Agency Accounting 101 with Chris Hervochon - Episode 27

Feb 19, 2020

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About Chris Hervocohon:

Chris Hervochon is often referred to as the Michael Jordan of accounting. A graduate from Elon University with a degree in Accounting and minor in Finance. He is a Certified Public Accountant (CPA) in South Carolina and Pennsylvania, and also holds the Certified Valuation Analyst (CVA) certification. A Certified QuickBooks Online ProAdvisor, and have earned the Data Analytics Executive Certificate from the AICPA.

In 2018, he was one of only 41 CPAs honored by the AICPA as a member of the Leadership Academy’s tenth graduating class. In 2019, I was named as one of CPA Practice Advisor's "40 Under 40" in the accounting profession.

He started his firm called Better Way CPA, where he helps creative, digital marketing agencies, and service-based businesses with intelligent, actionable accounting.

Follow Chris Online:

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Timestamps:

Intro 0:00

Who is Chris 01:00

How Chris Started in the Service Business Industry 2:20

What Makes Accounting Service Businesses Unique 4:48

Why is it Important for Agencies to Have a Clean Accounting Data 8:58

Common Mistakes Agencies Commit in Terms of Accounting 10:04

Why Service Businesses Must Use Accrual Basis 13:53

Revenue Recognition for Accrual Accounting 17:25

Benefits of Cloud-Based Accounting 19:48

Cash Reserves for Agency’s Survival 22:30

The Right Corporate Entity for Your Business 28:10

Biggest Problem for Service Agencies’ Chart of Accounts 30:35

Freelancers Vs. Full-Time Employees 35:00

Allocating Your Salaries 39:48

Gross Profit Vs. Net Profit 41:50

Maximizing Profit: Pricing and Operating Perspective 45:50

Outro 50:00

Often, we base an agency’s success on its profitability. However, we tend to forget the financial aspect of things. And, why agencies need to understand the importance of accounting. And so there's just so many things that I want to talk to you about. And, I want you to ask yourselves why you chose to run or work on a service business.

And according to Chris Hervechon:

“Marketing agencies are a lot like accounting firms. How they operate. It’s a different service. Sure, it’s more creative, generally speaking. But they’re both service-based businesses.”

What Makes Accounting for Service Businesses Unique

According to Chris Hervochon, there’s a lot of agency owners that do not realize that running a service business when it comes to accounting, which is very different than almost every other service business.

And, its main difference happens above the margin. So your margin is your gross revenue minus all the variable costs that go into generating that gross revenue.

If you think about a retail store that tends to have lower margins, your gross revenue is gonna be all the stuff that you sell. Let’s say you sold a television for $850, then that’s already your gross revenue. If it cost you $500 to buy the television, including taxes and licenses, then your gross profit is $350.

On the other hand, service-based businesses tend to have higher margins. There is not much variable cost going into generating the revenue. It is solely based on human capital, on the amount of effort agency owners and their employees put into to generate profits.

Why is it Important for Agencies to Have a Clean Accounting Data?

The entire purpose of accounting is so that you can ask questions about your business and get accurate and reliable answers.

According to Chris, you must ask yourselves these questions while also knowing how to answer them to see whether your business/es are properly tracked and documented:

Is this project profitable?
Is this service profitable?
Is this niche profitable?
What are the fixed expenses?
Where can I cut costs to be more profitable?
What's too expensive?
What's not expensive enough?
Am I spending enough or too much on my marketing?

Through these questions, you will be able to know your agency’s trajectory and what to expect.

Common Mistakes Agencies Commit in Terms of Accounting

You will be surprised at how agencies commit the same mistakes.

Let's start with how often you sit down with your accountant. Agency owners are usually the creative type who is good at marketing and promotion. However, it is important that you, as an agency owner know to hire someone who has proven knowledge in accounting.

Not having organized and systematic documentation of your expenses and revenue. Make sure that you keep track of the inflows and outflows of your money.

They did not start using the accrual basis. From an accrual accounting perspective. I've got somebody who comes and goes. My clients come every week on a Monday, we hope, but they come every week nonetheless. That's a real base accounting. It's matching the activity with the expense of the revenue when it happened.

