On this episode of THRIVE—sponsored by Workamajig—Kelly demystifies profitability for agencies with guest Ryan Watson, Founder of Upsourced Accounting, a financial firm for creative agencies. They talk about the levers needed to move margin in the right direction, as opposed to focusing on lagging indicators.
EP 28: Demystifying Profitability, with Ryan Watson
Kelly: So today we’re talking about demystifying profitability, and my guest today is Ryan Watson, co-founder and partner of Upsourced Accounting, which is really a firm that specializes in accounting for Creative Agencies, Media Tech, etc. Typically in the 1-5 million dollar range, 10-30 employees. But this conversation is going to be really relevant for firms that are smaller than that and much, much larger.
So thanks for being here Ryan I really appreciate it, it’s great to have you on Thrive today.
Ryan: Thanks for having me, excited to be here! Excited to get into it.
Kelly: Yeah! So let’s do that. I think that based on previous conversations we’ve had, you and I are definitely in agreement that profitability isn’t one lever, it’s not one of these things that gets wrenched up or wrenched down based on something that you’re doing day-to-day. So it’s really the result of numerous levers that are being pulled and when we talked you had this really great analogy that really stuck with me and I’d love to share that with the audience.
Ryan: Yeah! And you’re totally right, so obviously I am an accountant I’m a finance person, so profit matters, so it’s not that we as agency owners should ignore profit, but the point is, you can’t manage to profit right? Profit is that there’s this idea of leading and lagging indicators in everything, in life, in the economy, whatever it is. And profit is a lagging indicator, so take the example I gave you which is weight loss.
So, if I want to lose weight, the lagging indicator of weight loss is I step on a scale and it reads out a number and that’s how much I weight right? I want that number to be lower, but that number is the lagging indicator, I can’t just go in a healthy way, just remove the weight and just say, “Hey I just want it to be gone,” right?
Kelly: Not without surgical intervention.
Ryan: Not without surgical intervention, which I guess it can be done but that’s not what we’re talking about. So the way to move the lagging indicator is by focusing on the leading indicator, so in weight loss the leading indicator very simply would be calories in and calories out right? So then it’s about thinking, "Ok, from a calories perspective how do I manage the tactics around a good healthy diet? What are the tools I use like my fitness pal to manage some sort of number right?"
Calories out, same thing, how do I, the tactics being developing exercise regimen, pulling in a trainer, using technology like Fitbit or Apple watch to manage the calories burnt, and as you’re managing the leading indicators, the natural result will be the lagging indicator. And that’s the same thing with profit. Profit is the result, it’s the destination, it’s not the journey.
Kelly: Yeah. It’s so funny that you just said that, because we didn’t talk about that and that’s literally the blog post that I wrote a couple of days ago, literally verbatim. That’s awesome! We’re there! And it’s interesting to me. I love this conversation because it’s the thing that most agency owners that I talk to, that’s the thing that they want to focus on. What are your goals and objectives? I want a higher profit margin. Ok, how are we going to get there?
Ryan: Well, that’s right and you know, we are accountants, financial professionals, that’s traditionally where the agency owners will bring us in. They say, "Ok, I want profit, how do I do that?" And then they’re very surprised that we say, “Ok, well let’s talk about the leading indicators,” which look a whole lot more like operational metrics right?
I’d say, the one thing if I frame this in sort of a financial conversation, a high level profit for an agency is revenue, money in the door, minus expenses. And there’s really only two types of expenses. The first is what’s called like “cost of goods.” This is just what you pay your employees, the cost of actually delivering the work, usually labor. And then the other is just like operating expenses, things you pay on rent, contractors, telemarketing, and that sort of things.
So the revenue minus the labor, the cost of goods, that’s what called Gross Margin. That’s ultimately the money we make on a project before you have to go pay all the other stuff. And ultimately, that’s where all the leading indicators live that really drive the business, so that’s where we focus. We talk a whole lot more on the revenue side, pricing, retention and user acquisition or client acquisition. And on the labor side it ends up looking a whole lot more like utilization, staffing and process. So that’s where we talk about to go to the tactics of those things.
Kelly: Right, and that’s what I think, when I talk to a lot of agency leaders if they aren’t to the point where they have a controller or a CFO, and they are using some kind of outsourced solution for accounting and things like that, they don’t really think about things in that way, and it’s really interesting that your firm specializes in agencies, because agency world is just rife with so many variables and so many different moving parts, that it’s hard for a financial professional who doesn’t understand the agency world, not that this is a completely unique business model, but there’s a lot to talk about and a lot to think about, a lot to consider, it’s great that you specialize in that you’ve really positioned very well.
Ryan: Totally, and look I’d say generally speaking, ignoring agencies for a second, every business has its own unique complexities, and so you’re going to involve a professional to help you, they can’t possibly be an expert in everything, so they had certainly better be an expert in the thing that you’re doing, and so we found that early on. We specialize not only in compliance and things like that but how do we help an agency owner grow their business, we realize very quickly that couldn’t be as talented with agency owners as with lawyers as with dental offices, you have to specify. Which is no different than the agency owners themselves, agency owners have learned the same thing, you have to have an edge.
