Agency profitability playbook: Marketing agency operations, metrics, and profit margins
In partnership with Parakeeto
Keep reading to:
- Discover how to think more profitably as an agency owner
- Learn the key financial metrics you need to be watching and how to calculate them
- Master the art of project estimation and improve the accuracy of your client billing today
- Explore opportunities to fine-tune your systems and processes, taking control of profit margins
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How to Think More Profitably as an Agency
How do marketing agencies make money?
Let’s start with the basic formula for how marketing agencies make money with the goal of subsequently earning a profit. While we will go over these points in more detail later, here is a brief overview of the factors in the equation.
- Agency gross income (AGI). The revenue that agencies collect after subtracting all of the money that is simply passing through. For example, money spent on digital ads or payments going to external vendors is considered “pass-through.”
- Delivery costs. The cost of deploying time and resources to accomplish work for clients. If you subtract delivery costs from AGI, you are left with your agency’s “delivery margin.”
- Delivery margin. The amount of money left over after an agency has earned a dollar of revenue. The delivery margin can be the first indicator of how fundamentally profitable an agency’s service offering is.
- Overhead. All the fundamental costs of running a functioning business. Overhead costs may include office space, software, hardware, accounting for agencies, and more.
Did you know: According to Parakeeto CEO and Co-founder Marcel Petitpas, agencies struggling with low digital marketing agency profit margins tend to misdirect their focus on reducing overhead—even when overhead is already reasonable or lean. Instead, most agencies should focus their energy on their delivery margins to become more efficient at earning revenue and increasing profits.
A high-level understanding of the agency model for earning revenue expressed as an equation looks like this:
What does profit mean for marketing agencies?
Profit describes the financial benefit realized when revenue generated from a business activity exceeds the expenses, costs, and taxes involved in sustaining the activity in question, according to Investopedia.
Any profits earned funnel back to business owners, who choose to either pocket the cash or reinvest it back into the business. Profit is calculated as total revenue less total expenses.
But how can agencies ensure that they’re not only exceeding their profitability threshold but surpassing it with enough of a digital marketing agency profit margin to allow for sustainable growth?
Questions to ask before diving into marketing agency metrics
According to Petitpas, before you dive into agency metrics gleaned from using tools like agency time tracking software, agency CRM reporting, and project management software, there are some foundational questions you should be asking first.
To ensure you’re choosing the right path to become one of the most profitable businesses in the agency world, ask yourself:
- Who do we need to hire and when? Do they have the skills we need?
- What if we close this deal?
- What if we don’t close this deal?
- What if this deal starts two weeks later than planned?
- Are we making money on clients and projects, and if so, how much?
- Which clients or types of work are most and least profitable for us?
- Are we scoping projects properly?
- Did this take as much time as we thought it was going to when we sold it?
PARAKEETO CEO AND CO-FOUNDER
Sometimes, winning the work isn’t the hardest part of the job
To rise to the occasion and join the ranks of the most profitable businesses in the B2B space, your marketing agency not only has to become a master at winning new business but also realize it’s everything that happens after the sale that will determine whether or not a client is going to continue to contribute to your bottom line. This is critical to successful agency operations
There’s a lot of complexity involved in finding the answers to the questions agency owners have. You’re dealing with humans, you’re dealing with time, and it can feel like the business is happening to you instead of for you.
If you can get into a place where you can be looking ahead in your decision-making, it’s a game changer, according to Petitpas.
Digging into solving and answering the questions above will:
- Make the business more enjoyable to run
Help to set better expectations for clients
Ensure you’re not asking your teams to stay late to hit deliverables as often
Gain better visibility into the future profitability of the agency
Improve agency operations
Why marketing agencies should focus on their best-fit customer
Becoming laser-focused on the ideal clients that make the most sense for your business can help offer clarity in other areas of the work as well. Petitpas suggests this foundational work can help steer acquisition efforts and even inform your agency pricing model.
“When it comes to an agency pricing model, should you be lenient or should you be aggressive and stick to your guns at the risk of losing the client? There is math that you can look at to determine where on that spectrum you exist,” explains Petitpas.
Petitpas outlines two scenarios:
- Your agency is making one dollar an hour on a project. If utilization is low, it’s better to make one dollar an hour than to make nothing and let those hours go bad.
- If your agency is forecasting high utilization, or has several other opportunities in the pipeline, it may make more sense to stand your ground on pricing and keep the quality of your revenue high.
“What I see happening often is that owners are relying on their gut instead of what the agency metrics are telling them. They end up in a rut of systemic discounting when it’s not necessary. It ends up causing indigestion, which feels similar to starvation and has the same effect on the bottom line,” Petitpas says when discussing accounting for agencies.
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How savvy agencies set themselves up to scale
Setting up the right strategy to investigate a profitability problem
Your accountant rushes into your office, frazzled, and exclaims, “We have a profitability problem!”
