How to Make Your Agency Profitable in 2025

7 Dec 2024 · 56 min

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Podcast Episode Summary: How to Make Your Agency Profitable in 2025

Podcast Information

  • Title: Marketing School - Digital Marketing and Online Marketing Tips
  • Hosts: Neil Patel and Eric Siu
  • Special Guest: Marcel Petitpas, CEO and co-founder of Parakeeto
  • Episode Number: Bonus Episode (specific number not provided)

Episode Overview In this episode, Marcel Petitpas shares insights from the Agency Owners Association (AOA) regarding profitability strategies for agencies in 2025. The conversation focuses on key financial metrics and pricing strategies that can enhance an agency's profitability.

Time-Stamped Show Notes

Introduction

  • (00:00): Introduction to AOA Coaching Call and Marcel Petitpas.

Understanding Agency Operations

  • (00:58): The interconnectedness of agency operations impacting finance, delivery, and sales.

Cycle of Insolvency in Agency Growth

  • (02:53): Discussion on how agencies often find themselves in a cycle of insolvency due to mismanagement of growth and resources.

Core Financial Metrics for Agency Profitability

  • (06:06): Introduction of critical metrics to measure agency health and profitability.

Delivery Margin Significance

  • (09:02): Importance of understanding and improving delivery margin.

Key Metrics for Agency Success

  • (11:47): Metrics that agencies should consistently track.

Strategies to Improve Delivery Margin

  • (14:51): Discuss actionable strategies to enhance delivery margins.

Average Cost Per Hour

  • (18:15): Importance of calculating Average Cost Per Hour (ACPH) to monitor profitability.

Utilization in Agency Operations

  • (33:11): Discusses the role of utilization in operational efficiency.

Maximizing Profitability

  • (39:46): Strategies to maximize profitability through smart adjustments.

Effective Pricing Strategies

  • (45:08): Insights on navigating pricing strategies to achieve better margins.

Key Concepts and Discussions

The Cycle of Insolvency

  • Agencies can experience a cycle where they win new clients but struggle to manage the increased workload.
  • Often leads to overhiring and financial strain, resulting in a situation where revenue increases but profits do not.

Financial Metrics

  1. Agency Gross Income (AGI): Revenue after subtracting pass-through expenses.
  2. Delivery Margin: Critical metric measuring profitability; ideally should be 50% or more.
  3. Average Cost Per Hour (ACPH): Measure of labor costs, important to track for financial efficiency.
  4. Utilization Rate: Percentage of time spent on billable tasks versus overall capacity.

Pricing Strategies

  • Aim for a 70% direct delivery margin when pricing services to ensure profitability.
  • Use different pricing models based on project risk and value:
  • Time and Materials: Suitable for low-value, high-risk projects where the cost is unpredictable.
  • Flat Fees: Appropriate for predictable projects with clear outcomes.
  • Value-Based Pricing: Focus on the value delivered to the client rather than just costs incurred.

Conclusion

  • The episode emphasizes the importance of understanding financial metrics and optimizing pricing strategies to enhance agency profitability. Marcel Petitpas provides actionable advice for agency owners to navigate their financial operations effectively.

Key Takeaways

  • Awareness of interconnected agency operations can help prevent financial mismanagement.
  • Regularly tracking core metrics is essential for maintaining profitability.
  • Strategic pricing can significantly impact overall financial health and sustainability.

Call to Action

  • Listeners are encouraged to explore more content related to agency operations and profitability through the Marketing School resources and connect for further insights.

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For more information, visit [Marketing School](https://www.marketingschool.io).

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Transcript

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0:28All right, so we have a little treat for you. the CEO and co-founder of Parakito. It's a company dedicated to helping agencies measure and improve the profitability by streamlining their operations, reporting on the systems. He's also the head strategic coach at SaaS Academy by Dan Martel and the number one coaching program for B2B SaaS businesses in the world. Welcome. Thank you for being here. I appreciate you for being here, Marcel. I'm going to turn it over to you. Let's get cracking. Thank you very much, Austin. Hey, everyone. I'm super stoked about this because like it's a small intimate group.

1:04So typically when I'm doing stuff like this, it's a much bigger room. I'm kind of talking at you guys, you know, we'll do Q and a and do some engagement and stuff, but like, we can just really get into the weeds today and talk about the stuff that is most important to all of you. So I know we, there was like a voting process that happened before I showed up here and there's a focus on forecasting. We could definitely get into that, but I want to take the opportunity to just kind of get to know who you guys are, where you're at in your businesses, and field maybe some of the burning questions that you have as it relates to the scope that I spend all of my time thinking about, speaking about, publishing content on, and that we've built an entire company around, which is that there's no other word to use to describe it, that clusterfuck that is trying to make sense of the interconnected nature of finance, operations and delivery, and new business and sales.

1:56right as owners of an agency we know that these things are interconnected and they're part of this constantly moving puzzle and when something changes in one area it impacts everything in these other areas and so when we're trying to answer simple questions like are we making money on the stuff that we're selling and delivering do we need to hire people when do we need to hire those people is our team busy enough what should our margins even look like are we spending the right amount of money on overhead on delivery on sales and marketing like these are some of the things that I struggled with when I was building my business.

2:28It's the stuff that hundreds of agencies come to us every year for help with. And so anything related to that scope, I'm happy to dig into today. So with all of that being said, let's dig into some stuff. I'm going to call a couple audibles here. We will, I can briefly talk about forecasting, but I want to start with some of the first principles because it sounds like those are important. Yeah. Where to invest. Awesome. Packaging services for good margins. Awesome. Okay. All right. This gives me a good sense of where we can go. 900K trying to break 35 % of profitability. Amazing. Kevin. Okay. Let's have some fun, guys.

3:04Let's have some fun. I'm going to share my iPad screen. I'm going to pin myself. Can everybody see my iPad on your screen? Give me a thumbs up if you can see that. Incredible. Austin's good. We're good. All right. So, yeah, this is me. I won't bore you with my accolades. All I do is talk about profitability and helping agencies measure their profitability. And then, you know, a lot of what I do today in SaaS Academy is helping software companies get more sophisticated about how they manage professional services because, spoiler alert, professional services are coming back in style in the software world because all of a sudden people care about how profitable software companies are.

