6 Critical KPIs to Improve Your Agency's Profitability
If you run a digital marketing agency, you may have found yourself looking at your bank account, wondering how it’s possible that you can be busier than you’ve ever been, and still not have much cash to show for it.
It’s something I’ve seen time and time again in my work as an agency profitability consultant and SaaS CEO, focused on helping agencies improve their profitability.
The truth is, just about every agency I’ve worked with has hit that first critical growth ceiling when they’ve figured out how to get clients, but are still struggling with cash flow and profitability.
In this post, I’m going to walk you through the key KPIs I’ve used to not only lead clients to improved profitability, but to also show their progress and hone their strategy along the way. The six metrics I'm going to cover include:
- Revenue earning efficiency
- Gross margin
- Average billable rate
- Accuracy of scope
- Overhead spending
For each metric, I will explain what it is, why it's important, and how to measure it; and then provide benchmarks to help you identify what your agency should aim for.
Profitability metric #1: utilization rate
If you have an internal team that delivers work to clients, utilization rate will be the first and most foundational metric to start paying attention to in terms of profitability.
What is utilization rate?
For employees that interface with clients, their working time can be split into billable vs non-billable hours. Billable hours are those spent on client projects or directly working with their clients, while non-billable hours are those spent not directly on the client, such as with internal projects and meetings.
Utilization is defined as the percent of your employees' total time that is billable. What this means is, in order to increase your agency's profitability, you need to make sure your team has enough work to do for clients to keep a threshold of billable hours.
Why is utilization rate important?
Understanding your utilization rate helps you avoid situations where you’re paying a salary to the team, but not earning any revenue in return. If the team isn’t busy, there’s not much point in optimizing for profitability, because the increased efficiency can’t be transferred to other revenue-earning opportunities.
If you primarily lean on contractors or outsourced partners to do work for clients, you may not need to worry about utilization as much, since you’re not paying those contractors when the agency isn’t busy. Your contribution/gross margins may be lower, but if you haven’t figured out how to predictably acquire clients yet, keeping your workforce more elastic might be a good idea until you’ve sorted out your funnel and acquisition channels.
How to calculate utilization rate
Utilization can be calculated using the following formula:
Gross Capacity / Billable Hours = Utilization Rate
- Gross capacity is the total number of hours they have available per year (most employees are 40 hours per week for 52 hours per year, or 2080 hours).
- Billable hours is the amount of time they spend doing work for clients (regardless of whether you’re billing hourly or not).
Utilization benchmarks to aim for
On a week-to-week basis, you generally want your “pure” producers (designers, developers, copywriters, etc.) to land somewhere between 75% and 90% utilization.
On an annual basis, you should aim to have your production team hit a utilization rate of between 65% and 80%.
With utilization above 65%, you should be putting yourself in a position to achieve healthy margins as a business, so long as you’re earning your revenue efficiently (more on that next).
Profitability metric #2: revenue earning efficiency
What is revenue earning efficiency?
There’s a trap many of my clients fall into before they call me: the trap of selling work to meet a revenue target, without thinking about the liability that that work creates. This often leads to them working long hours and yet still not having much cash flow to show for it. And this is where revenue earning efficiency comes into play. This metric basically describes how well you use your assets and resources to generate income.
Why is revenue earning efficiency important?
As a service business, your revenue is a liability until it’s earned. Your margin is determined by how much it costs you to earn that revenue, and that cost is often a function of the time it takes to complete the work. That’s why it’s critical to track how efficiently you’re earning your revenue.
How to track your revenue earning efficiency
There are two primary ways for digital marketing agencies to track their earning efficiency: gross margin and average billable rate. These will comprise the next two metrics, where I'll break down the pros and cons to help you determine which metric is best for measuring and improving agency's profitability.
Profitability metric #3: gross margin
As mentioned above, gross margin is one of two metrics you can use to help track your revenue earning efficiency.
What is gross margin?
Gross margin is a tried and true method to getting a handle on your production profitability. Simply put, it means calculating the profit margin on a per-client or per-project basis by subtracting time & material costs from whatever the client has paid you.
