So far, we have discussed a few of the basics as it relates to Digital Agency accounting, but now it is time to take a look at the bigger picture. There are a few key performance indicators (KPIs) you should be aware of to monitor the overall success of your company. We will outline the basic elements required and how they will impact the big picture, so you can ensure you are getting the most out of your business data.
It is super important that you’ve got the basics figured out before we move on, so let’s take a second to remember the items you should already understand and track, that we have outlined in previous articles.
As a quick recap:
- we mapped out how to properly track and account for your time,
- how to get the true cost of your labor by factoring in utilization,
- ways to calculate what you should be charging (billable rate), and
- how to understand what each client is costing you (client profitability).
In a perfect world, you have been up and running in these areas; time, labor, and client costs and you are ready to view your business’s profitability as a whole.
Production Labor Versus Overhead Labor: Now Is When to Get it Right
As we get into reviewing the higher level picture, we will be focused on revenue and top line growth. These two facets of your business need to be appropriately categorized to get accurate numbers. We cannot stress the importance of ensuring the smaller details are in check at this point. Here is your quick guide to making sure you’ve got things dialed in.
Your team members focused on the client project directly is production labor. They are going to be factored into the cost of goods sold and will influence your gross profit margin directly.
The team members focused on the general and administrative tasks are overhead labor. They should be in the Overhead, General and Administrative, or in the Sales and Marketing buckets.
These both need to be accurate to give your P and L the correct high level data.
Generally speaking, the purpose of a business exists to make money. The first indicator of your health in this area is gross profit margin, so we will start there. The basic calculation for this metric is:
Revenue - Cost Of Goods Sold = Gross Profit
Gross Profit / Revenue = Gross Margin
The target for this should be about 50%. If it’s higher than that, awesome. The dynamic will change depending on the size of the company. Generally speaking, a company of about 5-10 will be in that 50% + range to be considered on track. As you venture into the 30 - 60 person range, it'll decrease because of how it works from a service perspective. This is experienced when you increase labor cost to expand your business.
The next side of the profit picture is understanding how your overall expenses tie into your operating profit. This is where the overhead cost number comes into play. The calculation for this metric is:
Gross Margin - Overhead = Operating Profit Dollars
Operating Profit/ Revenue = Operating Profit %
This number is before interest, taxes, depreciation, amortization etc (i.e. EBITDA). Your target number for this KPI should be 20%, especially for that smaller operation in the 0 - 20 person agency. As you get bigger, your percentage will likely get a bit lower, as your labor gets more expensive, and supporting more overhead.
Average Bill Rate
When you figured out your billable rate, essentially this should equal the average bill rate. We all know that this won't always be the case, as you may end up eating some of that profit. This is especially the case if you are a fixed fee company. You will need to look at the average bill rate to understand a goal number to cover all of your “blended” expenses. Especially if you have different staff classes, with employees at various billable rates, this calculation will help find your optimal number and allow you to understand where you are (and where you need to go) on the profitability scale. The calculation for this is:
Revenue/ Total Billable Hours Incurred (on clients)
After reviewing this number, you may be able to consider a multitude of things to influence profitability. Can you be more efficient? Are you just in a transition with employees working longer as they learn? This may dictate if you truly need to change your fees, or if it is a short term challenge that won’t become a permanent cost.
Overhead Per Billable Hour
Heading back over to a stat every company needs to track accurately, is that overhead per billable hour number. Remember, this metric is part of calculating profitable margins so it is important to track. Two things need to be accurately tracked for this number to be accurate; 1) your time, and 2) your overhead costs to include staff that truly fall into the overhead category.
To get this number, use this calculation:
Total Overhead Expenses/ Billable Hours
Once you have calculated this number, you will have another viewpoint into whether or not you are charging enough. If this number is on the high side, you may need to charge more for your services. If you can keep it lower and still be functioning well, you may be able to take advantage of the higher profit margin if the current pricing structure is working well for the amount of overhead required.
Revenue per Production Labor Dollars
In this metric, we are going back to our cost of goods sold area with production labor. We are assessing the value of each labor dollar spent on direct client work, answering the question: for the revenue I'm getting, what is the return on the production labor dollar itself? Remember, production labor includes the calculation of payroll + salaries + payroll taxes + benefits. To get the percentage of return on your labor dollars, use this calculation:
Revenue/ Production Labor Dollars
Your target is $2.00 or above or near that range for the 0-20. For example, if you have $500k of revenue, maybe you have $250k of spend on your labor dollars. Knowing your margins here, will help you budget production labor dollars more accurately and can help you forecast costs (stay tuned, we will dive into this piece more later).
Revenue per Full Time Equivalent (FTE)
This number assesses how much revenue each employee is generating against how many total employees you have. This number is typically annualized. A good range is $100,000 per employee. A great range is $200,000 per employee. Some agencies can hit this, but you are generally on track at $100k with a team of up to about 30 people. To calculate this, you will do the following:
Revenue/ Total Headcount
If you were to think of a perfect structure to hit the optimal Revenue per FTE, your staff should be organized like a pyramid, with the base containing your lower cost team members, doing more of the administrative and bulk of the menial work. As you venture up, you will have more higher paid professionals.
For example, If you are at about $73k per year salary average, and you've got about an annualized Revenue per FTE hitting $100K, you're making a net $27k on your labor. Not too shabby. This goes toward covering overhead costs and other expenses.
Utilization of Staff by Staff Class
The final metric that you should be assessing is your utilization of staff by staff class. So remember that percentage we were assessing as each employee’s utilization rate? Remember how when one employee was over or under-used, it threw the profitability dynamic off (especially depending on their rate)? This is where that comes back into play again.
Keeping track of utilization rate on a monthly basis will be the only way you can make sure your big picture numbers can be assessed properly. You will need to make adjustments or be aware of deviations that throw off the big picture. Ultimately, your employees should be hitting that target billable rate to make an accurate assessment of your target margins, but sometimes deviations happen for known reasons. For example, if a team member is below the target rate by 20% they may not need to be re-tasked to meet better utilization, it may just be a temporary cause. This could be that newer employee taking some time to get immersed into the flow of your business, or there’s a longer term employee taking a large chunk of PTO. Either way, tracking utilization on a month over month basis, and comparing them against the targets, will give you the heads up to make adjustments as needed.
Your Recap of Metrics
So, here’s the recap for you. The goal of tracking these metrics exists to ensure you can adjust your operations to maintain and improve profitability. Whether it comes from adjusting rates, or better utilizing your team, or both - you will need to track these metrics first, to know where to focus your efforts. The second piece to these, is to have the data required to track them: tracking time, utilization, production and overhead labor, etc. When it is time to review the big picture of the health of your service based business, these are your KPIs to track:
- Gross Profit Margin, targeting 50%
- Operating Profit, targeting 20%
- Average Bill Rate
- Revenue Per Billable Hour
- Overhead Per Billable Hour
- Revenue Per Production Labor Dollars, targeting $2.00
- Revenue Per Full Time Equivalent (FTE), targeting $100k
- Utilization of Staff, by Staff Class
Once you get a sense of where your business stands using these metrics, will help you make decisions that can help you improve and grow your business.
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If it sounds a tad overwhelming, we can help. Tell us about your business and we will discuss how you can track these important KPIs too.