3:44It's like a really weird thing that just happened like in the last 18 months. So they're realizing that, hey, we actually do a lot of services and there's a lot of human capital involved in SaaS, but we just don't charge for it and call it things like support, customer success, onboarding, et cetera. I digress. It's my little hot take on where SaaS is going. I get to talk a lot. I do a lot of this, which is great because the only thing that I like more than speaking is hearing myself speak. So it's kind of just a wonderful thing that I make a living doing this. And I want to talk really briefly about the thing that a lot of people come to us with.

4:15And I'm really curious if this resonates for anybody on the call. I call this the cycle of insolvency. And it's the unfortunate experience that a lot of people have when they build an agency for the first time. And it is the cycle of you go out and you win a bunch of new business. I was super excited. We got all these new clients. We're stoked. We're pumped up. And then all of a sudden your team starts to go, oh shit, there's so much work to do. We're so overwhelmed. We need help. So you're like, okay, no problem. Founder mode. Let me put my cape on, roll up my sleeves. Let me get in to the weeds here and help my team through this because there's a lot of new clients coming on.

4:46And then maybe you're in this mastermind group or you're talking to your coach and you're like, oh shit, I'm in the business. I got to be working on the business, right? So, okay, let me go hire some people, get back out of the weeds so I can keep building the business. So you go hire a bunch of new people. You're not really selling as much because you're in the weeds doing client work. You're recruiting, you're hiring, you're training, you're onboarding, your profitability drops because now you take on all this new payroll, but you don't have as much sales coming in. You finally get these people trained up and ready to go, you lift your head up and you go, oh shit, we need more work to keep these people busy.

5:15Our cashflow is not that great. You go back to selling. It works. Awesome. Cause you're really good at what you do. And then all of a sudden the same problems start catching up to you. And here's the crazy thing. I've talked to agencies that have gotten to 10, 15,$20 million in revenue, and they're still caught in this cycle. And they start wondering, Hey, are we ever going to outgrow this? Cause that's what they always thought, right? It's like, oh, at some point, we're going to outgrow this, right? But they don't. And these problems keep catching up to them and they just get bigger and bigger and bigger.

5:47And it's even in some cases so bad that they start making less money, the bigger they get. So I literally had a client that we worked with, they went from one to$3 million in revenue in 18 months, the founders were making less money at 3 million than they were at 1 million. And I remember speaking to them and they're like, dude, we don't even understand how this is possible. How can we have more revenue, more clients be busier than we've ever been. And we're making less money. I don't get it. Right. And the thing that's so frustrating about this is you might be having this experience of going to talk to your accountant and your accountant gives you your P and L and you're like, all right, so like, what's going on?

6:23Why, why aren't we making more money? And they're like, well, you, uh, you have revenue coming in, you have a bunch of expenses going out and then you don't have a whole lot of profit left over. And you're like, all right, cool. Why? And they're like, well, your revenue is too low and your expenses are too high. And you're like, all right, dude, but like, what the fuck does that mean? Actually? Like, what is actually the problem? Right? So if this looks familiar, the question is, why aren't we more profitable? Is it that we don't charge enough? Is it that we spend too much time doing things? Is it that our team isn't utilized?

6:54Is it that we spend too much on our team that our payroll is just too high? We're had too expensive of labor costs? Is it that our overhead is too high? Is it a combination of all of those things? And if so, to what extent is it each of them? And in what order should I be prioritizing those things? These are the questions that we all end up looking at when we're trying to improve our profitability. But if you've ever tried to get to those answers, you know that in practice, it's really quite hard. So I'm curious, let me know in the chat, is any of this resonating with you? Have you kind of experienced this?

7:26Have you seen this movie before? I just want to know if we're in the right room. Peck says this is his life. Pat says, absolutely.

7:35Rebecca's on board. Yeah. Okay, good. Well, at least a few of you hear where we're coming from with this. All right. So let's talk about this. I want to cover just like some of the first principles, the 20 % of information that you need to know to get 80 % of the insight into your business. And what I'll try to cover in the time that we have here, and we'll make this dynamic, we'll do some Q &A, of course, as we go through is what are like the most important metrics that you need to track and the benchmarks that you need to aim for to be profitable. Then we'll talk about pricing. So how do you make sure when you're selling something, you're setting yourself up for success.

8:08And even if you can't predict the scope, right? So we had a conversation about scope creep earlier, right? You can try to prevent scope creep, but what if you just can't prevent scope creep? What if it's just inherently risky, the work that you're doing, right? How do we handle that? We'll talk about that. And then we can have a couple of discussions about first principles on forecasting as well. Let's do it. So a couple of disclaimers. Everything I'm about to share with you is simple. That does not mean that it's easy. Isn't that true about business? A lot of things are simple in business. Doesn't mean that they're easy.

8:41Right. So you might figure out through this process that your delivery margin isn't very strong. That's a simple insight to get to doing something about it. Not necessarily easy. So I wish that I could fix this. Unfortunately, I can't. But that's business. We all signed up for it. I think we all know what the drill is. So everybody on this call knows that hard things are going to be hard. And you signed up to do hard things because you know that you're a special human being. So that's all good. The second thing I want to make clear here is that we're in the business of accuracy, not precision.

9:11These are not the same thing. They're often in conflict with one another. And this is the trap that so many, especially people that come from a project management or finance background fall into is they conflate precision and accuracy as being the same. But let me give you an example of this not being the case, right? If I was to ask you, hey, what's the weather going to be today? And you said it's going to be 73.4 degrees. Well, that's a very precise answer. but the more accurate answer might be, it's going to be between 70 and 78, depending on the time of the day and where you are in the city.

9:46That's not as precise of an answer, but it's more accurate of an answer, right? And so this is an important thing for us to consider when we're thinking about measuring moments in our business and we're measuring metrics in our business is that sometimes the pursuit of precision actually comes at the cost of accuracy in that it might give us a false sense of certainty on a data point, which could be dangerous. The other thing that it can do is make the data so complex that it actually makes us harder for us to see the thing that we're actually trying to see in that information, right? So another good example of this is people install time tracking in their business, try and get insight.