This method is generally more accurate, but can be more expensive and time-consuming to calculate since it usually happens in an accounting tool—and without an aggressive bookkeeping schedule, this may be something you can only ever look at in a retroactive way.
Who should use gross margin?
I generally recommend the gross margin metric to mature agencies (several millions+ in revenue) with a bookkeeper making updates on a biweekly or weekly basis, and/or agencies who work with a lot of contractors.
How to calculate gross margin
Gross margin can be calculated with the following formula:
Adjusted Gross Income - (COGS/Labor Costs) = Gross Margin
Gross Margin / Adjusted Gross Income = Gross Margin %
- Adjusted gross income (AGI) in this formula refers to the amount of revenue left over for the agency to earn after any pass-through expenses are paid (ad spend, print budgets, equipment rentals, etc.).
- COGS/labor costs are the costs associated with the people you’ve brought on to work on this project, be they internal team members or external contractors.
To calculate your employee cost per hour for internal team members, you’ll need to take their salary + benefits and divide it by their gross capacity. For most employees, this comes out to 2080 hours per year (40 hours x 52 weeks).
For a deeper dive into this metric, check out my guide on accurately calculating your billable employee cost per hour.
Why gross margin is important
Being able to consistently hit gross margins in this range means your delivery systems are efficient enough to scale profitably, thereby allowing you to cash-flow your agency's growth.
Gross margin benchmarks to aim for
To run a highly profitable, scalable agency, you’ll want to aim for a gross margin of 50-70% on a per-client or per-project basis.
That should set you up to hit a margin of 40-60% agency-wide at the end of the year, leaving you enough room to carry normal levels of overhead and accommodate for slow times without compromising net profitability.
Profitability metric #4: average billable rate (ABR)
Average billable rate is often a much simpler, more accessible way to get an idea of your revenue-earning efficiency (which is metric #2) and benchmark different clients or projects against each other.
What is ABR?
ABR basically helps us understand the average rate we’re earning per-hour, based on the amount of time it actually takes us to earn our revenue. This method is generally a bit less accurate, but much faster and easier to calculate and doesn’t require a bookkeeper or accountant to figure out.
Who should use average billable rate (ABR)?
I generally recommend using the ABR metric method for smaller agencies who may just be getting started with tracking metrics, and for agencies who tend to work with fewer contractors and keep most of their labor in-house.
How to calculate ABR:
Average billable rate (ABR) can be calculated with the following formula:
Adjusted Gross Income / Hours Worked = ABR
- Adjusted gross income (AGI) is the amount of revenue left over for the agency to earn after any pass-through expenses are paid (ad spend, print budgets, equipment rentals, etc.).
- Hours worked is the total amount of time your team spent to complete the work for your client.
ABR benchmarks to aim for
The target for average billable rate is the same as for gross margin. When we look at our average cost per hour for our production labor, we want to land in the 50-70% margin range.
Usually that means aiming for around 2.5x your average employee cost per hour or whatever contractor rates you’re paying the team.
For example, if our hourly cost per hour is $50 to pay someone to do the work for us, we’d want to target an average billable rate of $125 (which is 2.5 x $50 and equates to a gross margin of 60%).
Profitability metric #5: scoping accuracy
The riskiest part of any service business is the fact that many of its critical functions rely on assumptions that are made every day when scoping work.
What is scoping accuracy?
The information we use to determine how much to charge for work, when to hire or fire employees, how to resource a plan, and how to assign team members, all comes down to what we believe is going to be required to complete the deliverables we’ve promised our clients—aka the scope of the work.
The importance of scoping accuracy
Without feedback about how accurate those assumptions are, it’s very difficult to build out the systems required to scale our agency and our teams’ profitably. That’s why it’s so important to install a feedback loop to help us understand whether the assumptions behind our pricing are accurate or not.
How to calculate scoping accuracy
Scoping accuracy can be easily calculated by the following formula:
Estimated Time & Cost / Actual Time & Cost = Scoping Accuracy (%)
- Estimated time & cost is the amount of time or money we estimated it would take to complete the work.
