The landscape for digital agencies has shifted. Over the last twenty years, there’s been a downward pressure on profit margins. People want to get paid more, clients want to pay less, and (thank goodness) the 80-hour work week is a thing of the past.
To protect margins, marketing agencies develop complex billing and staffing models: full-time employees and freelancers working together on the same projects. On top of all this, there are more service offerings and departments than ever.
So, how do you get insights into the health of your gross margin? How do you know what to do if it’s not where you want it to be?
You need to understand your agency’s financials and related industry benchmarks and determine ways to shift these key metrics if they aren’t in an ideal position. Working with agency clients, we have uncovered trends in creative agency profitability and determined how agency owners can move the needle on their gross profit margin–without getting lost in the weeds.
But First–Calculate Your Agency Profit Margin
Your gross profit margin uncovers how much profit your agency is able to keep compared to the costs of your services. The higher your gross profit margin, the “healthier” your agency’s profitability.
To calculate your agency’s gross profit margin, you just need a simple formula:
Gross Profit Margin = (Total Revenue – Cost of Services Sold (or COGS)) / Revenue x 100.
If you notice that your digital marketing agency’s gross margin isn’t ideal, it’s time to look at three specific non-financial metrics (what we refer to as Creative Agency KPIs):
- average billable rate
- utilization rate
- average cost per hour
Adjusting business strategies to influence these three metrics quickly shifts your gross profit margin. To influence these metrics, you need to reassess your agency’s time tracking procedures. This will help you diagnose areas of concern and potential opportunity. You may need to re-evaluate your pricing strategy, prevent scope creep, use a more effective project management tool, cut “fat”, optimize your utilization rate – or all of the above.
Track Time–but Stay Out of the Weeds
Time tracking has a bad reputation. It’s true, if you do it for the wrong reasons, it can be a black hole of busy work. However, if we agree that gross margin is important, and you want to know what’s happening at a more granular level, there’s no way around it.
Time tracking is a useful tool to determine where your team’s time is going, and therefore, where inefficiencies could be happening. These inefficiencies drastically impact your average billable rate, utilization rate, and average cost per hour, so addressing them is of the utmost importance. A few inefficiencies to look for include:
- Software that might be bogging down your team’s time
- Processes that aren’t as efficient
- Types of services or deliverables that are taking more staff time
- Departments with longer project timelines than others
- Client accounts that may be prone to scope creep
That’s where we can start to surface the insights that drive the profitability of the business forward.
Imagine you have a small inefficiency in your most popular offering, costing you a few hours per week per client. When you multiply that one inefficiency by 150 clients for 52 weeks out of the year, it’s a huge impact on your average billable rate–so you know it’s worth your while to invest time in finding a solution.
The danger of tracking is creating a system so complex that no one uses it. So, identify why you’re tracking. If you set up your systems with a clear picture of what you need your team to tell you on a regular basis, then you know where to look for insights.
Optimize Your Team’s Utilization Rate
Your utilization rate measures what portion of your employee’s working hours are spent on billable work. The basic formula to calculate utilization rate is total billable hours/total working hours.
Once you determine how many working hours are spent on client work on average, you can determine whether there is room to make more of these hours billable. Making nonbillable hours more efficient cuts down on time spent on these activities. Then, more time can be spent on client work that can move the needle on profitability. Look into optimizing time spent on time tracking, training events, continuing education, team meetings, etc.
Creative agency owners frequently worry about pricing services too high. Unconsciously, owners assume every person on this earth is looking for the cheapest option. However, effective pricing strategies are based on value provided. There is an opportunity cost to pursuing the cheapest option in many circumstances and agency services are no exception. That’s why your clients are willing to pay your prices!
It also likely comes as no surprise to you that pricing your services too low causes profitability issues and puts you at risk of struggling to break even or even losing money on client services. So, it’s best to price according to the value provided—for both your profitability and to honor the time you and your team commit to agency work.