10:21And then they're asking their team to track like the subtask within the task, within the deliverable, within the milestone, within the phase, within the, right? It's just like way too much detail. And then their team is like so confused and overwhelmed by this but they only put 30 % of their time into the system. So while every time entry is very precise, as a whole, this measure of time is inaccurate. You see what I'm saying? Anyway, I'm not going to be on the soapbox for too much longer, but just understand we're in the business of accuracy. So you might notice that a lot of the things I'm going to share with you are very simple.

10:51That's by design. It's because we're focused on getting an accurate answer to a specific and important question. The last thing I'll speak to is our framework at Paraketo for running the business is a management framework. We're not focused on tax. We're not focused on cashflow. Those are things that the finance department does. They're different jobs. They're important jobs. But like, this is the funny thing is I'll talk to a lot of agency owners and they're like, why do my PNLs and my financial reports that I get from my accountant, why does it always feel like it's just not really the experience that I'm having in my business?

11:26And we double click on it and we realize like, oh, well, your accountant is focused on you're doing your taxes. and his job or her job, their job is to lower your taxable income as much as possible. And there are a lot of things that they're going to do to accomplish that outcome that are actually in direct conflict with an accurate lens on what your business is actually doing, because they want to make it seem like you're less profitable than you actually are. They want to put a bunch of your personal expenses through the business. So they're going to actually try to obfuscate reality. It's a different job, right?

11:57So understand that as we talk through this, I'm not here to make your tax accountant's job easier, etc. I'm here to talk about how do you, as the owner of the business, get members that help you make decisions and understand what's really going on. So those are some great questions in the chat. We're going to get to those. So those are some disclaimers. Let's talk about core financial metrics. Here are some things that you should know about your business, ideally on a monthly basis. and you probably won't get here by restructuring your P &L, but you should be able to calculate this stuff in a spreadsheet or just doing some quick math by looking at your P &L.

12:33The first metric is something that we call AGI. And this stands for quick warning. My handwriting is not good. So you're really going to have to pay attention. Okay, I'm setting very low expectations. Agency, gross income. See how bad that is? What is this even? This situation back here. The good news is if you take this, any kind of chicken scratch that I write on the screen during this session, if you take it to a pharmacy, they'll give you drugs. You might not know what you're getting, but they're going to interpret this as a script from your MD. That was a joke. You're supposed to laugh when I make jokes.

13:12Okay. So agency gross income. What is agency gross income? For a lot of you in this room, because you do digital, this is a very important distinction. It is revenue minus what we call pass-through expenses. Okay, so what are pass-through expenses? Well, basically, it's money that you collect from the client that does not belong to you. So as an example, if I have a client that pays me$10 ,000 a month for Facebook ads, but I spend$8 ,000 a month on Facebook ads, that's not a$10 ,000 client. That's a$2 ,000 client to me. My agency gross income, the money that I keep is$2 ,000 because 8 ,000 of that is passed through.

13:55It was Facebook's money all along. It just flowed through my business onto another business. Now, you might be marking up pass-through expenses. That's excellent. That is flowing through to agency gross income. So what we're looking at is how much did we get paid? How much did we pay to an external third-party vendor that we're not responsible for that money? What's left over? That's our agency gross income. That's the true size of our business. That's the thing we want to be measuring profitability against. And this is critical because we're not making the separation and we have material pass-through expenses.

14:24Then we might think our business is a lot bigger than it actually is. And just last week, we worked with a client. We did an audit on their business. They thought they were in a$6 million business. Turns out they have a$900 ,000 business. But their payroll was$2 million. So this lack of clarity meant that they were actually losing$800 ,000 a year because they had no idea how big their business actually was. was because this separation was not clear. So this is really important and it's material. So step number one, be able to isolate your pass-through expenses to measure your agency gross income.

14:57Everybody good on this so far? Yes or yes? Awesome. All right. We're following. I love the engagement. I appreciate it guys. Okay. So question number one, how much money are we actually making? That's AGI. Question number two, very important question. What does it cost us to earn that revenue. Okay. So here's a big idea. The biggest challenge with a professional services business is that you have to spend money to earn your revenue, but it's not necessarily clear ahead of time how much it's going to cost you to earn that revenue. Right? So if you're Apple, you make an iPhone, you know what it costs to make an iPhone.

15:36You have all these components. They go through a very regimented process, right? It costs us a hundred bucks to make an iPhone. We sell it for a thousand. But in an agency, the majority of the cost of earning a revenue is the amount of time it takes you to do something. And you might be able to predict that, but you might not. And it might fluctuate over time. So it's very important that we isolate what is it actually costing us to earn our revenue. And the other way to think about this is what do we have to spend to get the promise that was made to the client delivered so that this agency gross income actually belongs to us on a contractual basis.

16:08So the way that we do this is we isolate the payroll costs that are allocated to delivery. So we look through our team, we go, whose job is it to do work for clients? The SEO specialist, the copywriter, the backlink builder, the designer, the project manager, most of those people, 100 % of their salary is a delivery cost. For some of us founders in the earlier days, we might be spending a considerable amount of our time still doing client work. So we might say, okay, 50 % of my income is going to be a delivery cost. And the other 50 % is going to go into overhead, which we'll talk about in a moment.

16:40So that's the major thing to consider here. The second thing to consider here is shared delivery expenses. So you might be using Ubersuggest, you might be using Adobe Creative Cloud, like there's all kinds of software that you have to bring to the job every day, just like a plumber needs to bring a tool bag with a bunch of tools. So those are usually going to make up anywhere from four to 6 % of your agency gross income. You need to include those delivery costs here as well. And so the objective here is you want to keep your delivery costs under 50 % of agency gross income so that the margin in the middle here is 50 % or higher.

