Agency Profitability

Swift resolution of issues is also important, at one of Bill Fritsch’s agencies “we created a special FIRE ALERT line. If clients had hot issues, this line would be answered 24/7. And whoever was on the Fire line was rewarded for getting answers so clients didn’t have to sweat.”

If you are delivering projects well, and managing issues swiftly, you should hopefully have earned permission to ask for more work from that client. As Bill suggests “encouraging clients to do more with your firm can be as simple as training people to “always have an idea” that leads to the next thing. We developed a reward system that gave significant bonuses to client teams that turned the first project into a second opportunity before the first project was delivered. And an even bigger bonus for winning a third assignment in the same period of time.”

A critical aspect of increasing client loyalty, longevity and revenue is to keep in touch with how happy they are with your agency. A client survey on a regular basis can help to benchmark client satisfaction and keep people in the agency focused on continuous improvement. The most common method is using an NPS score to track client satisfaction, along with a number of qualitative questions you could include in a (short) client survey. 

This doesn’t replace regular face-to-face discussions with the client of course, whether in a formal or social setting – and this is also something you can set a goal against and measure – all of your most important client accounts should see you personally at least once every few months.

Reduce project cost overruns

Reducing (or removing) cost overruns on projects is easy to say, but hard to do. But with concerted focus and effort you can make improvements continually over time, and it has the potential to revolutionise your bottom line.

Top performing digital agencies are able to keep average cost overruns below 10%, and the best are below 5%.

Cost-overruns on projects can be measured by the quoted rate (the hourly rate you quoted) vs the effective/actual rate (total project revenue / total hours spent). As Wesley (Wes) ter Haar (Co-founder and COO of MediaMonks, merged with Sir Martin Sorrell’s S4 Capital in 2018) puts it “The actual rate per project/client is probably the key indication [of agency profitability], if you’re over delivering against paid scope or struggling with operational efficiencies, it will show up in the actual rates you’re getting for the work.”

Most agencies have a mix of project-based work and client retainers. Both project work and retainers are priced either at a Fixed Cost (with fixed scope), or on some variation of Time and Materials (T&M), e.g. in an agile delivery it might be Sprint-based pricing with “fixed cost” but variable scope). The benefit of working on a T&M basis is that your team should be getting paid for every hour they work, the result is the reduction or elimination of overruns. 

Based on data from the 2018 SoDA KPI Benchmark Study, digital agencies that predominantly work on a T&M basis overrun on projects at a rate of 5% lessthan agencies that work on a majority fixed-fee basis. This alone would equate to a roughly 2% – 3% higher EBIDTA margin!

As Wes, says; “the bulk of lost profitability tends to be a mix of over-delivery on scope without getting paid for it and operational inefficiencies which become a (mostly) deferred issue in T&M.”

There are two key ways to reduce cost overruns, which could be done in parallel;

1. Increase the proportion of retainer (or predictable recurring) revenue vs project revenue – this is dependent on having strong client relationships and closely linked to having repeat customers (see above). The more a client trusts you, the more likely they are to commit to a retainer. Also, some services are more suitable to retainer than others, for example maintenance, support, digital marketing, social and search marketing are all long-term commitments that a client may agree to a set dollar spend per month – and for which your agency can charge for the time used.
2. Migrate your project pricing from fixed cost toT&M – fortunately the swing towards Agile delivery in the past few years has made this discussion much easier with clients. At MediaMonks (amongst others), they switched their sales process to focus on agile teams wherever possible, with projects quoted as Sprints with dedicated teams.

These changes won’t happen overnight, but if you set an annual target for each and ensure your sales and account management people get behind it, even a slow transition will help to improve profitability over time.

A counter-argument to increasing T&M work came from Russ Whitman of Globant, who said “Fixed cost quotes can actually increase margin if you are really good at managing projects this way and can be a way to win business by taking the risk off the client”. I agree that taking on more risk at your agency can be a competitive advantage, but the key word here is “risk”. To improve profitability, shift risk away from your agency, or allow for it in your pricing.

Aside from transitioning to T&M pricing, a great recommendation from Johnathan Tann (formerly CEO of Odopod, which was acquired by Nurun in 2011, now founder of agency consultancy Spring Advisors) was to focus less on the hours worked on a project, and put the energy into the discipline of start and end dates. 

