will be the same if your team doesn't properly address the effect of a request for additional work.
Solutions to Scope Creep
The high-level solution to scope creep is relatively simple; standardize client workflows within your agency. But, how to go about that is easier said than done. Here are some common suggestions WeConsult uses with its clients.
Create a clear scope of work, clarify what "done" means, and ensure that the internal team and external stakeholders agree on the definition.
Work in phases. Sometimes, it can be best to offer clients a v1 to start and let them know you can do another iteration once they finish phase one.
Create a way for additional work to be officially requested, like a change order. Does the client want a feature now instead of waiting for the next implementation phase? Create a way to capture the client's agreement to the change in budget and deadline. Even if the request comes in the form of a simple conversation, ideally, there's still an internal way a Project Manager can document this change.
Properly train your team to handle client requests and effectively communicate back to the client. If you feel your team could be stronger in this area, Louder Than Ten has some fantastic resources on project management and even offers sample verbiage in challenging situations.
If your agency works on a more flexible retainer model, it'll be helpful to carve out the scope of work each month and have the client "sign off" on the work beforehand. If a request comes in outside that month's scope, your team can tell the client they can add that; however, they will need to push X initiative next month. OR, if it's a really short, urgent request, you can implement a rush fee by billing them 1.5-2x the client's billable rate.
Poor Project Gross Margins
Simply put, Project Gross Margin refers to a project's profitability. It's an essential line item that will ensure your agency's success.
Since many agencies revolve around creative services, determining project gross margins probably isn't a task that owners are clamoring to complete. However, calculating this figure and knowing acceptable project margins that will let your agency scale comfortably is critical.
To calculate the project gross margin, take the project revenue and subtract project expenses. Then, divide the gross margin by the total project revenue to get to your project gross margin percent. Here's an example:
Project revenue = $100k
Project expenses = $40k
Gross margin ($100k-$40k) = $60k
Project gross margin percent = $60k/$100k = 60%
As you can see in this calculation, the higher the gross margin percentage, the more overall profit your agency will accumulate.
How Low Project Profitability Margins Happen
Low margins can occur in several ways.
Not charging enough for the project. This is an obvious no-brainer. Bringing in enough revenue to keep the lights on and adequately compensate your team (and yourself) is crucial for agency success.
The project's internal costs are too high. Many agencies may be dealing with this problem after the inflation of salaries during and after COVID-19. Many salaries for agency-related roles increased significantly, greatly reducing project profitability rates.
Projects are incorrectly estimated. Inaccurately estimating projects can lead to other serious issues other than simply losing money. Not only does this chip away at the confidence of the team over time, it can also communicate to employees that the budgets don’t matter in the first place.
Proper workflows aren't in place to prevent scope creep. Projects can quickly exceed budget if team members accept client requests without boundaries.
Solutions to Low Project Gross Margins
There are a few ways to increase project gross margins, depending on the cause.
Simply knowing if you’re charging at current market levels can be challenging due to socioeconomic shifts that occur under the radar. Working with a consultant is a great way to bring some outside perspective and put you back into the black by helping reset your rates to reflect fair market values.
Reevaluating company cost structures is critical in increasing profit margins. Knowing if you're over-paying team members is equally essential to higher profit margins than charging enough for the project. Every industry is having to do more with less these days, and there are tools like salary bands and role ladders that can help. If you need more insight into the going rates, Promethean Research has an excellent annual salary survey to shed some light on what roles are going for these days.
Estimate projects correctly. If you're not already using an estimation tool, use historical data to build one. Before a project is approved, make sure that the estimation tool has the correct margins in place. After completing each project, conduct a retro to see where you missed the mark regarding estimation and how you can improve the process moving forward.
How to Begin Patching the Leaks
In the current market, where it feels like we're doing more for less, tightening up your processes is even more crucial to keeping profitability healthy. Whether you're underutilizing your team, falling victim to scope creep, or aren't properly hitting your project profitability margins, the good news is there are levers to implement to ensure you don't succumb to these common pitfalls.
If implementing these feels overwhelming, pick one that you know your agency can improve upon and work from there. If you're still feeling overwhelmed, WeConsult can help you implement a plan that fits your agency's needs.
At the end of the day, running an agency is tough work and the last thing you need is profitability slipping through your fingertips.
