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Published by Jody Grunden on 19 Jul 2023

The landscape for digital agencies has shifted. Over the last twenty years, there’s been a downward pressure on profit margins. People want to get paid more, clients want to pay less, and the 80-hour work week is a thing of the past (thank goodness). 

To protect margins, marketing agencies end up developing complex billing and staffing models: combinations of full-time employees and freelancers working together on the same projects. On top of all this, there are more service offerings and departments than ever. 

So how do you get insights into the health of your gross margin? How do you know what to do if it’s not where you want it to be? And how do you project your financial health into the future?

agency profitability

You need to understand financials, of course, but that can no longer be the only way that you get those insights; you need to understand operations as well.

To talk about new trends in creative agency profitability, I sat down with Marcel Petitpas, co-founder of Parakeeto. When it comes to using data to improve profitability, Parakeeto–a technology-leveraged service firm, specialized in helping agencies measure and improve performance–comes from the same school of thought as Summit. 

I wanted to hear from Marcel–as a creator of software that he describes as “bookkeeping for your non-financial data”–to hear his thoughts on how agency owners can take advantage of all the information that’s now available to them to really understand their overall profitability–and not get lost in the weeds. 

Here’s what we discussed. 

Understand–and then influence–gross margin 

When a digital marketing agency gets off to a great start, it can lead to problems: They nail their pricing model, and they think they’re really great at finances, but it’s just luck. Often, they don’t know what it costs them to earn $1 of revenue. 

Without knowing that number (whether you call it your gross margin or delivery margin), and without it being healthy, it's very difficult to be profitable. When that number is healthy, profit starts to feel more like a choice than a random outcome. 

There are three non-financial metrics that control gross margin: average billable rate, utilization rate, and average cost per hour. There’s also fiscal management for overhead costs. It’s important to understand these because they're so much more timely and so much less expensive to make precise in terms of the different areas of the business that you can measure. 

Once you understand your gross margin, the next issue is knowing how to influence that number and what levers you have available to improve your bottom line. When you understand how to control the outcome, you take luck out of the equation. 

Track time–but use your ‘why’ to keep you out of the weeds 

Time tracking has a bad reputation. And it’s true, if you do it for the wrong reasons, it can be a black hole of busywork. But if we agree that gross margin is important, and you want to know what’s happening at a more granular level, there’s no way around it. 

Time tracking does not necessarily mean embracing the billable hour or investing in fancy saas products. What it does mean is asking the question, “Where is our largest expense (payroll) being allocated?” 

When we have a model for that, then we can start to ask really great questions like: “What type of clients, services, different types of deliverables or departments are more or less efficient as revenue streams?” or “Are we experiencing scope creep?” That’s where we can start to surface the insights that drive the profitability of the business forward. 

At Summit, we’ve made so many improvements thanks to time tracking, identifying issues that we never could have otherwise. A major example was our cash flow forecasting process that we provide to about 60% of our clients. I thought it was taking us around 1.5 hours, when really, it was taking 3-5 hours – and sometimes even longer. When you multiply that one inefficiency by 150 clients for 52 weeks out of the year, it’s a huge impact–so you know it’s worth your while to invest time in finding a solution. 

The danger of tracking is creating a system so complex that no one uses it. Knowing why you’re tracking will go a long way in making sure that doesn’t happen. If you set up your systems with a clear picture of what you need them to tell you on a regular basis (rather than planning for one-off scenarios that needlessly complicate things), then you’ll know where to look for insights when it’s time to make decisions. 

Pick the tool that works for your team 

There's so much technology out there. It’s easy to sign up for 20 different tools that promise to simplify some part of the process, but if the tools don’t speak the same language, more ends up being less. 

We hear it on sales calls all the time, “My tools are the problem.” But the tools are never the problem. Spoiler alert: It’s how the tools are being used. 

The best one is the one your team actually uses. That means it has to fit into your workflow. If you don't have good compliance, it doesn't matter how precise the data is; it's not going to be accurate. Precision and accuracy are not the same thing. Often precision actually comes with the cost of accuracy if it increases complexity enough. 

Whether you choose an all-in-one, or a bunch of specialized tools, what’s important is making sure that you understand: “What is the core data schema that you need to measure for your business?” If you understand that the core outcome needs to produce data that looks a certain way, then you can align everything else to that. 

Keep in mind these two questions when choosing tools:

  • Can your team use them?

  • Can it create the data structure you need? 

Collecting the data is the first step. The second step is the reporting–and that’s where you need to control for human error. The bigger the team, the more mistakes they're going to make. Sometimes you're going to forget your timer is running and you're going to log a 99-hour time entry. Sometimes there's going to be an apostrophe in the client’s name in the time tracking tool but not in the finance tool. 

You don’t want incorrect data going straight into a report, which is why you need a middle layer between collection and reporting–a process that’s deliberate for extracting, cleaning, transforming and formatting the data, and then doing something with it. (This is where managed software like Parakeeto comes in handy.) 

The right amount of data is the data you pay attention to 

A financial statement can be as simple as three lines: sales, expenses and net income. You can file taxes with that, but you can’t figure out what you’re doing right and wrong. Are there operational inefficiencies? Are you using the right pricing strategies to maximize your utilization without underselling? There’s no way to know.

That’s one extreme. 

But before you get all the way to the other extreme with 300 tasks for each client project and 3,000 accounts, you need to weigh the cost of collecting the data, for your team members; not to mention the time it will take you to analyze it. If you spend all day looking at the data, you won’t have time to make decisions and think about it. 

Finding the right balance with what you can handle takes trial and error, but you want to start before you’re in the middle of a fire drill. We saw this with the pandemic: our clients who had been doing modeling and forecasting were perfectly used to reacting to different potential scenarios before it came time to jump into action. 

Understanding what makes a profitable agency is great insurance in a crisis, but the long-term benefit is that it helps you make day-to-day decisions that profoundly impact your agency.

For me, it’s always been about what can make my life simpler: Is it hiring somebody to do something? Is it a tool that can do something? Is it a process that can be changed? Or is it a combination of all three–that's what we continue to look at ourselves. 

The real reason behind doing this kind of work is to help you figure out where that little optimization might be, to help your people and help your processes.

Want to learn more about how to optimize agency profitability? Watch this webinar replay with Marcel Petitpas.

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