Running an agency often means wearing far too many hats, juggling clients across verticals, and dealing with a perennial talent shortage.
The last thing you want in the mix is dealing with low margins due to pricing issues, inefficient processes, and high expenses.
The question now is: how exactly do you calculate profit margins? And if your margins are too low, what can you do to increase them?
In this article, we'll outline everything your agency needs to know. Read on to learn about:
Let’s get started.
What Are Profit Margins?
Simply put, a profit margin refers to the revenue a client’s business has generated minus incurred costs. Additionally, profit margins are good indicators of business profitability and are expressed as percentages of overall revenue.
Why Profit Margins Are Important
Calculating margins for a digital agency can be notoriously difficult. But it's important to understand how much money your agency actually sees in the profit column at the end of the day.
While eCommerce and SaaS companies typically know exactly how much it makes for each product sold, digital agencies often have to deal with unforeseen expenses and client budget changes.
The account that made you $2,000 this month at a 20% margin sounds great! But a couple of revision requests from the client and your profit drops to $200. Spend 2.5 hours putting together their client report at the end of the month, and that profit drops even further.
In this uncertainty, the first thing you need to do is to calculate your own margins.
Surprisingly, in a survey of 750+ agencies, only 49% said that they tracked revenue per client. Even fewer (24%) tracked revenue per employee.
The same survey found a correlation between profit margin and revenue tracking. Agencies that tracked revenue per client had higher profit margins than those that didn't.
The first thing you need to do, therefore, is to track your profit margins for each client. Then, you’ll want to communicate how your campaigns are contributing to your clients’ overall revenue.
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How To Calculate Your Profit Margins
Now that we know why it's important to understand the profit margins that are behind the curtain, let's look at a step-by-step process for calculating them.
Step #1: Determine Hourly Cost per Staff Member
Your first step should be to calculate the hourly cost for each staff member.
For your full-time staff, this should include:
Pension (if applicable)
Insurance & other benefits
And other expenses, such as equipment, travel, and training
Next, calculate how many hours per year they're available to work. To do this, simply calculate the total available hours in the year (40 hours per week x 52 weeks) minus the number of paid holidays, sick leave days, and national holidays.
If you assume a 40-hour work week and two weeks each of vacation and sick leave, you get 1,920 total hours of available work.
To calculate your hourly staff member cost, simply divide their total annual cost by the total available work hours. For instance, an employee with a $70,000 salary, $12,000 in benefits, and a $4,000 budget for travel and training costs a total of $44.79/hour ($86,000 / 1,920 hours).
That's a lot of money to waste on tasks that are not driving the bottom line.
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Step #2: Calculate Operational Costs
To calculate your agency's operational costs, you need to estimate your overall expenses for the year.
Your operational costs should include every single foreseeable expense, such as:
Renting office space, or connectivity costs for remote workers
Associated maintenance costs (e.g., monthly cleaning services for the office)
Utility costs (e.g., electricity, water, and internet bills)
Monthly marketing subscriptions (e.g., an email marketing service like Mailchimp, or a CRM such as HubSpot)
PPC advertising efforts to boost your agency's brand presence (e.g., Facebook Ads, Google Ads)
Administrative costs (e.g., purchasing office stationery)
External support costs, such as freelancers or suppliers
Agency Tip: If your agency uses suppliers or freelancers when fulfilling client projects, use this same procedure to calculate their hourly costs. Factor these costs into your profit margins for a more accurate picture.
Step #3: Calculate Cost per Hour for Overheads
In the next step, calculate your total billable hours for the year.
For example, if you have 5 employees, you get 9,600 billable hours for the year (@ 5 x 1,920 hours).
This effectively means that you have 9,600 billable hours to pay for your overheads.
You can calculate your cost per hour for overheads by dividing total overhead with total billable hours.
For example, if your overheads are $192,000, your cost per hour would be $20 (@ $192,000/9,600).