Jonathan (better known as JT) said “We were religious about start and end dates (both with ourselves and our clients). What we found, was that for a project that went over by a day or more, there would be a double impact to profitability:

1. Not getting paid additional fees for the original project
2. Opportunity costs associated with not being able to start the next project”

Another simple hack from Steve Glauberman (founder and CEO of Enlighten, acquired by Perficient in 2015) was to “break projects down into smaller contractual parts”, giving you the opportunity to price following stages appropriately based on what was learned in the previous stages. Avoiding monolithic fixed-cost projects is a mandatory strategy to avoid cost overruns!

Whether projects are being delivered under a retainer, as fixed-cost or T&M, it is important to track what Russ calls Delivery Investment, which is “every dollar for every hour we spend on a project that the client doesn’t pay for. It’s the often hidden hole in agencies that profit slips out of. Mostly because it’s not tracked and human nature allows us to rationalize what we don’t actually track”.

Another thing to consider, as suggested by Tamir Scheinok (co-founder and COO/CFO of eCommerce specialists Fluid, acquired by Astound Commerce in 2018), is assessing the risk when you are pricing projects. Calculate a contingency (in hours and dollars) and use this figure to determine your price to the client, but do not make the contingency available to the project team until an unforeseen risk is encountered. 

There is discipline required for the leadership team to track projects as they’re in the studio, Kath Blackham from Versa (one of Australia’s top voice and digital experience agencies) says “We report on billable rates and write-offs on a weekly basis and interrogate the why constantly. This allows us to address any issues that are brewing before they become too much of a problem to the bottom line”.

Maximise billable utilisation

Unsurprisingly, one of the strongest leading indicators for profitability is how busy your agency is, which is most commonly measured as Billable Staff Utilisation. Assuming you have a healthy ratio of billable vs non-billable people in your agency, a good benchmark to provide high profitability is to have utilisation over 75% and ideally higher than 80%.

Something many agencies have difficulty with is charging for the time spent by the senior team, and this can be a major drain on profitability. As Russ Whitman from Globant puts it, “stop letting your senior talent give their time away for free!!!” He goes on to say, “These are arguably the most valued resources in the agency, they know more and can move faster than nearly everyone else – and they donate their time”.

At Accenture Interactive, all of the senior people in the business have a utilisation target and are expected to add value to clients, and charge appropriately for this time. In one memorable training session we were told that – if we were having trouble getting clients to pay for our time, we should “get better at our jobs!” Harsh but true… if the client doesn’t value what you are doing, maybe you shouldn’t be doing it. 

On a more operational level, to maximise utilisation in the studio, Enlighten would closely manage their contractor base, so they could scale back when needed. Both Enlighten and Red Badger said they are very considered when hiring staff, doing so only after a sustained need.

Improving utilisation is a team effort. Jenn DePauw, Managing Director of The1stMovement, says “taking the time to get your team involved in the “why” when it comes to tracking utilization, is a good way to drive accuracy in reporting their billable time. When the team understands your benchmarks, they are more invested in the process.” This was reinforced by Kath, who said that at Versa “we have started to share these [utilisation figures] with the wider team and integrate them into an individual’s KPIs wherever possible”. 

A great suggestion from Tamir Scheinok at Fluid was to price projects and reserve resources in blocks of time that make the leftovers usable by other projects. “For example, use defined weekly utilization levels of 40, 20, 16, 8, 4. Do not allow 36.5 hours reserved which is effectively 40 because no one is going to make productive use of the 3.5 hours remaining”.

A simple but insightful comment (see below) from Guy Cooper, MD of Wave Digital. He said "one of the biggest changes for our agency was thinking in terms of days (not hours)". This is a relatively easy thing to implement in an agency, but can greatly improve utilisation by avoiding those scrappy 1 or 2 hours of spare (read: unbillable) time between projects.

And Johnathan Tann described a tactic they used at Odopod to maximise utilisation; “Invariably, there would be gaps between projects. When we found ourselves in that situation, we would offer clients a small discount to start an engagement earlier(and, thus, finishing earlier). This would:

• Minimize team downtime
• Allow us to recognize revenue sooner
• Provide a longer runway for slotting projects in the future”.

