One of the most common questions I get asked by digital agency founders is, ‘What profit margin should I be aiming for?’
This is a nuanced question, because your net profit margins will ultimately depend on a few key factors. One is the stage of your business. For example, if you’re just starting up, you’re probably going to have no profit. In fact, you’re probably running at a loss, and that’s OK.
Another factor is what your priorities are, or what you’re optimising for. If you’re focused on growth, it’s likely you’ll be reinvesting a lot of profit into customer acquisition tactics – such as sales and marketing – to grow revenue and value.
Alternatively, if you’re optimising for profitability, you may not have a big sales team, and your focus could be on keeping the business operations as lean as possible.
Strict net profit benchmarks, then, are not always a useful tool to help you understand financial performance. But as a general rule, there are some shortcuts that accountants and finance people lean on to set a target for this. Read on to find out what your profit margin should be, and how to get there.
In this article:
- The rule of thirds
- Calculating your gross profit margin
- Improving your gross profit margin
The rule of thirds
For service-based business models, we refer to the rule of thirds, a back-of-the-envelope measure of performance.
The rule goes like this: For every 1 unit of revenue you have, 1/3 should be your direct wages cost, 1/3 should be your overheads, and 1/3 should be your profit.
So what this implies is that in a mature service-based business, your net profit (before tax) should be around 30 per cent.
We work with a lot of digital agencies and can safely say that some of them are overachieving on this 30 per cent margin, while others are falling below.
If you’re in the latter category, you will no doubt be wondering how you can increase your profit to get to that 30 per cent.
Most accountants would default to suggesting that you lower your expenses, but that’s not always possible, nor necessary, in our experience. Your biggest gains come from improving your gross profit – but to do this, you need to make sure you’re looking at the right number. So, let’s take a look at how you calculate your gross profit.
Calculating your gross profit
For service-based businesses, gross profit is calculated as revenue, less the wages of employees that are “on the tools” servicing clients.
With the rule of thirds, what this is implying is that the gross profit generated on your direct staff is around 60 per cent.
Now, from an accounting perspective, it’s highly likely that your books are not structured to treat your wages as direct costs. Rather, they’re likely to be lumped together under total wages and salaries in your P&L.
Let’s take a look at this example.
In this example, you will note that wages and salaries are grouped together in “the operating costs” section. This unfortunately doesn’t give you any visibility on your gross profit margins.
If you’re a digital agency trying to improve your profit, start by calculating your gross profit by re-allocating the wages of your ‘revenue-generating staff’ up to the cost of sales. This will allow you to calculate your gross profit.
Once you’ve done that, compare that margin against the 60 per cent gross profit target.
From here, you can look to increase your gross profit margin.
Increasing your gross profit margin
If the top question I get is, ‘What profit margin should I be aiming for?’, then the second most frequent question I get is, ‘How do I increase my margin?’ Of course, this is the million dollar question – sometimes literally.
Accountants may suggest to reduce your expenses, but we generally lean towards increasing your prices, or better utilising your team.
Increasing your prices is a no-brainer. You’re probably undercharging – perhaps a relic from your startup days, or a failure to keep your prices in line with movement in the Consumer Price Index.
Utilisation of staff isn’t as straightforward. By far one of the biggest performance issues we see across digital agencies is under-utilisation of staff. In our digital agency whitepaper, we showed that the average productivity rate across digital firms in Australia is 83 per cent. Yet among firms we talk to, it is not uncommon to see productivity as low as 60 per cent. You can dive deeper into this topic with my three steps to improve the productivity of your staff here.
So, can you increase your prices? Or can you get better utilisation from your team? Or perhaps both?
Go on, do it now. Let me know how you go.