Step #4: Calculate Gross and Net Margin for Each Client
The gross margin is easy enough to calculate – just subtract your gross sales by total hours worked per employee and cost per hour of the employee.
For example, if an employee costing $30/hour works 100 hours on a client project, your total cost is $3,000. Assuming a contract value of $6,000, your gross margin is $3,000 (@ $6,000 – $3,000) - or 50%.
To calculate net margin for a client, you need to add your overhead costs/hour to employee cost/hour.
In the above example, your net margin would be:
Gross sales = $6,000
Total hours worked = 100
Employee cost per hour = $30
Overhead cost per hour = $20
Net margin = $6,000 – (100 * ($20 + $30)) = $1,000
Expressed as a percentage, your net margin is $16.67%.
In reality, you'll have employees working at different rates and a variety of recurring and one-off clients. This makes the calculation more complicated, but the overall process remains the same.
Using a Profit Margin Calculator
Thankfully, you don't have to go through the entire process yourself; there are plenty of profit margin calculators to help you out. And we've made one just for agencies!
Start with this profit margin calculator. Just make a copy of the Google spreadsheet to plug in your numbers!
Download Your Agency Profit Margin Calculator
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This calculator works wonderfully well for larger agencies with a wide variety of clients and employees. Instead of the tiered "levels" used in the spreadsheet, you might just have 3-4 employees at the same rate.
Modify the spreadsheet accordingly. These calculators will help you figure out your profit multiple, annual salary, and head-hour rates.
What Is the Average Profit Margin for Digital Agencies?
When it comes to agency margins, what's acceptable to clients, and what's acceptable to agencies themselves are seldom the same.
Case in point: according to one study, clients believe a 14% profit margin is acceptable. Agencies, on the other hand, see a 17% margin as more acceptable.
In HubSpot's survey of digital agencies, a majority of companies were either not sure of their profit margins, or reported margins between 11 and 20%.
As a rule of thumb, margins in the single digits are probably too low to run a viable business.
Anything above 20% means you're doing great. Beyond that and you're doing spectacularly well.
What To Do if Your Profit Margins Are Too Low
While we'd all love to make 20%+ margins, unforeseen costs, unpredictable clients and an uncertain business environment can eat into your profits.
In such a situation, there are a few things you can do to boost profit margins:
1. Switch To Value-based Pricing
Most agencies use a cost-based pricing model. They calculate their cost for each resource, add their profit margins, and quote a price.
The problem with this model is that it creates an adversarial relationship with your clients.
If you're an agency veteran, you already know this – clients will question you on everything from your efficiency and quality to your expertise and personnel selection.
One way to solve this problem is to shift from a cost-based to a value-based pricing model.
This essentially means that instead of charging clients on your costs, you charge them based on the value you bring to their business.
There is a simple formula for calculating your pricing based on value:
An Example of Value-based Pricing
If you bring in 10 new customers each month with an average customer LTV of $10,000, you've just helped the client make an extra $100,000.
And if you were to charge even 10% of that, your pricing would be $10,000.
It doesn't matter whether you spent $1,000 or $5,000 on acquiring these customers, what matters is the value you provide your clients.
Of course, this is a big shift in the way you structure your pricing. It's also radically different from the pricing structure your clients are used to.
However, if you can convince your clients to adopt this model, you'll never have to struggle with low margins.
As MIT Sloan Management Review notes, value-based pricing is the "most preferable way to set new product prices or to adjust prices for existing product", and that "customer value-based pricing is especially relevant in highly competitive industries".
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2. Create a Long-term Capacity Plan
On paper, this is a problem every agency would love to have – growing so fast that you can't keep up with the demand.
In reality, if you don't have a capacity plan to deal with rapid growth, you'll end up outsourcing work or even losing older clients.
Not to mention the effect on your team's morale of pulling far too many all-nighters to meet deadlines.
The result? Lower profit margins and poor hiring practices.
One way to solve this problem is to create a capacity plan.
