Agency profitability improvement is a perennial challenge facing new and seasoned agency owners alike. Blog articles on this and similar topics abound. Most provide tips for tactics that rarely get to the heart of the matter. This article is focussed on improving profitability, not growth. Although there are obviously some principles that would apply to growth.
|At the time of writing, we are still in the throes of dealing with the Coronavirus pandemic. Some may think this article is untimely under the circumstances. But this article deals with immutable business truths that are universally applicable, even under these most difficult circumstances.|
The need for a focus on profitability improvement
At the end of the day, any business other than a ‘not-for-profit’, is there to generate profit for the shareholders. This may not be the business’s stated purpose, but it needs to be a focus rather than just an accepted byproduct of activity. Seriously focusing on profit maximisation can make a substantial difference to outcomes. Apart from having to pay more tax, more profits can mean:
- Higher shareholder dividends
- Faster loan repayments
- Re-investment opportunities to fund growth etc. etc.
Many agencies that I see, have their focus on growth. Nothing wrong with that. But trying to grow any business that has not mastered the management of profitability is close to impossible. Before you can fill a bucket, you need to mend all holes!
In most agencies and other professional service business there two principle profitability traps that need to be understood: (more here: Operational and Workflow Efficiencies)
- Inaccurate quoting. Often, work done by agencies is complex. If the complexity and the associated risks are not adequately understood, the pricing will be out. No matter how good you are, money lost by incorrect quoting is irrecoverable. Or put another way, money lost (by whatever means) is funded by the shareholders. If this happens in a big way on a big project, this could have a devastating impact on the whole year’s profit. What’s more, if one’s quoting is consistently wrong, it is simply not possible to make the amount of profit the business expects or requires.
Inaccurate quoting is not always easy to detect. It could originate in a variety of places and could have a compound cause. It could be
- a lack of understanding of the true complexity of an issue or elements of a solution
- incorrect risk assessment of a project component
- lack of experience of certain aspects of a project leading to knock-on effects
- and believe it or not, simple calculations errors
Sometimes incorrect pricing is very hard for the people who are doing the quoting to pinpoint themselves and a pair of fresh eyes is helpful to see the obvious.
- Inefficient delivery. Once quoted, the delivery has to be done to budget. There are a host of reasons why delivery can go wrong. As most costs will relate directly to wages paid, most delivery inefficiencies will manifest as time blowouts or delays. By their nature, these are impossible to correct or recover after the fact. And so it behoves agency management to have a full suite of pre-planned strategies in-place to preempt and mitigate the likes of scope-creep, scope variations, content delivery delays etc. etc. that end up being cost of sale write-off’s.
There are obviously other areas of inefficiency as there would be in any business, but these would most likely be relatively small.
Efficiency improvements will only take you so far. To make any sort of significant improvements to profitability one has to look beyond efficiency. That said, attempting some of the other profit improvement opportunities below will be made a lot harder if attempted on top of inherently inefficient underpinnings.
7 Principles for agency profitability improvement
- Focus on a Niche.
It’s simply not possible to be all things to all people. If you are a generalist, you are competing with the largest number of competitors possible. Firms with the highest operating margins, position themselves as experts and experts come at a premium.. They display in-depth knowledge about their chosen niche in all aspects of their go-to-market strategies and come across as authoritative. Companies with recognised expertise are able to charge at least 20% more than those that are undifferentiated.
The easiest way to add to the bottom line is to add to the topline! So putting your business in a position where it can motivate its higher prices will generate bottom-line benefits immediately.
To smaller companies that are finding it relatively tough going, the idea of narrowing their focus is hard to swallow. It seems illogical to ignore all the other opportunities. But as antithetical as it may seem, not only would any student of business strategy concur, but results in the market unequivocally bear this out. As time goes by the agency can expand from a solid base into an additional specialty if indeed that proves necessary.
The benefits of operating in a niche are manifold.
