Article - Gross Margins - A Guide For Agency Owners

ARTICLE: 5 mins

AUTHOR: Janusz Stabik

As an agency owner, keeping a close watch on your gross margins is one of the best ways to set you and your agency up for long-term success. The trouble is that gross margins can often be misunderstood, particularly in an agency environment where what we’re doing is essentially selling time as a service (just to be clear, we’re not advocating charging by the hour, that’s a topic for another day).

In this article, we’ll unpack exactly what gross margins are (and are not), what a good gross margin looks like and how to fix your gross margins if they’re not up to scratch. 

First & Foremost, What Actually Is Gross Margin?

When it comes to digital agencies, gross margin is a simple calculation using the direct costs of delivering a specific service and the price at which you sell it out - the gross margin is what’s left in the middle. 

In a product-based business, like a chippy, the gross margin will be what the customer pays for the chips, less the cost of the potato and the labour required to peel & cut them. It might cost the chippy £1 to buy the potatoes and 50p in labour to prepare them, which means when they sell them for £2 the gross margin is 50p (or 25%).

Whereas in an agency, where the offering is service-based, the question is how much are we selling our time for and how much does that time cost?

It’s crucial you calculate your gross margin against the separate groups of revenue within your agency. For some, this might be geographically (UK vs US) or by industry (eCommerce or Lead Generation), while for others this could be the individual services (PPC, WebDev, Design etc.)

For example, if you’re an agency that delivers PPC, and you charge £1000 per month for PPC, and the salaries and freelancer fees for your PPC team are £500, then your gross margin is £500 (or 50%). 

How Do Gross Margins Differ From Net Profit?

Your gross margin considers the revenue the service generates and the direct costs associated with getting the job done. What your gross margin won’t include, is all your general overheads, like your office, accountancy fees, utilities and so on. These still have to be deducted in order to understand your Net Profit. 

In order to make sure there’s still plenty leftover in your net profit, you need to ensure your gross margin is healthy enough to allow for all your general expenses. If your services are unprofitable at a gross margin level, then there’s no hope for your agency to be making any money at a net profit level.

Where Agency Owners Get Tripped Up

In our experience, a lot of agency owners muddle the waters when it comes to their gross margins, direct costs, overheads and net profit - which is how they end up providing unprofitable services and losing money. 

The key learning here is that your salaries and contractor or freelancer fees must be attributed as direct costs to the associated service, not in your general overheads. Remember you can also factor in partial salaries of team members such as account managers, who spend only a portion of their time on chargeable client work.

This enables you to look at your services objectively and understand which ones are actually profitable. Rather than taking note of a huge gross margin number on your P&L sheet that tricks you into thinking your services are 95% profitable because you haven’t calculated the wage bill. 

What Good Gross Margins Look Like? (With Agency Benchmarks)

Now to the bit we’re all here for - what does a good gross margin actually look like, what should you be aiming for in order to grow your agency and become one of the high performers?

In our experience, agencies with gross margins anywhere above 50% are doing great. North of 60% and you are doing brilliantly. On the contrary, if you’re numbers are anywhere less than 40% then you have some serious work to do to ensure your agency is still profitable once you get to your net profit. 

How To Fix Your Gross Margins

Now that you've calculated your gross margins and know exactly what each of your services is generating, you can take an objective view about what’s actually making your agency money (and what isn’t for that matter).

For any services that are underperforming - ie. the cost (salaries & tools) associated with delivering them are higher than the revenue they bring in, you need to ask whether you can fix them. If you can increase your prices and/or decrease your costs by making the service more efficient and your team more productive and grow your gross margins back up to 50-60%, then brilliant. 

If you can’t make these changes, then it’s time to drop the service and refine your offering to focus on the services that are actually generating a healthy gross margin. Without taking this action, your agency won’t be growing anywhere.