17:20And this is called delivery margin. Okay? This, if there's one thing you take away from this entire presentation, please let it be this. Delivery margin. the single most important metric for the profitability of your firm. If this is healthy, everything's easy. If this is not healthy, everything feels hard, right? And the reason for that is because once you have, let's say you're in this position, you spend 50 cents to earn every dollar of revenue, which means you have 50 cents left over. You're generally going to spend anywhere from another 20 to 30 % with most firms being closer to 30 % on overhead.

18:02And this is typically going to be broken down more specifically into three subcategories. Your sales and marketing are typically going to be 8 % to 14%. Your admin is typically going to be another 8 % to 14%. And if you have an office, most of us on this call probably don't, but facilities are going to be 0 % to 6%. And these benchmarks are not nearly as important. Like if you don't have an office, you might say, okay, well, let's spend more on sales and marketing so we can grow faster. That's great. The important thing is that you're able to kind of get to within that 20 to 30%, which should leave you with ideally a 20 to 30 % profit on AGI or more.

18:47So here's a pop quiz for you. Yes, founder salaries are included. Salaries are included in both of these. Great question. Right? So as a founder in an early stage company, you're probably going to be kind of split in between these two things. but this overhead number would include all the salaries that are allocated to sales and marketing admin facilities and i'd say for most of you where you're running a bit of a smaller firm you're probably wearing all of these hats doing most of these jobs might have an assistant a little bit of help but i'm guessing that's the case so pop quiz we've audited hundreds of agencies in the last six years gone in looked at their finances recalibrated them so that we could see this information.

19:28What percentage do you think we've looked at that had an overhead problem, so their overhead was too high, versus had a delivery margin problem, their delivery margin was too high? What percent do you think had an overhead problem? I think it's 1%, 10%, 50%, 75%. Kevin thinks 75 % had an overhead problem. Rebecca says 10%. Austin says less than 25%. passes 20%. These are all good guesses. It's under 10%. Almost nobody in the agency space has an overhead problem. I never audit an agency. And I'm like, yes, good job, Rebecca. You get a gold star. I almost never go in and audit an agency. And I'm like, geez, you guys give everybody $900 Aeron chairs?

20:18Wow, you guys are doing catered lunches every day. Everyone's cruising around on segues. This isn't Google. Agency owners are typically pretty good about keeping their overhead costs lean. They don't have crazy lavish offices. They typically don't overinvest in overhead. The handful of times that I've seen this, it's usually a firm that they got really big and hired a bunch of C-level management, and then they had to slow down in sales. So they had to do a bunch of layoffs, but they laid off all of their producers, and then they just ended up being super top heavy. That's pretty much the only time that I see this be an issue.

20:5090 plus percent of the firms that we work with, their issue is right here. Their delivery margin isn't high enough. Therefore, there's no oxygen in the business. And if it does look like their overhead is struggling, when we correct this, it fixes the overhead problem. So most of the time when we help agencies improve their profitability, they don't have to make any cuts to overhead. They generally don't have to increase their prices. They can, but a lot of times that's not even really necessary. They often don't have to hire any additional people. They may not even need to increase the number of clients that they have if they do a lot of monthly recurring work.

21:24And I'll explain how that works here in a moment if you guys are interested. So yeah, so far, are we tracking? Do you guys want to learn about how basically the only three ways that you can increase delivery margin and then give yourself the option to either spend more on overhead, have more profit come through, basically do whatever you want. If you're an agency owner and you want to grow faster, check out the Agency Owners Association that's hosted by my podcast co-host Neil Patel and myself. And we have other agency owners that are doing eight figures a year. They were doing nine figures a year.

21:55They sold their business for hundreds of millions of dollars and they're gonna share their experiences with you. There's a whole host of other benefits. And the cool thing is that there's a seven day free trial and you should check it out now because we're going to take the prices up. So just go to marketingschool.io slash agency to learn more and we'll see you inside. Pricing, can I hire Airbnb? Just remove myself. If you've ever built a website, you know how tough it can be to keep a strong design while ensuring site performance is fast. That's where Framer comes in, and it totally changes the game.

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24:22Yeah. Great question, Pat. We'll get to pricing after this. So we're going to do the three levers and then we'll talk pricing because pricing is definitely a big lever. And the big idea here that I want everyone to take away is the higher your delivery margin, the more optionality you have. And I've seen firms that have 60, 70, 80 % delivery margins. 80 % is unusual, but it does happen, especially when they have like a technology leverage component to their business. And so if you have an 80 % delivery margin, it's like, man, you got a lot of choices. You can hire great talent. You can spend a ton more money on overhead.

25:04You can just have crazy profit margins. You can kind of do both. So what I want for all of you is to have really, really strong delivery margins. So you get to choose what you want to do with your business and it's happening for you, not to you. So we're going to skip through this example here. Let's talk about the three levers to improve delivery margin, right? So if we want to improve that metric, what are the three things that we need to focus on and how do we control them. And this is really quite simple. Let's go back to the formula for this. So the formula for delivery margin is AGI over delivery or minus delivery expenses over AGI.

25:42So as an example, if I made a million bucks in agency gross income and I spent$400 ,000 on payroll and salaries, et cetera, for delivery and shared delivery expenses and all those things, and I had a million dollars in AGI, I would have a 60 % delivery margin. So that's how I do the math on this. Now, the question is, how do I improve this metric? You go and do this quick math and you're like, hey, my delivery margin is not that high. How do we improve this? So the simple answer is, well, we either lower what we spend to earn our revenue or we earn more revenue without increasing what we spend to earn it.

26:18Okay, thanks, Doc. That's helpful. How do we do that, right? So three metrics that you can start paying attention to. Before I go through these, here's what I love about them. You don't need to rely on your accountant. They're really cheap and simple to measure. And you can use them to look at all kinds of different vectors in the business. So horizontal vectors, which would be things like different time horizons. I want to look at my daily, weekly, quarterly, monthly, yearly value for this. But then also vertical slices. So I want to look at a single client or project, or I want to look at a group of clients and projects, or a specific service that we sell, or a specific department within the business.