Have keen financial discipline

Our expert interviewees included agency leaders with decades of experience in financial management of digital agencies, and they weighed in on the importance of discipline in budgeting and forecasting in order to maintain healthy profitability.

In fact, based on the SoDA KPI Benchmark study, digital agencies with a Chief Financial Officer (or similar) are significantly more likely to have high profitability than those without.

Many smaller digital agencies that I know were founded by ‘practitioners’ such as designers or developers and have not yet reached the scale required to hire a CFO or equivalent role, meaning financial management is a continual work in progress as the agency grows. 

Some solutions for this are to create an Advisory Board to fill this gap, consider a Virtual CFO service, or to hire a General Manager that can bring financial rigor but also fulfill other operational roles in the business.

A recommendation made by Nancy Daum (COO/CFO of Pereira O’Dell) is to regularly audit your agency’s recurring expenses, identifying duplicate or unnecessary expenses such as software licenses that are no longer required. As Nancy puts it “we determined that we could consolidate a number of tools or platforms we were using and/ or replace them with more cost effective ones… it resulted in saving administrative time and costs.“

Nancy also recommends keeping a rolling 12-month forecast (on an accrual basis) in addition to the annual financial year budget. This will provide a roadmap for the next 12 months to stay on track with forecasted costs and spending.

Tamir Scheinok from Fluid’s top recommendation is to “use Professional Services Automation (PSA) software to manage project profitability on a weekly basis, looking forward 2 months, not just backward.” Most digital agencies use some form of studio / project management software (such as Mavenlink or Harvest) but not many use PSA software which will provide much more detailed reporting, budgeting and forecasting. Examples of PSA software are ProjectorPSA (which Tamir uses at Fluid), Unanet, Workbook and Kimble.

Another important suggestion from Tamir, which can easily be overlooked, is the importance of regularly auditing and validating your Bill and Cost Rates. When doing this, set targets for your Gross Margin and Revenue Per Head, and then integrate these into your pricing process. In short; make sure you are charging your team out at a rate that is profitable.

Build a strong sales pipeline

“A healthy sales pipeline and the ability to say no to work tends to help push up margin as it takes away the risk of having to take on bad work”. Wise words from Wes ter Haar of MediaMonks.

Every agency knows that it’s impossible to make a healthy profit margin without enough work coming through the door. Unfortunately, not every agency has walls lined with Cyber Lions like MediaMonks, but they also don’t have more than 750 hungry mouths to feed! 

Even the most famous agencies in the world need to invest (with diligence) to maintain a strong pipeline. As Wes says, “this has mostly been about expanding our sales efforts from mostly inbound to growing a sales team in our high budget markets (US, UK) and diversifying our sales: more focus on different solutions to sell, instead of a generic digital offering.”

In addition to this, MediaMonks focuses on partnerships to help generate new leads, in particular with technology and ad platforms like Google, Adobe and Facebook. 

Russ Whitman from Globant emphasises the importance of Project Managers in finding new opportunities with your existing clients; “The one thing I’ve learned is to value great PMs highly, they ensure quality, margin and revenue – they become a trusted partner with the client and can learn about new business opportunities that the "sales guy" will not hear about.”

It’s critical to use a CRM (Pipedrive is popular with digital agencies) to manage your sales pipeline and provide forecasting of future revenue, with many of the agency leaders interviewed saying the pipeline (projected revenue) was the most important leading indicator for agency profitability. I like to use weighted revenue as a measure, and then compare this to the revenue target and existing sold work, and calculate the “gap” that needs to be filled. Ideally in a three-month forecast your sold work + weighted pipeline revenue exceeds target revenue, meaning there is no gap and your pipe is overflowing! 

From JT’s experience at Spring Advisors, “most agencies that have predictable profitability get a substantial amount of their new business from inbound/non-solicited leads”, which was reinforced by Kath Blackham’s success with PR at Versa “after our success with the four day week, we have realised the value in doing something different that gets people talking”.

On average, SoDA agencies reported that 68% of new clients came from “Inbound Leads” (versus outbound marketing). And the agencies with the highest profitability showed even higher at 75% and above. 

If you can build your brand, win positive PR and have an efficient sales team, with luck your pipeline will exceed your needs and allow you to be selective with the work you take on. The final word belongs to Wes; “nothing solves margin more than selling a bunch of well-paid work”.

