If you’re running an agency but are struggling to figure out if you’re as profitable as you should be, then you’ve come to the right place.

In this guide, you’ll learn everything you need to know about how to Calculate Profitability for your marketing agency clients and project, how you stack up against industry benchmarks and where to find resources to help you improve profitability going forward.

Why is it so hard to calculate agency profitability?


I want to start by making it clear that if you’re reading this post because you’re confused on how to best figure out profitability – you’re not alone.

Many agency owners find themselves with larger businesses than they’re really comfortable running. Often, they find themselves there almost by accident. I call it the “curse of competency”– when you’re doing amazing work for clients, so they keep asking for more and telling their friends about it.

Next thing you know you’ve got a team of people on your payroll, overhead to cover, and more clients than you ever thought you’d have.

You’re busier than ever, clients keep coming in the door – but that number in the bank account at the end of the month always seems to be lower than it should be.

Sound familiar?

The truth is that service businesses like agencies have few barriers to entry. But they’re one of the more challenging business models to scale. They are complex in nature and aren’t as straightforward as most other “product” focussed businesses.

In order to scale, it’s critically important to solve profitability issues and take control of your efficiency when it comes to earning revenue. If you’re not managing profitability correctly, selling more services can actually make cash flow problems worse, and even become the reason you have to shut things down.

That’s why we wrote this detailed guide to demystify the nuances and walk you through exactly how to track your performance and profitability as an agency.

The Industry is Changing – The Switch to Flat Rates & Value-Based Pricing

Value-Based Pricing

The era of the billable hour is largely behind us. Most agencies have moved away from billing clients for a time in favor of fixed-rate, flat retainer or value-based pricing models.

While these models generally lend themselves to ultimately bringing in higher fees for the same work, they introduce a new level of risk to providing services that the billable hour often helped mitigate.

If a project wasn’t scoped properly, the client made additional requests or an unforeseen expense came up – it was often passed on to the client as extra hours billed.

Profitability in this world was pretty straightforward:

It was about setting rates that set the company up for a healthy margin at the onset and making sure billable utilization stayed high and those billable hours were paid for by the client as often as possible.

However, in a flat fee world, the importance of measuring what it takes to deliver outcomes to clients has become even more important. We have to make sure margins are protected, and the benefit of pricing on value is actually achieved.

It doesn’t help that most of the information on the internet is informed by this era of charging for time – which makes it hard to discern what is relevant in alternative and flat fee-based pricing models.

So with all of that said, how profitable should you be, and where do you start when it comes to calculating and protecting profitability?

Profitability Benchmarks

I – Net Profit (EBITDA) Benchmarks for Your Agency

The first place for us to start is at the bottom line.

We generally like to benchmark profitability for the entire agency using EBITDA (Earnings Before Interest, Taxes, Depreciation & Amortization)

Which is a fancy way to say, money left over after all the expenses are paid, and before tax.

We mostly look at it this way because it levels the playing field as different parts of the world have different tax systems, and when the accountants start optimizing for tax efficiency, the books can get extremely convoluted.

So, how much profit should you have in your agency at the end of the year?

The industry average is right around 10%

What has traditionally been considered healthy is 15-20%

What is generally required to cash-flow explosive growth is 25-30%

I always encourage my clients to shoot for 25%

Note: These are net profit targets AFTER paying the founders/owners a market rate (which should be no less than $100,000) but BEFORE paying out any additional bonuses that are not a part of regular compensation for the team and owners.

Net profit is generally something you’re going to look at in your accounting software at an agency-wide level, as it’s difficult to accurately get there working backward from averaged hourly costs and time tracking data and to do the accounting necessary to narrow in at the client or project level.


In fact, net profitability at the client level isn’t something we generally recommend trying too hard to calculate in most cases. Instead, we like to focus on Gross Profit on projects as it’s a better reflection of delivery efficiency and is much less costly to track accurately.

II – Gross Margin Benchmarks for Your Agency, Clients & Projects

Gross Margin is another important profitability metric to track because it tells a story about how efficient our agency is at earning revenue, which is a reflection of how good our processes are for delivering work to clients without going over budget. It’s also the foundation for a profitable agency.

If you can’t consistently achieve a healthy gross margin – it’s extremely hard to have a healthy bottom line.