26:57So all of those slices become available to you to the extent that you can get the simple inputs that are required for each of these metrics. So that's the reason I love these so much, and they're real simple. So let's start with the first one. It is ACPH, and that stands for Average Cost Per Hour. Okay? So Average Cost Per Hour is a proxy for delivery expenses. Basically, the question that it answers is, what is the average cost of an hour of labor in a given area of the business? The way that we calculate average cost per hour is we take the payroll, fully loaded payroll, so that includes benefits, 401k, matching, all that stuff, and we divide it by capacity.

27:45And this formula applies to one person or it could apply to a group of people. So if you wanted to just take like all of your payroll, let's say you had 10 people on the team and each person you were hiring them full time, so 2 ,080 hours per year, then you would divide a million dollars by 20 ,800 and that would give you an average cost per hour of 48 bucks an hour. So this metric, it's the same whether you're looking at one person or 10 people and that gives you a sense of, okay, what is the average cost of an hour? of labor in our business. So to the extent that we can lower this, what we can start to do is actually spend less on payroll and earn the same amount of revenue.

28:30And so the big idea here is if you start measuring average cost per hour on different types of work that you do, you might see these opportunities where it's like, I've got this person that is really expensive, like a senior strategist, doing stuff that someone way less expensive could be doing. Why is my senior strategist writing follow-up emails to clients after strategy calls, when I could just have an assistant out of the Philippines that cost$10 an hour doing that thing. And to the extent that you can start displacing time from expensive people to less expensive people, then what happens is when it comes time for you to hire your next two or three people, instead of each of them costing you$100 ,000, one of them might cost you$100 ,000, and then the other two cost you significantly less than that.

29:13So what you start to see is a separation between the rate at which your income grows and the rate at which your delivery expenses grow. And they start to grow separate from each other. Your margin increases over time. And for a lot of you that are early days, I bet you're using a lot of freelancers. And that's awesome because there's even less latency here where if you can lower your average cost per hour, you just start hiring cheaper freelancers. And then you start to see this benefit a lot quicker. So that's the first main metric. And it's really a proxy for lowering your delivery expenses.

29:44And this is the, again, the thing I like about this is you can start focusing at kind of a more granular level. This is sort of the leading indicator where if you can see your average cost per hour coming down over time, then you'll see your delivery expenses grow at a slower rate than your revenue as you scale. Is this checking out? Are we understanding this? Kevin likes it. Pat likes it.

30:09One full, yeah, one full day per month. You're not alone on that.

30:15Yeah, Anita, I said there's 10 people on the team. So 2 ,080 hours per person multiplied by 10 would be 20 ,800, which would give you a$48. Yeah, you got it. All right, awesome. We're tracking. Okay, so that's metric number one is average cost per hour. Metric number two is average billable rate or ABR for short. Average billable rate. Now, when I say this word, often the reaction I get from people is, oh, I don't sell hours, so I'm going to stop listening now. That would be a mistake. Because the thing is, average billable rate doesn't care about your billing model. In fact, what I love about this metric is it allows you to compare everything that you sell, even if some stuff is hourly, some stuff is value price, some stuff's retainer, some stuff's project, some stuff is percent of ad spend.

30:59Some stuff is some weird combination of getting paid in Bitcoin and, I don't know, Dogecoin and something else. It doesn't matter. All average billable rate cares about is two things. How much AGI did we collect from the client? We defined that earlier here. And how many delivery hours were required to earn that AGI? So again, you could use this to look at one project or client, a group of projects or clients, an entire service line, and you could look at a day, a week, a month, a quarter, a year. It doesn't matter. As long as you have these two inputs for that segment, you can start to measure it.

31:39And if you think about, like, it doesn't matter what the billing model is, at the end of the day, how much money did you get paid from the client and how much time did you spend to earn it? And what that will start to give you is the amount of money that you earned per hour spent doing that thing. And what you might start to find as you look at this is a really interesting insight. So like, here's an example of a really simple report that you might run where we're comparing three projects to each other. We have this website bill, we got paid 70 grand. So if I asked like, you know, a bunch of people, Hey, what was your most profitable project?

32:12If they didn't see this information over here, they'd almost always say the website bill because it just had the biggest number in front of it. And then we had this little funnel build down here and this brand design build. So the first thing we got to account for is, well, how much of this is actually our money? So on the website build, we spent 20 grand on external vendors. So we had a$50 ,000 AGI. The brand design was 15K. And the funnel build, this is the dark horse. We gave away like two thirds of the revenue to an external partner. And we just kind of managed the rest. But look at the efficiency.

32:41We spent 50 hours to earn 10 grand here. So we made$200 an hour. We spent 500 hours to earn 50 grand here. so we made$100 per hour. And in aggregate, we ended up with$115 average billable rate. So here's an interesting idea. If we understand that our capacity to earn revenue is always gated by the amount of time that we have available on our team, like it or not, that's the business model we're in. We buy time in bulk from people in exchange for a salary, we resell it as a profit. If we do that well, everybody wins. If we sold all of that time for twice as much money, we would make twice as much money.

33:22It kind of sounds too simple to be true, but it's not my opinion. It's just math. And what's illustrated by this example is that we can do that by just spending less time to earn the same amount of revenue. So yes, increasing prices is a great way to increase average billable rate, but everybody that's lived through 2023 knows that that's not really easy to do all the time. In fact, right now, you're probably going in the opposite direction to get new business. So what do you do in that situation? Well, you focus on efficiency and it has the same impact. And I'll show you guys an example in a moment of how crazy the transformation can be when you increase your average bubble rate.

34:03So that is concept number two is, can you get more efficient at earning revenue with your time? And to the degree that you can do that, you can increase the amount of revenue that your team earns without changing any of your cost structures. You just make them more efficient. Is this tracking so far? Yes or yes. Let me know in the chat if you're, you're following quick question and stay hydrated. Yeah. What's up? Um, the ACPH, you had payroll over, and I forgot whether it was underneath it. Yeah. It was payroll over capacity. Capacity. Okay. Got it. Thank you. and capacity in this situation is total capacity.

