Why you should pay your agency differently

I’ll confess, I’m writing this from the perspective of an agency, but some of my best friends are in procurement. So, here’s a guide as to how agencies make money and either why it’s beneficial to pay a bit or to remunerate them differently in 2022.

First up, how do agencies make money, or rather, how do they charge for what they do?

For the vast majority it’s about selling the hours required to make an output.

How much is a TV ad, how much is brand launch, how much is an insight persona report?

Several people charge their day rate by the number of days they work. That’s the charging out bit.

And clients can and should challenge all of it. Is that too many people on the project; their day rates seem high; and does it need that many days to deliver the project?

But how do agencies make money from this equation?

We need to understand how agencies measure their performance.

There are a lot of KPIs to track, depending on circumstance and the nature of the agency. These include revenue; net profit; revenue and profit per employee; client satisfaction/net promoter score; utilisation levels; EBITDA (Earnings Before Interest, Tax, Depreciation and Amortization); and so on.

To keep it simple, let’s just focus on:

• Staff costs

• Overheads

• Operating Profit Margin

UK-based accountancy firm, Kingston Smith (with years of experience of agencies annual returns) suggests: ‘A well-run agency should aim to make an operating margin between 15% and 20%.’

Plug in the 20% operating margin, and the target percentages against these metrics should come in at staff costs totaling 60%; overheads at 20%; and operating profit margins adding up to 20%.

Now the agency can affect all of these in different ways and to a different degree.

Overheads – could be reduced by cheaper premises, or in these days of hybrid working, how about not having an office? However, will you attract staff and clients if you’re in an undesirable location with limited surrounding facilities?

Staff costs – what is everyone being paid? Ideally fairly, in accordance with their outputs and benchmarked. Clients have previously asked me what I was paying staff, and I asked them what they pay their teams. Conversation tended to switch quite quickly.

However, the staff cost percentage, or staff cost ratio (the percent of staff costs varies depending on the charge for the project), as it is sometimes referred to, is important. As it can be a reflection of staff utilization.

Staff utilization refers to the amount of working time that is used for billable work and it’s what can lead to clients feeling the agency love or not.

If a team is highly billable, for example 75% or 100% billable, then all their time is being charged to the clients. And more time sold, equals more money for the agency.

However, this can lead to the feeling from clients that the agency is charging for everything, every time the phone is answered, every tiny amend to a design etc.

The agency will do everything they can to protect this utilization, including not bringing in freelancers, as this is a direct cost, increasing the overhead percentage, which could lead to slowing projects, as they wait for in-house resources to become available.

Instead, how about agencies switch from charging what it costs to make something, and instead clients reward agencies for the value their outputs have delivered?

Value-based pricing

Defined as 'a pricing strategy used by business to charge products and services at a rate they believe consumers are will to pay. As opposed to calculating production cost and applying a standard markup, business gauge the perceived value to the customer and charge accordingly.’

The client and the agency need to agree what appropriate value metrics are required to make to this work.

Let’s make it into a tangible example, and say the ‘value’ is defined use customer lifetime value (LTV).

In this instance, the value-based pricing = number of new customers x 10% reward for the agency of the customer LTV (you need know what metrics are used as the customer LTV – let’s make it £10,000).

It would then look like this: 100 new customers x average LTV per customer @£10,000 = £1,000,000. Agency is reward 10% = £100,000 as agency fee.

This also carries the benefit of agencies putting their money where the mouth is. It has the emotional benefit of tying both agency and clients in for mutual success, by sharing the same values and goals.

No more arguing over hours charged, day rates or size of team.

Stop charging for what you do and be rewarded for the value you deliver.

Adrian Nicholls, managing director and partner at bbp agency.