We calculate Gross Margin by looking at our revenue and subtracting all of the costs required to earn that revenue.

At the Client or Project Level, this means subtracting things like:

  • COGS
    • Contractors
    • Equipment rentals
    • Print/Ad Spend
    • Travel related to production
    • Any other hard marked up or pass-through expenses.
  • Labor Costs as a function of Time * Cost-per-hour

Notes:

  • Gross Profitability at the Client or Project level can be looked at in accounting software, but generally requires some highly detailed (and potentially costly) accounting practices to do on a regular basis.
  • It’s generally more efficient to look at in a spreadsheet or an agency operations reporting software like Parakeeto.

Notes:

  • Gross profit at the agency-wide level, like net profit, can be looked at in your accounting software and shouldn’t be too hard to achieve.
  • When looking at Gross Margin at the client or Project level, we’re already factoring in shared production expenses in the Labor Cost-Per-Hour calculation.

III – Benchmarks

Benchmarks for Gross Profitability will vary depending on your business model.

For example, if you run a more traditional agency with a team of full-time employees and an office – you might have a higher gross margin target (50-70%) since your overhead will be higher (20-30% of your Adjusted Gross Income AGI)

If you run a more distributed agency and use freelancers or contractors, you might have a lower overhead rate (14-24%) which allows you to compensate for a potentially higher cost-per-hour (paying freelancers instead of full-time employees) still be highly profitable with a lower gross margin target (40-60%)

The way to think about this is to set your Net Margin target, assess the amount of overhead required for your business model and add them together.

For example, if your target is 25% Net Margin, Your overhead is 20% of Adjusted Gross Income, then you’ll want to target at least a gross margin of 55% (100% – 45%) to make that goal attainable.

Now that you know what to target, how do you actually go about calculating these things in your agency in an accurate way?

Part 1:  Calculating Costs and Gross Margin on Projects & Clients

The foundation of agency profitability lies in the ability to be efficient in earning revenue and setting projects up for success from the get-go.

What often gets overlooked is that in a service business, revenue needs to be earned after it’s sold. That means people need to spend time doing the work and delivering things to clients, which means that earning revenue costs money.

How much money it costs you depends almost entirely on how much time needs to be invested.

The formula for Gross Margin is as follows:

Revenue – COGS = Gross Margin

Where COGS = Pass Through Expenses + Direct Labor Cost

So we need to know two things in order to calculate gross margin:

  1. Pass through Expenses
  2. Direct Labor Costs

This is probably a good time to mention that if you’re looking for a quick and easy way to model the profitability of your clients and projects, we have a Project Profitability Report Template included in our Agency Profitability Toolkit, which you can download free right here:


Now, let’s break down how to figure both of those things out

I – How to Calculate Pass-Through Expenses and Adjusted Gross Income (AGI)

The first step in this process is to subtract Pass-Through Expenses from your revenue – this will show you the Adjusted Gross Income (AGI) on your clients and projects. This is the amount of revenue from a project that actually belongs to you, and is earned by the work your team is doing.

It’s an important number because it allows you to better understand how efficient you are at earning revenue and benchmark healthy spending ratios in your business. We’ll use it elsewhere, so It’s good practice to start calculating it.


Examples of Pass-Through Expenses would be:

  • Stock images
  • Outsourced Work (contractors/freelancers)
  • Website Templates
  • Equipment rentals
  • Travel costs related to production
  • Any other cost that passes through you and into another vendor in order to deliver work to the client. (These may or may not be marked up – either way, it doesn’t affect this math)

Example of Adjusted Gross Revenue (AGI) calculation:

Total Project Revenue $100,000
Camera Rentals $10,000
Freelancers $5,000
Ad Spend $20,000
AGI $65,000

II – How to Calculate Labor Costs on Project & Clients

Next, we want to figure out how much it costs to earn our AGI based on the labor costs incurred on the project.

We do this simply by taking all of the time logged against the project or client and multiplying it by the Cost-Per-Hour of the employees involved.


Example:

Employee Cost Per Hour Hours Total
Samantha $57.50 120 $6,900
James $24.25 165 $4,001.25
Luis $42.80 75 $3,210
Total 360 $14,111.25

You might be asking yourself, how do I figure out my Cost-Per-Hour?

For details on that, check out this blog post we wrote on exactly how to figure that out.

