If you would rather watch than read, click here to watch the full video from Heath Advisory before diving in.
For most service businesses, payroll is about 50 to 70% of total expenses. It's the largest line item on the P&L by a wide margin, and most owners can recite the number from memory. What they usually can't tell you is what they're getting in exchange for that investment. There's typically quite a disconnect between what you're investing in your payroll and how much billable income that actually generates.
Until you understand how those two things work together, you're really just managing headcount, not profitability. The good news is that the analysis isn't complicated, and most agencies already have some version of the data it takes. Get that data right, and the decisions about whether to hold steady, restructure, hire, or, unfortunately, downsize stop being judgment calls and start being math.
How to Calculate an Employee's Break-Even Point
For owners to understand the difference between what they're paying an employee and what they're getting in return, the first thing they need to do is understand where that employee is putting their time. From there, you determine how many billable hours that employee needs to work in order to cover their cost.
Essentially, you need to establish a break-even point for that employee. In a service-hour business, an employee pays for themselves when they've worked enough billable hours to cover the total cost of having them on the payroll. And remember, you have to include all costs in your analysis. Salary and benefits alone understate the number. Most owners have never run this math explicitly for a single person on their team.
Why Creative Agencies Under-Bill Their Time
We see creative agencies under-bill their time more than any other service business, and part of it is culture. We want our clients to be happy. Creative work, at least in the eyes of the client, is subjective to some degree, and so we can often be swayed by a client into thinking, all right, just one more revision. That kind of scope creep puts you in a position where you can't bill for all of your time.
The other and more prominent reason is that creative agencies, above all other service businesses, hate tracking their time. And if you haven’t tracked it, you can't bill for it. That's a visibility problem more than a discipline problem, and it has to get solved first, because every other analysis here depends on it.
How to Tell If Your Team Is the Right Size
Owners can determine whether they have the right size team by first answering a simple question. Are we making money? Are we turning a profit? If the answer is yes, that's when you start performing further analysis. You need to understand where everybody's putting their time; you need to make sure that everybody is working an appropriate amount for your culture; and you need to confirm that your teams are structured so that your most expensive employees aren't doing all the heavy lifting.
The structure we recommend for understanding whether to keep your team the same, restructure, hire, or, unfortunately, downsize always comes back to the same thing. It's all about understanding your hours by employee and your hours by client or project. That's the data you need to make informed decisions about profitability, about client mix, and about client service delivery, and ultimately, all of those decisions lead to how you're going to structure your team.
Why Team Structure Has to Change as Revenue Grows
When we find that a service business's team structure isn't working for them financially, the conversation usually leads to a question. What team structure was working previously? Let's understand that first, so we can understand the team structure you might need in place now.
When you're a two-million-dollar agency, your team structure likely needs to look very different than it needs to look when you're doing four million. There might be different seniority levels on your client service teams. It might be a different billing structure. There are a whole number of things we need to look at, and none of them were wrong. They were just calibrated to a business that you’ve outgrown.
Building a 12-Month Forward-Looking Forecast
It's also not just about looking one month in advance. It's about looking 60, 90, 120 days out, and even over the next year. If we hold steady today, will our team still be serving us well in six months? What happens if our revenue doubles a year from now? Of course, we're going to need a different team. And what happens if we lose this significant client?
We recommend that owners always have a 12-month forward-looking forecast. As you move through Q3 and Q4, you want at least rough estimates for the first six months of the following year, so you can be confident that your current team structure still feels right as you approach the fourth quarter and the first part of next year. How far forward do you need to look? At least six months, and a year is much better.
When Your Team Is Over Capacity and Still Not Profitable
When owners are heading into fall planning and their teams feel over capacity but still underperforming financially, the owner needs to analyze the scope, what's being delivered against that scope, and the team structure. Do we have the right butts in the right seats? Do we have the right team structure for each particular project?
Typically, in a client service business, you want to make sure that your lower-level account folks are doing most of the heavy lifting, and that's what's going to help shift a service business into a more profitable range. When your most expensive people absorb the day-to-day tasks, the work still goes out the door, and so do your margins.
Why Delaying a People Cost Decision Costs More
The most common mistake we see owners make when they're trying to solve a people cost problem is not taking action soon enough. Taking action today, whether that's beginning to make the hire you need to make in the fourth quarter or making the other team change you already know is coming, is going to allow you to realize those results much sooner than waiting until later in the year.
The data doesn't get better by sitting on it. Once the hours tell you what your structure is costing, now it's time to take action.
Heath Advisory works with agencies and professional services firms to connect payroll investment to billable output, build the hours-by-employee and hours-by-client visibility that team decisions depend on, and model what your structure needs to look like six and twelve months from now. Reach out for a free consultation if your team feels busy and your margin doesn't reflect it.
