Research & Strategy for Digital Agencies

New Agency Economics - Margins Are Shifting

Published about 2 years ago • 3 min read

Notes from Nick

A quick recap of the key topics on digital agency owner's minds.

I was chatting with the owner of a small dev/design shop last week who mentioned she was frustrated with her firm’s financial performance. She was set on revenue generation (she actually had way more leads than she could handle) but she wasn’t thrilled with how well her firm was converting that revenue to profit. It seemed like a lot of headache and heartache for not much of a return. I asked her what she thought an average shop like hers should be making and I was shocked by her response.

“I feel like I’ve seen averages of 30%.”

While that’s not unheard of, it’s certainly not average. Not anymore at least.

Some posts and talks were floating around a while back that provided financial benchmarks for digital shops. They boiled down to something like the following:

“You’ll spend 45-50% of your revenue on cost of goods sold, and then you should limit operating expenses to 20-25%, and you’ll be left with a net income of 25-35%.”

Now, I’m not convinced that was ever true, even pre-pandemic, but I’m sure it’s inaccurate now.

We just wrapped our 2022 Digital Services Salary Report, where we analyzed over 700 salaries to see how they’ve changed since right before the pandemic began. (If you didn't participate, you can get a copy by becoming a member of the Bureau of Digital)

There’s been a massive shift in the costs to run a digital shop over the last few years. Salaries have always been the most significant expense, and in that report, we learned most have grown by 25-35% since mid-2019.

That change has altered agency economics.

When we combine that report with our 2022 Digital Services Outlook Report, we can zero in on what it really looks like to run a digital shop.

Over the last few years, the increases in salary costs have pushed COGS to ~55% and OpEx to ~28%. This leaves a net income of ~17%, which aligns with our survey work.

So what?

It’s important because the “little stuff” is starting to matter more. As margins narrow, there’s less room for missteps. It used to be easy (comparatively and with a healthy dose of nostalgia) to slap a 2-3x markup on a dev/design team and sell the heck out of it. Setting solid positioning, repeatable revenue generation systems, pricing well, and installing procedures that optimize utilization rates used to be nice-to-haves, but they’re becoming necessary.

The good news!

The silver lining in all this is that there are still plenty of levers you can pull to deliver above-average growth and margins. It always starts with strategy; get that right, and everything else comes easier. After that, there’s a ton to do in pricing, talent attraction and retention, utilization improvements, repeatable revenue generation, and more. You don’t need to be perfect in all of them to build a successful shop, but the average level of competency will be rising, so it’s best to get an early start.

Researched Resources

A curated list of recent articles from around the web and some thoughts on their topic's impact for your industry.

  • The Great Resignation has captured the attention of most Americans, but it seems employees may actually be entering a period of serious reflection around company culture, meaningful work, and alignment of life and career goals rather than just resigning from their jobs per a recent HBR article The Great Resignation or The Great Rethink.
  • The ad industry is in the midst of major transition. As the landscape continues to evolve, there is much to be learned from TV, merchant media and the unbundling of advertising.
  • The metaverse is exciting to some and worrisome to others. Understanding the hype versus reality for your business will help you navigate the potential Opportunities in the metaverse.

Pro(methean) Tip

Some of our most commonly given advice to make managing a digital shop just a bit easier.

It’s more common than I’d like for digital shops to lump all their labor costs into operating expenses instead of splitting them out into direct labor and indirect labor costs. This leads to tiny COGS and massive OpEx lines, along with some crazy expectations around what a “healthy” gross margin should be. Luckily, it’s easy for your accountant to fix this. They’ll take the employee salaries (fully burdened) who are directly involved in producing work, and move them to the COGS line. Those employee salaries that are more support-related will stay in OpEx. It’s just up to you to classify them correctly.

I’d recommend against getting too detailed and splitting out hours spent each week. That’ll quickly become too tedious to manage and it’s better to be close and actually do it vs. being exact and burning out on the process.

Once you’ve got that squared away the 55% gross margin above should make a lot more sense.

Research & Strategy for Digital Agencies

Nicholas Petroski

The latest research, insights, tools, and resources that make managing a digital shop easier,

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