III – Calculate Gross Margin on Projects

The last step is to subtract Labor Costs from Adjusted Gross Income (AGI) to get to our Gross Margin.

Example of Gross Margin calculation:

Total Project Revenue $100,000
Adjusted Gross Revenue (AGI) $65,000
Labor Costs $14,111.25
Gross Margin $50,888.75
Gross Margin (%) 50.8%

Bonus Metric: Average Billable Rate (ABR)

Now that you know how to calculate your Adjusted Gross Income AGI on a Project or Client, you can calculate some other useful metrics like Average Billable Rate (ABR) to figure out what types of engagements you’re most efficient at earning revenue at, and how closely you’re hitting budgets overall.

We like using Average Billable Rates (ABR) because, like EBITDA, it helps level the playing field compared to Gross Margin, and is also much easier/faster to calculate across different parts of your agency.

It’s also a really useful metric to use when trying to model out revenue capacity, or breaking down your sales pipeline into hours.

How to Calculate Average Billable Rates (ABR)

To calculate your Average Billable Rate (ABR) on any given client, project or area of your agency, for any given period of time, just divide your Adjusted Gross Income (AGI) by all the hours worked on in that given time period.

Example of Average Billable Rate (ABR) calculation:

AGI = $65,000

Hours Worked = 360

ABR = $180.55

Average Billable Rates (ABR) can be an extremely helpful metric when assessing which types of work are consistently hitting or missing budgets, and by how much.

They’re also useful for forecasting and modeling functions, like taking revenue from our pipeline and working backward into the capacity we need to service incoming deals.

For more on Average Billable Rates and forecasting in your agency, check out this blog post we wrote.

Bonus #2: Calculating Net Profit on Projects

We don’t generally encourage agencies to look at net profitability at the project or client level since it’s difficult to do accurately and is often not the best way to draw insights into how efficient our delivery processes are.

However, for certain business models and in specific contexts, it can be a useful metric to look at. So we’re going to cover that part just in case you happen to fall into one of those camps.

Note:

The technique we’re outlining here describes a method of reaching your net profitability at the client level without necessarily having to do a ton of extra work in your accounting software. It’s not designed to be 100% accurate, but instead to give you a relative idea of net margins on a project by project basis.

Step 1 – Calculating Your Total Overhead

The first step is to get a sense of your overhead cost per hour. This is done simply by taking your total overhead expenses over a given period of time and rolling them up.

Your overhead expenses should take into account every expense that hasn’t been factored into production costs, such as:

  • Admin Staff
  • Insurance and Taxes
  • Rent & Utilities
  • Sales & Marketing Costs
  • Website hosting & Admin software
  • Legal & Accounting Fees
  • Office Equipment (Purchase + Maintenance)
  • Founder salaries (Or a portion of founder salaries for non-billable time)
  • etc.


You should be able to run a report in your accounting software to pull this information for any given period of time fairly easily, assuming your Chart of Accounts is set up the right way and you’re accounting on an accrual basis.

Step 2: Calculating overhead cost-per-hour

The next step is to look at the same period of time for which you’ve pulled your overhead expenses, and figure out your billable team’s gross capacity in that time frame.

This is done exactly in the same way as discussed in the Labor Cost Per Hour section earlier in this post.

It’s simply a function of each employee’s Gross Capacity which is the number of hours per day they work multiplied by the working days in that period.

Once you have those numbers, divide your Overhead Expenses by your Capacity, and that gets you Overhead Cost-Per-Hour.

Example of Overhead Cost-Per-Hour calculation:

$20,000 / 1,000 hours = $25/hour

Step 3: Calculate the Net Margin on Clients & Projects

The last step is taking your Overhead Cost-Per-Hour figure and multiplying it by the number of billable hours worked on a project.

This gets you your Overhead Cost, which when subtracted from Gross Margin should give you a Net Margin for your client or project.

Example Overhead Cost Calculation:

360 hours x $25/hour = $7200

Example Net Margin Calculation for a Client or Project:

Here is an example cost of a project to help you understand;

Project Revenue $100,000 %
Cost of Goods Sold (COGS) $35,000 25%
Adjusted Gross Income (AGI) $65,000 65%
Labor Costs $14,111.25  
Gross Margin $50,888.75 50.1%
Overhead Costs 9000  
Net Margin $41,888.75 41%