34:47So we're not taking out time off, vacations, sick days, any of that. We're leaving it all in here. And the reason for that is we've accounted for those costs in our margin target, and we'll account for it in utilization, which is the next metric we're going to talk about. So there's a rhyme or reason to all of this. We just want to keep that metric super simple. And we also want to make sure that average cost per hour isn't changing all the time, as all of those other variables are changing, because then it actually makes it harder to figure out how profitable are things. because we have the same person with a different cost because some externality changed.

35:16Anyway, again, I'm not getting on my soapbox. Accuracy over precision. So we've talked about average cost per hour. We've talked about average billable rate. The last metric, some of you might get hives when I say this. For the Star Wars nerds in the room, this is the dark saber of agency metrics. Okay? It comes with great power, but also great responsibility. It can be very damaging when used improperly. Any guesses on what this metric might be? It's utilization, of course. If you've ever worked in another agency, you've probably heard this word, and it's probably been used the wrong way, which is probably the reason that it makes you anxious.

35:51So what is utilization at a fundamental level? It's the measure of the percentage of capacity that is being used to earn the average billable rate that we just talked about. Essentially, what percentage of our team's time is used to earn revenue? So the formula for utilization, very simple. it is the number of delivery hours that were worked

36:17divided by the capacity of the segment that's being measured. So again, we could do this for one person. This person's capacity for this month was X. They worked this many delivery hours. We could do this for an entire department. We could do it for any slice of the business that we want to look at. That's how we look at this. I want to draw your attention to this very specific language of delivery hours. You might be thinking, hey, this sounds a lot like billable hours. And it might be the same as billable hours, if that's what you call it in your business. But it also might not be. And here's the nuance.

36:51Show of hands, who has had a situation where you're like, yeah, we billed the client for 100 hours, but we actually spent 125 on it because we kind of messed something up and we didn't want to piss them off. And so, right, that stuff happens all the time. So delivery hours is the 125. It's what it actually cost us to get this done and how busy we actually were. The billable hours is a pricing billing client management concept. It's what we charge the client for. This is important because if we start doing capacity based on the billable hour and we calculate our average billable rate, which we talked about earlier, which is AGI divided by hours, by billable hours, then what we would start to see in that situation is, oh, the team's not that busy.

37:41And our project was perfectly on budget. When the reality is the team was actually more busy than we expected and the project was not on budget. That's a more accurate lens on what's truly going on in the business. And what's interesting is the delivery margin would look exactly the same in both situations. So what's changing here is our understanding of what's really going on. Okay. So that's why this nuance is really important. So two ways to improve utilization is you can lower capacity or you can increase the number of delivery hours that you have sold. Okay. So another big mistake I see with utilization, people take this metric, they go to their team and they go, Hey everybody, I just heard this incredibly handsome, charismatic guy on a, you know, live session in the group.

38:27And he said, utilization is important. So I want everyone to be focused on utilization. I want you to get it up. And what the team does is they go, okay, boss, no problem. I'm going to go spend a whole bunch more time doing the same stuff I was doing before. So what happens in that situation? Well, your profit's not going to change. Your utilization will go up. But if we remember the math on average billable rate, which was AGI over delivery hours, all we're going to see is a directly proportionate trade between utilization and average billable rate. This will go down because this number of deliver hours will go up and our utilization will go up and our profitability won't change.

39:02So there's no benefit to that whatsoever. I never encourage people to use this utilization metric with their team. This is a management metric. This is a metric that gives you feedback as the owner of the business and as the manager of the business on how good of a job am I doing of balancing the capacity that I have on my team to the amount of work that's required and making sure that I'm using a good share of that team's capacity to earn revenue. That's the big idea. So real quick, some benchmarks on this. And I'm happy to share these slides. And of course, this is being recorded, but screenshot away if you want to.

39:38When we look at this on a weekly basis, pure producers, so this is like designers, copywriters, et cetera, engineers, the people that really come in and like pretty much all they do is client work. We generally expect them to be about 75 % or more. So this is, you know, 30, 32 hours. And in some cases you can get them up to 34, 36 hours a week. The main determinant in terms of how high you can get someone's utilization rate without them getting super burnt out is what I call client dilution. So if, you know, for example, I've, I've worked with engineers that are writing software. they work on the same project every day for like a year so they're 38 billable hours a week and they're super chill because there's just not like they just come in they do the same thing every day there's not a lot of meetings there's not a lot of context switching they're not like spinning a bunch of plates whereas the poor project manager that has 70 clients that they're managing and their entire day is going by in four minute increments and slack messages and emails and phone calls they might only be 25 billable hours but they're super duper stressed because they're so diluted across a lot of clients.

40:43So that's the primary lever that I see affect, like how high can you push this on your team without them actually becoming like unmanageable or unmanageably burnt out. So this is why delivery managers, so these are the PMs, AMs, you typically see that target be a lot lower because a lot of the work that they're doing is not really going to show up as a delivery hour. It's going to be basically managing the delivery team. So it's updating click up for like all 50 of your projects. It's running a team meeting and talking about every client at once. They're not going to go log 45 seconds per client in the time tracking tool.

41:16It's just not feasible. They're a function of the delivery team, but it's not really directly attributable to client work. So the important thing here is when you look at your entire agency and you factor in all the people that don't do any client work at all, you want to be able to get 65 % or more of your time on a weekly basis available to do client work. That's typically the balance that you're looking for. And on an annual basis, once you strip out all your time off, holidays, stick time, vacation time, et cetera, you want your team to be able to accomplish a 50 % or higher utilization rate.

41:46So that's the big idea. And you can get away with having a lower feeling than this, but you just need to be either spending a lot less on labor or charging a lot more than average. But all things being equal, this is roughly where you want to land. So those are the three main KPIs. And I want to bring this together, an example, if I could, of just what kind of an impact this can have on your business, because this has all been somewhat ephemeral. But I think that this will be a really interesting example. So let's take this agency. They've got 100 ,000 hours of capacity. This is roughly 50 people.

42:28They spend$3 million a year on delivery costs. and their overhead is about one and a half million dollars a year. Okay. Have you ever wanted to target a bunch of accounts on LinkedIn at once and personalize them? Well, previously you couldn't do this. Let's say you wanted to target 500 enterprise companies and you wanted to hyper-personalize those ads. You can do that now. And LinkedIn has confirmed with us that nobody else can do this right now. Only we can do it. The product is called Carrot. That's K-A-R-R-O-T and it's Carrot account-based marketing. So if you go to carrot.ai, you can go learn more about it and we'll see you on the other side.