Why Service Businesses Must Use Accrual Basis

Looking at things on an accrual basis is certainly a change for a lot of people, especially small businesses. But it's something that you need to do. Because there's no way to forecast cash accurately. And, it will answer the questions:

How is my business doing?
How is it looking for next month?

In a service-based business, accrual accounting is important because it's reflective of the business model. It's reflective of the way that value is earned and value is actually accrued over time. So if you run a service-based business, you should be doing your books and you're counting on an accrual basis so that you can get accurate insights into your business.

Accrual-based accounting is more time-intensive. It does require more expertise and so to do it is more expensive. But there is a line where the business is big enough.

Revenue Recognition for Accrual Accounting

Chris said that before anyone starts with what accounting method they’re going to use, you must start with what your contract stipulates. If the contract says that it's going to be based on specific deliverables, then you base your revenue recognition on those specific deliverables.

If the contract says it's gonna be there's one deliverable and you're doing it over some time. If it were me, I would allocate it based on the amount of time it's been spent on that particular project. But, to get down to the real nitty-gritty. Look at the contract for the contract is going to dictate it and then go to some sort of another allocation method.

Benefits of Cloud-Based Accounting

Chris states that as an agency owner, you need actual accounting software, you need applications that play well with that software, and most importantly your accounting software should be cloud-based instead not desktop based.

The reason being is if you have an accountant who's halfway across the country, you could be looking at the same numbers in real-time while doing the same thing

And, what you can effectively do with cloud-based accounting systems is offload the security to somebody who's probably a lot better at it than you are. You must protect your business information and there has been a lot of hackers targeting these hosted type platforms like QuickBooks.

The third thing is that cloud-based accounting systems make it easier to plug-in other applications. Whether it’s a bill pay system or an expense tracking system or maybe it's just other marketing data that you can then combine with your financial data to make it leverage data.

Non-financial data equals leverage data. When you can combine these two things, you can get greater insights out of it. That's near and dear to your heart as well.

Cash Reserves for Agency’s Survival

Chris Hervochon recommends that agencies must set aside between two to six months’ worth of fixed expenses before investing in a new venture or offering new services. Fixed expenses are expenses that are going to exist in the business, whether or not you generate revenue for the whole month.

Earlier we talked about margins, on how they’re a variable. Your revenue variable is the uncertainty of earning revenue for tomorrow. And the expenses to generate that revenue which are expenses that bring down to a margin. Because if you don't have the revenue, you're not going to have those expenses. So fixed expenses are all that inevitable expenses that come along with the operation of your business.

Biggest Problem for Service Agencies’ Chart of Accounts

The chard of accounts is the foundation on which the insights that you get from your accounting data is built, or from which you get to the insights that you want to build. This is something that a lot of people don't think about a whole lot when they're setting up books for the first time or if they're hiring an accountant that doesn't know a lot about service businesses.

Chris mentioned to try and answer the questions that they want to answer, they've got to sift through a ton of data and do a bunch of math. So when it comes to setting up your chart of accounts as a service business where some of the best practices we want to make sure we're keeping an eye on the inflows and outflows of our businesses.

The biggest problem Chris generally sees is what we would refer to as a sprawling chart of accounts where you've got a separate account. When we say account, what we need is a bucket, a bucket where you would put activity. So in other words, it goes in a rent bucket and where a rent account and the chart of accounts is the total listing of all of the accounts that you have for your business.

That said, the biggest mistake is a sprawling chart of accounts where you've got one account for every little transaction. So if you have accounts that you know, on a very regular basis have one transaction per month or one transaction per year, you've got way too many accounts.

Charter accounts make it very difficult to manage. It makes it very difficult to do the accounting because now you're splitting hairs on how you're going to classify this transaction of that transaction.

The two biggest things, according to Chris Hervochon are:

You've got to be able to get to a good margin. And we talked about that a little bit earlier. The gross profit margin is everything variable. Revenue is variable, Revenue is variable and all the expenses that need to achieve that gross margin.
You’ve got to break out your salaries and wages.
And, make sure that your chart of accounts isn't enormous because it is going to be impossible to manage.