There are specific metrics that help you determine if you are pricing too low. While we can’t cover all of them in this one blog post, we can cover one of the most important: closing ratio (or the percentage of sales opportunities that are successfully converted to closed deals).
Your closing ratio should be between 25-35%. If you are closing less than 25% of deals, your pricing is too high. If your closing ratio is above 35%, your pricing is too low and likely doesn’t match the value that your service provides.
Once your pricing model is adjusted in the correct direction, you will see closing ratios improve and profit margins increase.
Prevent Scope Creep
As marketing evolves and new technologies come into play, scope creep has become a frequent problem for creative agencies. Agency clients want more than they initially requested, but they don’t necessarily know how much these services increase time spent on deliverables by their agency team. While your agency should charge more for these added lines, you may feel like you’d be jeopardizing client relationships. So, your team does the work without modifying the contract to match the additional work and time spent.
However, scope creep drastically impacts average billable rates, utilization rates, and average cost per hour. Rather than bypassing this conversation with clients, expectations should be set from the onset of the client relationship. Create proposals and SOWs that clearly outline contracted work and fill clients in on how you will charge/document additional work that is requested later on in the relationship.
Setting expectations prevents surprise and frustration on the client side and will ensure your agency gets paid for all work performed.
Pick the Right Project Management Tool
There are so many project management tools out there. It’s easy to sign up for 20 different tools that promise to simplify some part of your project management process, but if your software and team don’t speak the same language, more ends up being less.
We hear it on sales calls all the time, “My tools are the problem.” But the tools are never the problem. Spoiler alert: It’s how the tools are being used.
The best tool is the one your team uses. (We’re having a great experience with ClickUp, an “everything” project management tool with time tracking included.) An effective project management tool fits into your team’s workflow. If your team pushes back on using the tool, it doesn’t matter how precise the data is; it’s not going to be accurate.
Whether you choose an all-in-one, or a bunch of specialized tools, what’s important is making sure that you understand: “What is the core data schema that you need to measure for your business?” If you understand that the core outcome needs to produce data that looks a certain way, then you can align your project management tools with your needs.
Keep in mind these two questions when choosing a tool:
- Can it create the data structure you need?
Collecting the data is the first step. The second step is reporting–and that’s where you need to control for human error. The bigger the team, the more mistakes they’re going to make. Sometimes you’re going to forget your timer is running and you’re going to log a 99-hour entry. Sometimes there’s going to be an apostrophe in the client’s name in the project management tool but not in the finance tool.
You don’t want incorrect data going straight into a report, which is why you need a middle layer between collection and reporting–a process that’s deliberate for extracting, cleaning, transforming and formatting the data, and then doing something with it.
Insights gained from project management tools inform how our team is spending their time and what client relationships are positively (or negatively) impacting profitability. So, prioritize correct implementation of the software from the onset.
Cut Business Fat
What we call “cutting business fat” is actually a broad phrase to describe cutting any unnecessary expenses within your business. Cutting fat is not only a great practice in efficiency, but it also significantly impacts the financial health of your business. According to industry data gathered by SoDA in their Q1 2025 Sales Pipeline and Outlook report, 56% of agencies stated reduced spending is the reason for 15%+ net margins in 2024.
Take a look at all of your expenses, including operating expenses and overhead costs. Identify any expenses that are affecting your bottom line but not leading to any business benefit. A few examples include unused software and subscriptions, more office space than necessary, etc.
Unused expenses can quickly drive up project costs, affecting your average cost per hour. By cutting anything unnecessary, you directly influence profitability.
Understanding what makes a profitable agency is great insurance in a crisis, but the long-term benefit is that it helps you make day-to-day decisions that profoundly impact your agency.
If you’d like more guidance on increasing profitability and financial performance within your agency, learn more about our virtual CFO services for agencies or sign up for a free consultation with one of our CFOs.
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