43:02So let's go through a couple of different examples. In situation one, they have a 50 % utilization rate and$100 average billable rate. So in other words, 50 % of their 100 ,000 hours get used for client work. That's 50 ,000. And then for every hour that they work across all the different stuff that they did on average, they earned 100 bucks per hour. So if everybody's good at math, how much money could this agency make if they achieve those two targets? $50 ,000 multiplied by$100 ,000.

43:33There's gold stars up for grabs. Rebecca, I know you like the gold stars. $5 million. Awesome. Awesome was on top of it. Okay. So this agency can earn$5 million. Pretty cool. Now they're going to spend$3 million to earn that$5 million because that's what it costs them for all the delivery people on the team. So they're going to end up with a delivery margin of$2 million, which is 40%. And we heard earlier, we want to be closer to 50%. So this is okay, but it's not great. And then, if we recall, they're going to spend another$1.5 million to run the business, acquire clients, pay for admin, their lawyers, their billion SaaS subscriptions, etc.

44:11So that leaves them with$500K in profit, which is 10%. So that's pretty average. That's like what most agencies are doing, about 10 % net profit. But I don't know about you guys. if I made all the sacrifices, blood, sweat, and tears, took on all the risks to get to 5 million, I would want a little bit more meat on the bone than this. It's not super interesting. So how do we get more out of this? So the first thing that this agency does is they go, hey, there's actually a lot of time available for client work that we're not utilizing. So let's dial in our sales forecasting, our resource planning, our project management.

44:45Let's get our utilization from 50 to 60%. Okay. So now instead of spending 50 ,000 hours earning revenue, They spend 60 ,000 hours earning revenue. They don't do anything to average billable rate. That just stays exactly the same. They just sell a little bit more work. They get their team a little bit busier. Pop quiz, how much more revenue can this company earn now? 60 ,000 multiplied by 100, it's 6 million bucks. So nothing else has changed. So their delivery margin is now$3 million. That's 50%. And their profit is now$1.5 million. That's pretty cool, which is 25%. Okay, things are getting a little bit more interesting now.

45:29But we're not done. We're high performers in this room. We want to take this a step further. So we're going to keep utilization where it is, and then we're going to get our average billable rate up to 125. Maybe we do a couple pricing tweaks, but let's say a lot of this is actually just getting more efficient. We find better ways to get things done. We develop some templates and systems. That's right, Kevin, man, you're ahead of the game. The gold star for Kevin, can we get him a gold star in the chat? $7.5 million now this agency can earn. Delivery margin goes to$4.5 million, which is 60%. But look what happens to profit.

46:06$3 million, which is a 40 % profit margin. And here's what we haven't done. We haven't even talked about lowering average cost per hour. We haven't even touched our overhead spending. because you can see that by fixing this delivery margin issue right here, it took care of the overhead challenge. Overhead got more efficient. In fact, if I was advising this agency, I would say, hey, you might want to consider spending a little bit more on overhead so you can grow faster because that's going to impact your valuation. And so that is the power of just even two of those three simple numbers on the agency's profitability and how you can kind of use these building blocks to get an understanding of what the outlook is for your business as you make these tweaks.

46:56So those are some big ideas on the basics. Now, there's one thing that I promised you guys that I haven't gotten to, which is pricing. So I want to make sure that I get to that before we wrap up. Before I do that, is everybody tracking with this so far? Any questions on this before I move on to pricing?

47:17how much is it the higher you again we could take that offline we could take that offline it's an excellent question kevin i'm not a big i'm not a big hard sell guy but i'll give you an opportunity to get in the funnel but i'm warning you you'll never get out it's like herpes it just once you're in there's no getting no getting away from it i should probably not say that but anyway i'm going to because it's funny okay pricing here's the big idea with pricing We've already talked about delivery margin. So the big idea with pricing is when you sell something, you want to aim for what we call a direct delivery margin of at least 70%.

47:55Okay, so the target is 70%. And you might be wondering, well, Marcel, why is the target 70 % when I sell a project, but the target on the P &L is 50 %? And the reason for that is twofold. Number one, you want to account for what we call indirect delivery expenses, which is going to be the amount of time that your team doesn't end up being utilized. You want to account for all the shared delivery expenses that we talked about earlier, all the software expenses and things like that that are not going to get directly attributed when you're estimating the cost of a project. Because like, let's say, for example, you have an Adobe Creative Cloud subscription, like you're not allocating that to every project that you sell.

48:31That's just like a thing that you have to pay for, but that's not going to make its way into your estimate. So you want to account for those additional costs. And those are generally going to eat up anywhere from 10 % to 20 % of your margin. So we want to assume it's going to be 20%. And the general floor here is we want to aim for a 70 % direct delivery margin. So there's two ways that you can calculate this. The first is you can figure out, okay, how much agency gross income am I going to make here? And then you can figure out what are my delivery costs going to be and divide that by agency gross income.

49:04So as an example, hey, I know the client's going to give me 10 grand. I'm going to spend two of that on Facebook ads. So I have$8 ,000 in AGI. And then for delivery costs, you would just look at, okay, how many hours do I think this is going to take? What's the average cost per hour of each person that I think might work on this? That gets you a sense of what your delivery costs are. And again, you're aiming for a target of 70 % margin. So at a high level, it's really that simple. Figure out what you expect your margin to be before you sell anything. And this could apply to an entire project. It can apply to a retainer.

49:33it could apply to an hourly rate. If you're selling something hourly, the question is, what do I think it's going to cost me on average for the time? And then what is the agency gross income that I can get? And do I end up with a 70 % margin or more on that thing? Now, here's the question. What if, what if you don't know what it's going to cost you? What if you can't figure out how many hours it's going to take you? That's where we get into our agency pricing quadrant. So here's the big idea. Everybody's talking about value-based pricing, productized services, all that stuff is awesome. But there's a little bit of nuance to that, right?