- Marketing can be done more cost effectively
- Better margins
- The cost of selling is lower
- More opportunities for operational leverage
- More referral opportunities to relevant opportunities
- Become a more prominent service provider (within the niche)
- Improve Client Acquisition Effectiveness
For high-value transactions such as you would expect from agency customers, the effort and cost of bringing on new clients is quite considerable, especially if you are not operating in a niche. Each proposal takes many hours to prepare and often involves the time of non-sales staff who may need to be consulted and distracted from their paid work. If one considers that most agencies have conversion rates of around 25%, then each successful sale requires four such efforts. This can add up to a considerable expense which is generally never properly accounted for or formally costed
By focusing on the efficacy of client acquisition, it is possible over time to improve the new client conversion rate considerably. This alone will reduce the cost of client acquisition considerably and make a marked contribution to your agency profitability improvement efforts. This is not purely an exercise in sales effectiveness, but encompasses positioning, messaging, effective communication, targeting and other related topics.
A by-product of ineffective client acquisition is to have an interrupted flow of quality work. Any interruption to the flow of work will remove the opportunity for paid employees to generate their full margin contribution and of course, leave holes in your revenue line.
- Use Value Based Pricing
Whilst the market is big, it’s also competitive. You need to be very effective at bringing on quality new business on your own terms. This means business that is higher margin but with manageable risk. This concept is what Value Based Pricing or Value Based Business is all about. Easy to talk about, quite difficult to actualise.
It usually takes some time to develop the necessary skill base and the business nous be able to pull this off. It requires that you base your pricing on a reasonable commercial return on investment for the client. If you are able to demonstrate this and deliver it at a cost lower than the total of the hourly costs, then you are in the value based pricing business. This requires that you have a strong command of the competitive environment, because less sophisticated competitors using cost based pricing could easily scupper your opportunity by undercutting you if it where down to price alone.
As hard as it is, value based pricing should remain an unrelenting focus – the longer term rewards make it well worth it and make this the strongest of all agency profitability improvement strategies.
- Margin Contribution Equalisation
Understand how and where your agency makes money and focus on improving each margin producing component to the point where they are all contributing approximately the same. Avoid cross-subsidising poor performing elements of your business through the efforts of the high performing ones. Know your numbers and drive your business accordingly.You should focus on developing strategies around low margin contributors such as outsourcing and upselling, or simply not offer them, if necessary or possible.
- Operational initiatives
Operations effectiveness will be a major component of agency profitability improvement. This requires a combination of systems, compliance and discipline to achieve. An agency needs to keep its utilisation level (utilisation is the percentage of time spent on billable work) where it needs to be, for good profitability. Good agencies are able to maintain utilisation levels of 60% or more. At the very least set it up as a KPI and make it a point of focus, otherwise it will not improve.
- Eliminating cost of sale write-offs. This refers to client work performed for no compensation. These can originate from a variety of sources and most often slip through without notice or consequence and can have a profound impact on profitability. It is good practice to specifically account for these as a cost of sale item. This will keep them in view and serve to remind management of the constant need to keep working on reducing them.
- Work to a Plan
Profit is not something that happens by accident in a business. Like many other things, it can only come about as a result of deliberate decisions and actions.
Plan x Action = Result
The benefit of planning is that you get to solve many of the operational challenges on paper. Your calculations will clearly demonstrate your theoretical profitability, and from there it becomes a matter of execution.
So as simple as it sounds, have a strong, thoroughly thought-through plan for achieving your agency profit improvement objectives, it will give you a way of making better management decisions that will make better profits. Without it, it will be hit or miss!
Even with a good plan and all other steps and precautions taken, profitability needs ongoing and continual management focus. The agency’s rank and file employees are not concerned with making profits. They are there doing their specific job and are not concerned with issues like speed and efficiency. That is the responsibility of management.
In addition to carrying out the ‘Action” part of the equation in (6) above, this means being totally familiar with what is going on in the business at a numbers level and being able to make preemptive decisions that optimise the business’s position where planning assumptions may have been wrong or where circumstances change.
A constant focus on driving activities to a plan that has been previously calculated and decided on, must lead to the desired result.
In smaller agencies where the management function is subordinated to other interests, profitability can easily slide.
These agency profitability improvement strategies may all sound like nothing more than ‘organised common-sense’. Indeed that is exactly what they are. Yet, until you have developed the necessary mastery over these issues and ‘put them to bed’ in your agency, you will be plagued by low profitability and the inability to grow and scale. Get them all under control and you will not only open the doors to the right level of profitability, but relieve yourself of a persistent headache and the opportunity to focus on growth.