Here's how you can do this:
A. Estimate Capacity
Start by auditing your existing staff and estimate your total billable hours for each service type. This should include their total billable hours each week minus their non-billable hours (i.e. time spent in administrative tasks).
You might have a table like this:
This gives you a fair idea of your existing capacity and what kind of talent you need to hire for future growth.
B. Calculate Capacity Utilization
Dig through your data to see how much of your existing capacity you're currently utilizing for each role.
Doing this for each month will tell you which roles are being fully-utilized and which areas need more attention.
For example, suppose your data shows that you bill for 60 hours of design work each week. However, your existing capacity is 90 billable hours/week, which means that 30 hours, or 33% of your capacity is being unutilized.
In contrast, if your data shows that you consistently bill for 100% of available hours of your copywriting work, it's probably a good sign to hire more copywriters to meet future demand.
Do this for all your roles and you'll have a good idea of projected demand and your existing capacity.
3. Focus On Predictable Revenue Channels
It's estimated that 70%+ of US agencies rely on per-project or hourly billing pricing.
The problem with this approach is that it creates a "feast or famine" cycle. One month you're drowning in work, and the next there's a sudden glut.
This not only affects your cash flow and profit margins, but also your team morale and the long-term financial health of your agency.
To solve this problem, shift focus to more predictable revenue channels such as marketing services with recurring billing or selling products (both digital and physical).
Omelet, an LA-based digital agency, experimented with a physical product – a brand of peanut butter named "Betsy's Best".
Similarly, there has been a shift towards subscription billing among digital agencies to create more predictable revenue streams.
For example, WebPageFX, a leading Pennsylvania based digital agency, offers monthly plans for nearly all its services.
This shift towards subscription billing has been facilitated by the rapid adoption of SaaS tools among enterprise customers.
Since companies are already used to paying a flat monthly rate for software, subscription billing for services doesn't seem like a radical idea.
It also helps that the subscription billing model is both agency and client-friendly. Clients don't have to worry about agencies billing them for non-productive hours, and agency employees don't have an excuse to slack off and inflate work hours.
This also ties into the value-based pricing model discussed earlier. With recurring billing, you have more room to deliver the best possible solution and not necessarily the solution that will take the most man-hours—a win-win for both clients and agencies.
4. Reduce Inefficient Processes That Reduce Profitability
To ensure that your business is profitable, you must have the right agency processes in place. Without a systematic approach, you'll end up using your valuable resources for manual, time-wasting tasks or taking on more than your agency can realistically handle.
For example, say your agency currently has a roster of ten clients. It’s a relatively manageable number of clients, and all seems well for a while. It’s tedious to copy and paste analytics into a manual spreadsheet when the monthly reporting period rolls around, but your staff has no issues so far.
Business starts booming and in a short space of time, you’ve onboarded twenty new clients. It’s great news! But now, your staff spends countless hours with client reporting and things are slipping through the cracks. After all, they’ve still got project execution and other things to attend to.
As a result, client retention suffers, and guess what? So does your agency’s profitability (and brand reputation).
To avoid these mishaps when scaling, invest in the right infrastructure such as an automated reporting tool like AgencyAnalytics. That way, you won’t have to worry about making errors, taking on more than your agency can handle, or losing out on profit.
Summary and Takeaways
If you find that your marketing agency margins are too low (< 10%), try the three strategies outlined above to shift to better capacity utilization and more profitable pricing models.
Here are the top takeaways to consider:
Average agency margins are in the 11-20% range. Single-digit margins are a sign of trouble.
Use a profit margin calculator to figure out your margins.
If your margins are too low, adopt value-based pricing, switch to recurring billing and create a capacity plan.
Calculating your agency margins is the first step in raising your prices and profits. By tracking profit and revenue per client and per employee, you'll not only have a better picture of your company's financial health, but will also be able to spot areas of improvement.
Create custom marketing reports that streamline your agency's processes while showing your agency’s value each month. Sign up for a free 14-day trial today!