- Actual time & cost is the amount of time or money we actually spent to complete the work.
Usually this will be broken down into “buckets” like design, development, and project management. To learn more and to avoid common agency mistakes in this area, you can check out my guide on choosing the correct structure for your estimates and actuals.
Scoping accuracy benchmarks to aim for
An acceptable margin of error is to consistently keep variance under 20% of the originally anticipated budget, with going over, of course, being more of a concern.
However, at scale, we should be aiming to keep our margin of error under 10% consistently. This should become achievable over time as we collect more data and install more processes to close the gaps between our assumptions and reality—thereby creating our own agency profitability flywheel.
Profitability metric #6: overhead spend
Once you’ve gotten a grip on utilization, earning efficiency, and scoping accuracy, you should already be head and shoulders above the competition. Your agency will feel more stable, you won’t find yourself worried about cash flow, and planning ahead for growth won’t feel so obscure.
The last piece of the puzzle for really dialing in your agency's profitability is paying attention to your overhead spending—making sure it’s balanced relative to your income.
What is overhead spend?
Overhead costs are expenses that support your agency but are not directly tied to the creation of a specific product or service. They are the ongoing and necessary expenses of running your business that do not generate revenue. The three main categories of overhead spending that we’ll talk about in this post are administrative, facilities, and sales & marketing.
How to calculate overhead spend
The percentages of overhead spending for each of the different areas below may shift depending on your accountant’s guidance on where to place expenditures that fall into “grey areas.”
Overhead % can be calculated using the following formula:
Overhead Spending / Adjusted Gross Income = Overhead %
- Overhead spending is any expense related to admin, facilities or sales & marketing (further defined below).
- Adjusted gross income (AGI) is the amount of revenue left over for the agency to earn after any pass-through expenses are paid (ad spend, print budgets, equipment rentals, etc.)
Overhead spend benchmarks to aim for
The general rule of thumb is that total overhead spending should be about 20-30% of your adjusted gross income (AGI). Within overhead, there are three primary categories to pay attention to:
- Administrative expenses (target = 8-12%)
Administrative expenses include things like accounting, legal fees, receptionist, part or all of the director’s or owner's salary, and more.
- Facilities expenses (target = 4-6%)
These include any expenses related to providing the team with a proper working environment such as a building (rent), parking, and utilities.
- Sales & Marketing (target = 8-14%)
Sales & marketing includes any expenses related to bringing in new business, including marketing spend, sales softwares, part of the directors or the team’s salary working on sales or internal marketing projects, etc.
Why overhead spend is important
Landing in the acceptable ranges for each of these areas should allow you to meet your agency’s needs relative to its size, while maintaining healthy profit margins.
Keep in mind that through periods of aggressive growth, you may find yourself spending out ahead of scale. For example, you may sign a lease on an office that is much larger than what is necessary for your current team, anticipating having to make a lot of hires in the coming months.
There’s nothing wrong with this, so long as you’re making these investments consciously and with a plan to eventually level your expenses back into a healthy relative range.
Use these metrics to make a big impact on your profitability
If there’s one thing I'd urge you to take away from this post, it’s that it doesn’t take much to start measuring the simple numbers that will make a big impact on your profitability. What I’ve learned from working with hundreds of agencies over the last few years is that most of them don’t do this stuff well (if at all)—so even doing just part of it can help you set your agency apart from your competitors, and position you to outlast or outgrow them in the long term.
The peace of mind that comes with having good cash flow, efficient systems, simple yet clear-cut numbers, and visibility into your progress can make running your agency much easier and more enjoyable for both you and your team.
Who doesn’t want that?
About the author
Marcel Petitpas is the CEO & Co-Founder of Parakeeto; a consultancy turned software company that helps service businesses increase profitability and close more deals.He’s also the fractional COO at Gold Front, an award winning creative agency working with top silicon valley brands like Uber, Slack, Google, Keap, and more. When he’s not helping agencies run more profitably, you’ll find him cycling, renovating his home with his fiancé Cearagh, or watching The Office on an endless loop.