Develop a capability for low cost delivery

We now live in a competitive digital industry, one that has reached a level of maturity and where some services have become commoditised over the last few years. This understandably puts pressure on costs, with clients expecting more for less, even when technical complexity has grown. 

Ideally your agency has an incredible brand, and is offering unique services that clients value highly. Good for you! But even then, no doubt there are some services you provide where cost competitiveness is required in order to bring work through the door.

Having the ability to provide low, or lower cost services requires a lower staff cost base, the advantage of which is more flexibility in assembling project or client teams in a way that will maximise profitability for the agency.

To achieve this, one thing that Odopod invested in was an intern program that would continuously introduce fresh junior talent to the team. Johnathan Tann says “We developed a deep relationship with a college that produced amazing designers/developers. Our entire intern and junior strategy revolved around getting as many of them to join us as possible. We also had a very strict promotion track to recognize high performers and reward them early and often.” 

I recommend sketching out a staff pyramid, and seeing whether you have the right mix of senior, mid and junior talent in your billable team. The “right mix” will depend on the work that you do, and also your method of charging to the client e.g. blended rate card or rate card based on seniority or skillset. The key thing is to understand the cost of staff at different levels of the business vs how much you charge for their time.

In addition to the staffing pyramid, having delivery teams in countries with lower wages is a common method of reducing average staff costs. For example, MediaMonks “acquired and scaled production facilities in South America, and have been able to leverage those mostly against the US market, which is the ideal balance” said Wes ter Haar. This can have a very measurable benefit to the bottom-line, but is difficult to get right.

Manage your ratio of billable vs non-billable staff

In a services business like a digital agency, our currency is time. More accurately, our currency is time that can be charged to a client. With staff wages being the highest expense in every agency, it’s clear that maximising the ratio of billable staff vs non-billable staff can have a massive impact on an agency’s profitability.

Furthermore, as Steve Glauberman from Enlighten points out “often unbillable or low billable staff are some of the highest paid employees. It is therefore important to watch this ratio”.

The SoDA KPI research showed that on average SoDA agencies say that 77% of their total staff headcount are in billable roles, with the remainder being sales, administration and executive leadership – non-billable roles. However, the agencies with the highest profit margin reported billable staff at closer to 85% of their total headcount.

At Enlighten, Steve “tried to get almost everyone billable at some level and we were very deliberate on any new non-billable hires”.

The question you may ask is “what if a senior team member is partially billable?”. In my opinion there is a mindset difference to thinking of, for example a Creative Director, as a mentoring (non-billable) role vs a leadership (billable) role.

The agencies interviewed had strong opinions on this, in particular how to think about partially-billable roles and the measurement of this. For example, Johnathan Tann (JT) said that at Odopod “We moved away from accounting for billable / non-billable staff on a factored basis (e.g. Account Directors should be 50% billable and 50% non-billable). Instead, anyone who had any relationship to clients or the work would be treated as billable. This meant that we couldn’t fool ourselves into thinking our utilization was great or that our gross margins were on target”. 

In this scenario, Account Directors were not penalised or incentivised against their billable hours, but it provided JT and the Odopod management team with a better view of the agency’s performance.

Tracking and reporting of billable time in theory is easy but having different targets for different roles adds complexity. At Fluid, they advocate for keeping it simple, as Tamir Scheinok says; “pick a utilization target company wide (e.g. 1,700 hours). Communicate that for everyone. Managers are expected to work less than that and their reports slightly more to make up the difference. The team overall is expected to achieve 1,700 each on average. Simple.”

For me, the most important thing is to be aware of this ratio as your agency grows. It is really easy to hire non-billable staff to cope with growing pains, and it’s even easier to gradually transition people from billable to partially billable roles – and for this to outstrip the hiring of billable team members. 

Value your people and culture

There are many benefits to having a fantastic agency culture and being surrounded by amazing people, fortunately higher profitability is one of these, yay!

Happier people are more productive, more efficient and are more likely to delight your customers with their radiating smiles and bug-free code. As Cain Ullah from Red Badger points out, having an amazing culture “will make staff committed to company success”.