Freelancers Vs. Full-Time Employees

Freelancers, generally speaking, are going to go above the line because you're only going to bring them on for certain projects, certain clients, certain services, whatever it is. They're 100% variable because you've already generated some sort of revenue or you think that you're going to generate revenue because you have a signed contract. So there should be some sort of a contract labor line in your chart of accounts to get you to that gross profit number.

Chris said that a lot of people are tied up with the idea of the relationship or the contractual relationship they have with an individual as it relates to “Are they an employee? Or are they a contractor?”

There are four components that you must ask yourself to determine if they’re an employee or a contractor:

Are they fixed or are they variable?
Are they contractors or are they employees?
Are you controlling when and where they do the work?
Are you providing them with tools or software?

This is an important point that you're making about the relationship that that person has with variability. If you have a person that isn't technically an employee of the company, but you pay them $2000 a month which is going to be more of a fixed cost.

And, this is how you classify people between contractors and employees. If you control how, when and why they do their work and you provide training and you provide the equipment and the software and all of that stuff, they’re an employee. If they can do the work unsupervised, they're going to provide you a deliverable. You're not controlling where they work or when they work. Then they're a contractor.

Most businesses want more contractors because contractors are cheaper. And the reason that they're cheaper is that you don't have to pay benefits. You don't have to pay employee-employer taxes. You've got to be careful because that's a really good way to get yourself in trouble.

Allocating Your Salaries

According to Chris, time tracking will help you accurately allocate salaries within your agency. You can either ask your freelancer or contractors to either track time or give an estimate on how much time they need to complete the project or how much will that certain project costs, whichever works.

There's no data-based way to go and allocate it aside from using a time tracker. At the end of the day, it's cost accounting and then you could allocate anything based on any model that you come up with. But if it's gonna be a data-driven approach, if it's gonna be based on reality.

Chris mentioned that you’ve got to make sure that when you're allocating those expenses that you're allocating the fully loaded expenses which include salaries, benefits, and taxes. The full cost of having that employee is what you want to allocate. You can't just allocate the salary.

Gross Profit Vs. Net Profit

It's important to define what is gross profit and what is net profit because I think a lot of agencies now are starting to look at gross profits on projects I think is a good thing. But then a lot of them are not clear on what that means and what should and shouldn't be factored into that.

So gross profit is gross revenue while net profit is gross revenue minus all of the variable costs that go into generating that revenue to revenue or so expenses that you would not generate otherwise if it were not for generating that revenue.

Maximizing Profit: Pricing and Operating Perspective

Agencies should be pricing not based on the time that they spend, they should be pricing based on the value that they deliver. And that's different for the different forms of agencies.

Chris mentioned a really good example is a digital direct marketing agency that is running ads. “You should be charging higher if your ads are more effective than the next agency down the street. You should be pricing based on the value that you deliver and you should not need to be measurable.”

As an example, while not all 20 of those industries are going to be profitable and you can't take the products or the service that you delivered for “Industry 1” and then apply that to “Industry 10.” Every age or every industry is different. You need to know about the business.

And being diligent and paying close attention to the expenses in your business because they can get out of control quickly, especially in a software-heavy society that we have now. By being vigilant about where all those numbers go and that gets back to the point, you need to be looking at your finances with somebody qualified to walk you through and tell you the status on a very regular basis.

From making sure that you're sitting down with your accountant regularly, reviewing these things, managing your expenses, the value-based pricing, which I think for most agencies need to do is probably a great way to increase the amount of money that you make for the amount of time that your team has to invest and the number of costs that you get.

There you have it, folks! I hope you’re getting so much value from this episode. And, if you’re looking for more checkout our Agency Profitability Tool Kit, and find awesome resources such as downloadable spreadsheet templates, KPI cheat sheets, benchmarks, and other awesome stuff you need in running a profitable agency.

And, we have Parakeeto, our software product which helps you keep track of all of your most important metrics in real-time without changing your software and processes. Things like bill rates, utilization, profitability capacity across your whole business, and even let you run simulations to help you gauge and understand business decisions before making them. All you have to do is request an early process to start earning more profits!