50:07Sometimes it's not that simple. And I get really upset when people are like, hey, what if I can't predict the scope? And then the person that's talking about value-based pricing is like, we'll make it predictable. It's like, okay, well, that's not actually a good answer. What if you can't do it? There has to be an answer. So here's the answer. You want to consider value. so is this a high value thing or is this a low value thing and that's in the eyes of the client but the other thing you want to consider is risk is this a low risk engagement and what this means is i can predict to within 10 to 20 percent what it's going to cost me to earn this thing to get this thing done or is it high risk in that i don't know what the scope is going to be the scope is going to be fluid the client doesn't even know what they need maybe we're using the agile methodology.

50:52So like the whole point is we're going to do a little bit of work and learn and adjust, right? So why would we use a contract model that forces us to make a bunch of assumptions up front if we know that that's not the right thing to do? So when we have low value, high risk work, this is where time and materials, selling hours actually makes a lot of sense. Because if we don't know how much time it's going to take, then the important thing is that we set an hourly rate that gets us that margin and then we get paid for our time. So if it takes more time, no problem. If it takes less time, no problem.

51:20We're still making a consistent margin. That's the key, consistent margin, right? If we have a high value, high risk engagement, this is where I like what I call abstracted time and materials. This is really popular in engineering firms where we're not selling hours, we're maybe selling broader time horizons. So days, weeks, sprints, months, and we're not doing individual rates, we're doing cross-functional rates. So this entire team of people is$20 ,000 per sprint. And the current scope of work for this, this enterprise software platform that we're building for you, we think it's between 40 and 60 sprints.

51:57And the nice thing about this model is because it's high risk, when things change, or the client asks you for a new thing, or especially in these kinds of engagements, when like half the people that started on the project got fired and replaced with new people, and all the requirements are different, and the company's goals have changed, because this is an 18 month thing that's ongoing. Every time they ask you for something new, the answer isn't yes, but let us go open up the scope of work and fight against it and renegotiate this whole thing. It's yes. And do you want to do that before or after all the other stuff that's in the backlog?

52:28It doesn't matter that the scope's changing as long as you've baked your margin into the time unit that you're selling. And when you can predict how long it's going to take, this is where we want to use flat fees on the low value, high risk stuff. We do this because we can create the perception of value by anchoring a flat fee to a deliverable and taking on the risk. So if you said, Hey, Marcel, I want a website. I said, no problem. It's$500 an hour. You might be like, screw you, dude. But if I said it's five grand and I'll get it to you in two weeks, I might still make$500 an hour, but it doesn't matter because you already get a lot of value out of just that$5 ,000 fee.

53:06I make that money because it's low risk. Up here, this is where we get into value-based pricing or the extension of that, which is outcome-based. So where there's a lot of value, it's the same premise, but instead of saying the website is five grand, I say, what is this website going to do for you? How much traffic do you get? How many clients do you get? How much revenue do you gain? What do you think the impact of a new website will be? They give you an outcome, you anchor the price to that outcome. Oh, it's an extra million bucks in revenue for you next year. Interesting. You think 10 % of that upside is a fair investment to get that outcome.

53:41So it's still often structured as a flat fee, but instead of anchoring to deliverables, we're anchoring to the value. And in the extreme case, I might say, let me charge you five grand for the website plus X percent of every additional sale that you make above and beyond that. So the key idea here is aim for a margin of 70 % or more. And then the calculus here is which of these pricing models is most likely to get us the highest possible margin on a consistent basis? Because here's the trap is we try to force everything into flat fees or value based pricing, but we can't price in the risk. And so we end up worse off than if we had just sold time because it takes us way more investments to earn our revenue than we thought we were going to.

54:27We get on the side of the equation, right? So understand that it's normal for things to start over here and over time graduate to this side. As you do more of it, you develop better process, you have a better portfolio, you understand what it takes. At a high level, that's the big idea around pricing. So I know I promised I was going to get to that. I ran through it quickly, but I hope that it's helpful. And I'll close on this. We've only scratched the surface. You could tell I could talk about this for a really long time. There's a lot more where this came from. So So at no cost to you, if you want to go watch more videos, get some free templates, tools, cheat sheets to help you calculate this stuff on your own.

55:05I put a bunch of this stuff together in our toolkit. So I encourage you guys to all grab that and connect with me on LinkedIn. Reach out. I'm always happy to help. And Kevin, you want to talk to me about how we work with clients. I want to talk to you. I want to talk to you. Yeah, we can make it happen. All right. I'm going to stop talking now. I don't have a hard stop. So if there are any final questions, I can stick around, but I understand that might not be possible for all of you. So this was fun.

From the publisher
In this bonus episode, we give you a sneak peek into what our Agency Owners Association (AOA) hangouts look like. Join their discussion as Marcel Petitpas, CEO and co-founder of Parakeeto, shares strategic adjustments that can lead to improved profitability and outlines effective pricing strategies to achieve desired margins.  Don’t forget to help us grow by subscribing and liking on YouTube!   Check out more of Eric’s content (Leveling UP YT) and Neil’s videos (Neil Patel YT)    TIME-STAMPED SHOW NOTES: (00:00) Introduction to Agency Owners Association Coaching Call (00:58) Understanding the Interconnectedness of Agency Operations (02:53) The Cycle of Insolvency in Agency Growth (06:06) Core Financial Metrics for Agency Profitability (09:02) The Importance of Delivery Margin (11:47) Key Metrics to Track for Agency Success (14:51) Improving Delivery Margin: Strategies and Insights (18:15) Leveraging Average Cost Per Hour for Profitability (28:01) Understanding Key Metrics for Agency Success (33:11) The Importance of Utilization in Agency Operations (39:46) Maximizing Profitability Through Strategic Adjustments (45:08) Navigating Pricing Strategies for Better Margins Go to https://www.marketingschool.io to learn more!   Leave Some Feedback: What should we talk about next?  Did you enjoy this episode? If so, please leave a short review.   Connect with Us:    Single Grain << Eric’s ad agency NP Digital << Neil’s ad agency X @neilpatel X @ericosiu

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