Is your agency's profitability falling short? Do you lack clarity about your real margins? Many agencies struggle to maximize performance due to a core issue - not accurately calculating gross margin. Misconceptions around margin math sabotage profits. Today’s guest specializes in increasing agency profitability by solving the single but costly problem of suboptimal agency margins. He shares how he helps agencies boost margins by correcting common errors in delivery margin calculations.

Marcel Petitpas is the founder of Parakeeto, a technology-leveraged service firm, specializing in helping agencies measure and improve their performance. His firm exists to solve one problem: Agency Profitability. Marcel discusses his experience helping agencies increase their profitability and shares what many firms are getting wrong about how to calculate their delivery margin. In this episode, he'll share valuable insights and strategies for agency owners looking to boost profitability.

In this episode, we’ll discuss:

Calculate gross income and delivery margin.
3 Ways to increase agency profitability.
Specialization is the key to improving profitability.

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Before pandemic-fueled virtual tours, Marcel built 3D home models in a glacial 2015 market. With houses languishing for years, his niche hobby lacked scale potential. So he pivoted into software, soon meeting an agency owner drowning in spreadsheet tedium.

This agency owner spent up to two precious days a week answering questions about his business like Can we take on more clients? Do we need more staff? Who's performing and who's perishing? There had to be a better way to operate and strategize.

In that moment of shared pain, Marcel's purpose sparked - a business focused on solving that problem and making it easier for small businesses to answer those questions. And so Parakeeto was born, to liberate founders from manual metrics and maximize their potential.

Opaque Profits: Shedding Light on Delivery Margin for Agencies

The big issue Marcel sees in many agency owners is that they don’t know what their gross margin is. Personally, he prefers to call it delivery margin to prevent any confusion. You can obtain an agency's delivery margin by answering how much of every dollar that clients paid to you after fulfilling on your promise is now left to you to have a profit? Most firms can’t answer that question when looking at their financials. In most cases, they're just a few steps away from being able to answer it but don’t know how to.

For Marcel, it all starts with how we measure profitability, which is a framework still stuck in the past. The growth of a firm still being predicated today is getting more bodies and utilizing them to grow. However, this is not necessarily how it works in a modern context. A lot of companies are doing at least some amount of flat-rate or value-based pricing so they don’t actually know how much money they make spending a certain amount of time on a client. As a result, the basis for their profitability is opaque and they're unsure how to do better.

How to Calculate Your Agency's Gross Income and Delivery Margin

According to Marcel, calculating your delivery margin shouldn't be so complicated if you've first established your revenue and pass-through expenses (which are third-party expenses the agency incurred by outsourcing work to satisfy client demand). The formula is:

Revenue - Pass-through Expenses = Agency Gross Income (AGI)

Once you have the Agency Gross Income (AGI), you can calculate the Delivery Cost, which is what it costs you to earn that revenue. Most of this will be your team’s time. On an agency basis, you are looking at the amount of your payroll is allocated towards delivery. On a project basis, you’d need to answer how much time you spent completing a project and the cost of that time. The formula is:

AGI - Delivery Cost/AGI. Ex: If you made $1 million and spent $400K on Delivery Costs, then you have a 60% delivery margin.

The challenge a lot of agencies have to really get a clear idea of their delivery margin is that in many cases they have all their payroll costs on the P&L in one bucket. In those cases, they may think they have a great gross profit, but what they’re looking at on the P&L is their gross income including delivery costs.

Three Ways to Improve Agency Profitability

According to those formulas, Marcel identifies three ways to increase delivery margin. You can either decrease your costs or increase the amount of revenue generated with the costs you have:

Decrease costs: Do you know your average cost per hour? This is the cost of every hour the team spends on client work. You can lower it by reducing the level of judgment required for the majority of the work in a deliverable. When there are no clear processes or requirements, it often takes a senior team member to ensure a successful outcome. Having clear processes, conducting thorough intake with clients, and leveraging technology and templates will allow you to lower the total payroll you need to get the same results.
Improve Average Billable Rate: This metric measures how much revenue is earned for every hour the team spends on any kind of work. It applies to businesses that bill by the hour as well as all other billing models. You can improve your average billable rate, either through pricing increases or by decreasing the time it takes to complete a deliverable. By doing this, agencies can effectively increase their revenue without needing to make any changes to their team or resources.
Utilization or "The Darksaber": This strategy comes with great power but also great responsibility. Used improperly, it can cause all kinds of damage to the agency. Utilization rate measures team efficiency by looking at the percentage of a team's capacity that is being used to generate revenue at the average billable rate. It’s a metric for the management team and it should not be used to hold individual team members accountable. Calculating this metric will allow agencies to make informed decisions about strategic moves like hiring more staff.

Why Specialization Is Key to Improving Your Agency's Profitability

Specialization is the key to improving your profitability. Specializing and eliminating non-profitable services will help you streamline operations and allocate resources more effectively. Identify the services not generating sufficient revenue and determine whether they contribute to your agency’s overall profitability. If these services do not lead to profitable outcomes, consider eliminating them. For Marcel, instead of offering a wide range of services, agency owners should focus on providing a complete solution to a specific problem.

In addition to specialization, agencies can also consider outsourcing certain tasks or partnering with other agencies that excel in areas where they may not be as proficient. Some of the most profitable agencies Marcel has audited outsource part of their work. This deliberate choice can be beneficial in terms of efficiency and profitability. In his opinion, just like the last 10 years have been about specialization in terms of what the client can see, the next 10 years are going to be about specialization inside the agency. It’ll be a time for agency owners to ask themselves, what are we good at doing? And cut the fat in terms of what they're doing operationally.

Outperforming Outdated Benchmarks

It’s really important to remember that no single path dictates profitability. With the right processes, even unconventional models like 4-day weeks can succeed. Explore various strategies aligned to your specific circumstances.

The key to profitability is to hit at least 50% delivery margin, enabling 30% for overhead and 20% EBITDA. Adjust billable rates and utilization to reach targets based on goals, constraints, and positioning.

But beware of over-reliance on benchmarks, Marcel warns. Definitional differences in billable hours or capacity distort comparisons. Instead of arbitrary standards, evaluate metrics in your context.

Profitability demands knowing your specific business, not the abstract industry. Define success on your terms, for your team. Then design the path to get there. With creativity and commitment, agencies can prosper on their own terms.

Do You Want to Transform Your Agency from a Liability to an Asset?

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Tuesday, July 25, 2023