If you're an agency owner and you feel like you're not getting the value from your business that you expect, it may be because you've lost sight of the core financial metrics you need to guide your decision-making and grow your business. 

This happens because delivering high-quality services is demanding, and often it becomes the sole focus of owners who are still deep in delivery.

Also, core financial metrics needed to make important decisions are often obscured in P&Ls created for tax purposes.

On tax-optimized P&Ls, owners' salaries and expenses can cause delivery costs to be understated and operating expenses to appear inflated. This gives the perception of better, stronger delivery margins than there actually are and can make it very difficult to tease out inefficient operating expenses. 

So, what are the core agency financial metrics that you should be concerned with and keeping an eye on every month?

Revenue

First is revenue, but it's important to note that the revenue number in your operating model and plan should exclude any passthrough on your client's behalf.

For example, paid media spend is revenue that might be passing through your books that could grossly misrepresent your revenue and skew the following margin.

You also need to have some view into future revenue forecasting and be able to map that out for at least 6 months, using account plans that incorporate renewal probability and expansion potential or other forecasting methodology.

Delivery Margin

Once revenue is noted, then it's time to calculate your cost of service so you can get to delivery margin. The floor for delivery margin is 50%. If you aren't making at least 50%, then you need to make some adjustments. A healthier target would be around 60% when compared to revenue. 

In order to get a better handle on your delivery margin, you have to have a clear and accurate delineation between delivery costs, and operating expenses.

All expenses take a bite out of profit, but breaking down delivery costs and separating them from operating expenses allows us to compare revenue percentage targets and narrow in on whether we need to optimize delivery efficiency, increase prices, or zero in on excessive operating expenses.

Operating Expenses

When it comes to operating expenses, the targeting is at most between 20 and 30% of revenue. At the end of the day, 25% operating profit margin is the healthiest target and will provide you the most flexibility in making decisions on how and when to grow your agency.

Of course, there are also good reasons why this can be less than 25% if you're actively investing and growing the business and are assuming more overhead, but those need to be choices that are made once your business can theoretically run as-is on a 25% operating profit margin.

Remember that operating profit margin is calculated as EBITDA before any owner's draws above and beyond owner's compensation that is assigned to cost of service and opex.

What to Do if You Aren't Meeting the Targets

To recap: 

• Gross delivery margin (revenue minus cost of service) should be well north of 50%
• Your operating expenses should be below 30% of revenue
• Your operating profit margin should be 25% or more, or you should understand specifically what you are investing in that is bringing it below that margin and be able to reduce that spend if needed.

If your gross delivery margin is not meeting targets, then you have a couple of options:

• Increase prices if your clients and the market will tolerate it. In some cases, depending on the size of your agency, this could be as low as an additional 10%. Now, raising prices opens up a whole other line of questioning about how you price and how you position. If it's as a low cost provider, this is risky! You can mitigate the risk of churn by only raising rates for new clients and monitoring close rates or by selectively raising rates for low-margin clients.
• Reduce delivery costs. Are you using a lot of hourly contractors? It may actually be more efficient to hire an FTE to take on those billable hours instead. Is your team under-utilized and not forecasted to be fully utilized in the next 6 months? It may be time to make cuts. 
• Improve efficiency. If you can take on more revenue with the costs you currently have and are able to scale revenue, then this will eventually drive up your delivery margins. This is where understanding what "bench" staff you can tolerate is important. Dipping below the 50% floor may be ok month-to-month if your revenue is variable and project-based.

If your operating expenses are above target, then it is likely one of the following scenarios that you need to deal with:

• Too many fractional operations contractors doing tasks in a silo
• Overspend on sales and marketing without the commensurate return on this investment
• Under-utilization of existing resources
• Overspend on software and productivity tools

The First Step to Fixing a Problem is Seeing It.

The math here is simple: Revenue in, expenses out. But if you still use your Quickbooks P&L report to try and figure out how you can adjust and alter your strategies to be more profitable and have more control and flexibility, you probably can't drill down into the real issues affecting your business' value.

Setting up an operating model isn't easy, it requires foresight into your revenue, delineation between operations expenses and cost of services expenses, and it requires monthly upkeep to ensure that the targets you've set for yourself and your business continue to be met. Over time, though, making the transition to running your business off a core operating model will help ensure that you are getting the value you want out of your hard work as the agency owner and ensure that you are able to have the right levers and control over the business that you want to grow.

At ServiceCrowd, we work with agencies to get an accurate view of core financial metrics before diving into client profitability and profit margins by service type and team.

Once we've identified what's bringing down profitability, we provide guidance to course correct, including resourcing and staffing plans, service pricing recommendations, and client account strategies.

Want to know more about us or do a 30-minute Profitability Consultation? Find us here!