What do you do?
How do you go about investigating that? It can be nearly impossible to determine why you’re struggling to make a profit on projects if you don’t have agency time tracking and cost tracking structure alignment.
If your time-tracking tasks aren’t aligned with how your agency’s project cost estimates are set up, your team will likely be making guesses about scope. It will come as no surprise that you have a profitability problem if those estimates are off.
When you have perfect alignment between how your estimates are created and how your time-tracking tool is set up to track data, it’s a different story. It’ll be a lot easier to not only create more accurate project cost estimates for your agency but to investigate profitability problems that may arise.
Designing the right system to align estimates and agency time tracking
To wrap your head around how your scoping and time-tracking system should be structured, use Parakeeto’s Incident Investigator™ exercise. When thinking about this exercise, consider a scenario where you have a project that went totally off the rails. Consider which questions you’d want to ask to determine what went wrong and why your profitability was so bad.
Parakeeto’s Time Tracking Mapper™ may help. Use the exercise below to think about whether the line items on your project cost estimates map to your time-tracking tool. Which time-tracking objects match to these estimate metrics in your agency?
Managing complexity in data
There’s one important note to consider when setting up your time-tracking tool: beware to manage complexity.
There’s this idea that precision equals accuracy. If you can be more precise and detailed, if you can know exactly how much time was spent on a subtask within a task within a deliverable within a milestone within a phase within a project, then that more precise data will let you be more accurate.
In fact, the opposite is true. It gets infinitely more expensive to get your team to track time at that level. What’s more, compliance in time tracking will go down with each layer of complexity you add to time tracking. You’ll then face more inconsistent data and have more buckets of data to contend with.
Often, agencies over-index on precision where they reach a point of diminished returns. This is where being 5 percent more precise adds 0 percent additional accuracy to the high-level insight you’re trying to get. The more you try to increase the level of precision, the higher the cost and complexity. This is poor agency operations.
“When you go in and determine how you should use your agency time-tracking tool, and which pieces of information you need on every time entry so you can match it back to the estimate, start with the simplest viable solution,” Petitpas says.
- Project (Use type tags for common projects (e.g., Website Builds))
- Role (Use a few major buckets (e.g., Project Management, Content, Design, Development))
You don’t want 500 unique tasks estimated for a project that you somehow then have to align to in your time-tracking or project-management tool. You want to put all those tasks in bigger buckets, like Design and Development, so you can map them back to a data scheme. As Petitpas explains, “You need some mechanism to group discrete tasks back to broader buckets to build data models around them.”
Don’t break it down any further than the agency time tracking example above. That’s the key to getting started: Keep it simple to start and get your team on board. Then you might realize that you don’t need any additional data or you might see where you need to drill deeper.
Ultimately, less complexity is better to start, so you can get compliance up before you go deeper. Petitpas explains, “If you can just have a conversation with the team to determine where you went over budget, that’s a much easier way to get insight than tracking extra layers of data that can’t provide the why.”
Using reference-class forecasting to accurately measure projects
To set up this new system, you must clearly define each part of the structure: clients, projects, and roles/tasks. You also need to ensure this structure is used consistently across projects and that your time-tracking or project-management tool can measure these data points.
If this is done consistently over time, and if you have this structure really well-defined, you can then improve your agency’s project cost estimates with reference-class forecasting.
Reference-class forecasting is based on a set of historical data, and the key is to understand the reference classes, such as how much design time is required on website projects.
With very little data, such as 5, 6, or 7 projects under your belt using your new structure, you can have a really reliable data line that can improve estimation efficiency and accuracy. You’ll be able to clearly see how much time was required for projects vs the budget in the past. This can eliminate bottoms-up guesswork, and it offers a faster and more accurate way to measure projects that require almost no context or expertise.
Closing the gaps and increasing agency profitability
The data can never tell us why the data is, it can only tell us what it is. This can leave gaps that need to be filled.
However, once you have the right strategy, structure, and data, you can start to fill in the gaps on detail by using reporting, feedback, and process optimization.
At the end of the project (or monthly for recurring projects), run a report to determine the estimate vs the actual and ask:
- What happened?
- Why did it happen?
- What can we learn?
This can close the gap.
Remember: A conversation with the team is a far richer way to get context. Sometimes it’s best to rely less on precise data and more on conversations with your team to determine how to improve the efficiency of your business.
With this information, you can then conduct process improvements to continue to increase profitability on projects and scale your agency.
Frequently asked questions
What is a utilization rate?
Agency utilization is the measure of how much time is spent generating revenue for the agency (working on deliverables for clients), as opposed to time spent on other activities.
How to calculate billing rate?
AGI for any project, client, or period of time divided by the number of billable hours worked gives you the billing rate. The average billable rate (ABR) can give you a quick snapshot into the profitability of any given segment you want to examine on a weekly or even daily basis.