Cain also makes the point that “permanent employees are cheaper than contractors and if you build a great culture, they stay longer (replacing leavers is expensive)”. Indeed, staff retention is an important indicator and influence on agency profitability. There are costs when staff leave, and even higher costs to hire and train a new staff member to take their place.

Based on the research from SoDA, average employee turnover rates were 20% (of SoDA agencies who completed the survey), but the agencies with the highest profitability had average staff turnover of closer to 10%. 

Retaining staff as an agency grows takes consideration of the long-term potential of new hires, as Steve Glauberman from Enlighten puts it, you should “hire amazing talented people that can grow/change with your agency over time, versus hiring for very specific needs”.

When hiring, it’s also critical to ensure you are closely watching the resources you need and put in place robust processes that balance sales, recruitment and resourcing. As Cain puts it – “If you recruit faster than you can win new business, your profitability will be low. If you can’t recruit quickly enough to service the sales, then you will lose business and again have a lower profit. Finding the perfect balance between sales and recruitment is the nirvana of agency land but the better you are at it, the better your profit”.

A contrarian idea put in place at Versa in Melbourne, is a four day working week, with the studio being closed on Wednesdays. This has had a positive effect on the culture and also profitability – “Staff are happier, retention is way up (saving thousands of dollars), sick days are down and effectiveness is up as well. It’s a win/win for our team and the agency” Kath Blackham says.

At Odopod, JT said “We didn’t try to cut corners on travel. If someone (at any level) was flying cross-country, they should fly business, stay in nice places and not worry about a per diem. This did a few things: 

• Was a perk that was genuinely appreciated and immediately felt
• Travel days became productive (hours that we could bill to clients)
• We could recoup a % from clients (reimbursable expenses), so it was subsidized”.

As with other larger agencies, at Red Badger they “have a dedicated People and Culture team to ensure that we are building an environment that people love to work in, that supports their career progression and puts the employee interests first”.

Summary

Each of the eight principles of profitability described above can individually, or collectively, help you to incrementally improve the bottom-line of your agency. But only if you take action. 

Agencies with the highest profitability don’t out-perform on all of the eight key drivers, but smash it out of the ballpark on two or three areas. Cumulatively these provide for a great margin.

Using either the benchmarking data or your own metrics or intuition, my recommendation is to decide which of the eight areas you are performing well in, and which are the leaky holes in your profit bucket. 

Next, decide on 3 or 4 specific tactics that you can put in place – decide how to measure these and set some KPIs. If you have a strategic planning process already, these will be great inputs into that. If you are new to setting Objectives and Key Results then read Measure what Matters and/or Scaling Up and embed these practices into your agency.

Don’t spread yourself too thin by tackling 5 or 10 different initiatives! 

If you don’t have one already, you could create a management reporting dashboard based on the insights from the 10 agencies we interviewed. Based on this research the leading indicators for profitability that you could include in a dashboard are;

• % of repeat business vs new clients (Nurture repeat customers)
• NPS score (Nurture repeat customers)
• Actual $ rate per project (Reduce cost overruns)
• Actual utilisation (Maximise billable utilisation)
• Projected revenue (Build a strong sales pipeline)
• Inbound leads (Build a strong sales pipeline)
• Staff attrition (Value your people and culture)

UPDATE: see my follow-up post which includes a best-practice KPI Dashboard template to make it easy to report on these indicators; https://www.linkedin.com/pulse/best-practice-kpi-dashboard-digital-agencies-tim-o-neill

This article has intentionally not delved too far into the dark art of staff incentives, as every agency leader I know has a different opinion on what works and what doesn’t. There is no doubt that a well-structured and fair remuneration and incentive program aids profitability, but the right one will differ greatly by your agency’s location, size and culture.

My final word of advice is this; ask for advice! I have found that other (non-competing) digital agency leaders are typically willing to offer advice that can help to improve your agencies bottom-line. For me, personally, the SoDA community has been an incredibly valuable asset for this. It’s in everyone’s best interests to have a healthy and profitable digital industry, and the more we can each help each other the better. 

Having a highly profitable agency is typically not the main goal that agency leaders have for their business, and for good reason. Agency reputation, culture, client value and quality of work are the cornerstones of longevity and growth. If your agency has sustainable profitability that can support this growth, it allows your agency leadership to relax and focus on the clients, your team and the work.