One thing I hear from agency owners all the time is “how do I know if we are doing well financially? What does good look like?”
In my view, the balance sheet is the most important financial statement to look at. I tell all of my clients, “the balance sheet is where the bodies are buried.” In other words, if your accounting processes and procedures are faulty, they will necessarily show up on the balance sheet. Additionally, an accurate balance sheet will tell you whether or not your business is healthy and likely to sustain itself.
The balance sheet is great, but most agency owners focus on the P&L (sometimes exclusively), plus they want to know how their financial performance compares to other agencies. For agency benchmarking, we look at resources such as ProfitCents, RMA and Ibis Industry Reports, as well as industry reports from associations such as The Bureau of Digital.
While benchmarking data is great, it’s only a point of reference as agency structures and service lines vary greatly. For instance, some agencies utilize contractors to deliver all of their work. Some exclusively utilize internal employees. With so much variability, how can you use benchmarking data effectively? Well, for starters, you should always be benchmarking your agency against itself. However, if you’re going to use external data, it’s all about comparing the margins.
Gross margin is calculated by subtracting cost of sales from gross revenue, which will tell you what amount of the next dollar you earn is available to pay fixed expenses and/or take as profit. Cost of sales are variable. In other words, they are expenses you will incur only when you derive a dollar of revenue. If the revenue doesn’t exist, neither does the cost. Examples of cost of sales are project-specific contractors, project-specific software and customer website hosting fees. To express this number as a percentage, more meaningful than simply assessing as a dollar figure, simply divide gross margin by gross revenue.
Net margin is calculated by subtracting fixed expenses from gross margin. Examples of fixed expenses are rent, operational software (e.g. Zoom), salaries, insurance, etc. Net margin is otherwise known as net income, or “the bottom line.” We want this number to be as high as possible, as it represents the amount of money the agency made for any given period. It’s worth noting, though, that net income does not necessarily equal cash flow, the explanation for which is beyond the scope of this blog. To express net margin as a percentage, simply divide net income by gross revenue. Generally, 15% is the minimum percentage we like to see from agencies.
Contribution margin is calculated by subtracting payroll expense from gross margin. Remember when I said earlier that benchmarks vary because some agencies use contractors (variable expense, reflected in cost of sales) rather than employees (fixed cost)? This calculation is how you normalize labor cost when considering external benchmarking data in relation to your agency. This measure can also be expressed as a percentage by dividing by gross revenue.
Benchmarking is an important exercise to understand whether your agency is performing good or bad relative to your peer group. Margins are important to measure as they will help you understand how much of the revenue you are likely to keep as you grow, as well as to give you targets to strive for. A good practice is for an agency owner to review all three margins on a regular basis, and to benchmark them both to the agency’s historical performance and the broader industry.
Have more questions? Reach out to Charleston AMA Treasurer and CPA extraordinaire Chris Hervochon here.