Kelly: Not all of them, but…
Ryan: Sure, but the ones that are managing their leading indicators around revenue and to set a good pricing like the way to… your biggest lever in driving a higher price, and one that is going to deliver a stronger gross margin is by specializing in delivering expertise, it’s how you deliver outsize… So I’d say, as I think about just kind of like to talk about it a couple of leading indicators on the revenue side, I’d say one that we talk about a lot with agencies is rate-per-hour.
And don’t mistake me to mean that I’m suggesting that you should charge on an hourly basis, I don’t think you should charge on an hourly basis, but retrospectively determining what is the revenue that I am earning per hour put into that project, is informative of a lot of things. It’s informative of how well you’re utilizing your people, it’s informative on how much pricing power you have, and generally speaking, we try to look for rate-per-hour somewhere between 4 and 5 times the hourly rate of the folks that are actually delivering the work and if you’re able to get that… go ahead.
Kelly: No I was just going to say so 3 is like break even or just plateauing you’re not making anything.
Ryan: That’s exactly right. The 3x is exactly kind of plateauing if we can get to 5 we’ve got clients that are above 5. That gives us some flexibility to actually earn a margin and ultimately you know, drive some profit. So that’s an example of an area, that’s a metric that helps us unpack, ok we’re at 3 or we’re at 2.5, now what’s the issue? Is it a utilization problem? Is it a pricing problem? Is it a positioning or retention problem? And that is like the: I have a bad diet, is it late night snacking, is it I’m eating too much on each meal? It’s the same thing, now we can unpack the tactics.
Kelly: So what would you say are the most common metrics that agency owners or agency people who are in charge of finance in some way, shape, or form at an agency, what are the metrics that they are not looking at that they should be?
Ryan: Yeah, well, boy. There’s a lot but if I were to just pick the two that I think are the most informative and allow us to ask the next question, I’d go back to rate-per-hour and utilization. If we can get our hands around average revenue per hour into a project, and when I say utilization, again I’m looking at the amount of billable hours divided by the amount of available hours.
Kelly: Which means that all of those employees have to be tracking their time if you want to even be talking about profitability.
Ryan: I’m glad you bring that up, because, you know, it’s interesting that agencies are facing the same conversation that accounting firms are, so I have a lot of empathy for this. Which is, we’re all moving towards value pricing and not only pricing, right? So there’s this debate around, if we’re pricing on value, the hours are relevant, shouldn’t track time, that’s a relic of the past. And there’s a lot of our clients who have that mentality and a lot of accounting firms that have that mentality. And whether this is a popular point of view or not, I disagree with that mentality.
Now, I completely agree that it should not drive your price right? The cost is independent of the value and it’s about what value we’re delivering but there’s no way to track the health of the leading indicator without knowing what am I putting into a project? You learn a lot about just overall how am I pricing, you learn a lot about specific offerings, or industries, or niches, or specific clients that may be more or less profitable for a variety of reasons. You just can’t diagnose any of those things if you don’t have the data.
Kelly: Right. I just had this conversation with an Agency client yesterday, that’s why I brought it up.
Ryan: Yeah, and I get it, especially in agencies it feels stuffy, it feels processed, it feels uncreative, and I get it. There are great tools that make time tracking as fun as humanly possible, and we recommend a host of them, but you have to have the data I mean there’s a balance.
Kelly: I do. So if we’re talking about profitability in terms of this rear view metric, what are the metrics that agencies should be paying attention to on the weekly, and the monthly, and maybe even the quarterly basis? Do you have a grouping or one or two things that you typically recommend to your clients that they should be paying attention to on that more frequent basis?
Ryan: Yeah, so, good question. I mean I would say the metrics that we focus on on the highly frequent basis. So let’s say the weekly or some monthly look like two things. They look more like sales pipeline driven metrics. So we’re talking about like funnel creation, funnel conversion, and they look more like operations. So those metrics are highly customized to the business itself, so depending on the service offering you’re creating, it’s things like timed on board, other operational metrics around the specific service offering. So financially, I guess to kind of bring this back, financially we don’t advocate over-measuring or over-analyzing particular metrics too frequently because reality is they just don’t change that often.
Kelly: It’s like stepping on the scale every single day.
Ryan: It’s like stepping on the scale every single day or like checking your portfolio every day, yeah it’s going to move, but it’s noise. Let’s just zoom out for a second, so financially we’ll look at certain things monthly, but generally, it’s more quarterly. And then again, the things that we look at somewhat in addition of the high level, I mention rate prone utilization are very informative.
From there, we’ll look at things like funnel metrics, we’ll look at retention rates, and kind of LTV’s of customers, and the relationship between that and what it costs us to acquire those. So just the idea of the health of bringing a customer in, and how do we grow long term valuable clients, both for profitability, but also to make us sellable, valuable agencies. So those are some of the things that we’ll talk about in addition to, or in conjunction with just basically how am I driving revenue, gross profit and then bottom line profit.
Kelly: Yeah, that’s awesome. And I love the LTV conversation, because I think it is really important if you spent a little bit more to acquire a client, and you find out through all of these different metrics that it is a pretty profitable client, and you want to get in there, you’ve already landed you want to expand the business with that existing client. Having that metric to look at what this long term lifetime value is, I think is really important, and I don’t think a lot of agencies really focus on that, and I don’t think it’s one of the things that they’re looking at often enough.
Ryan: No, I totally agree. And I think agencies underestimate the amount of investment that they can make in a long term valuable client. You generally think about on a project basis, so this particular project might come in at 50k, and so look I can only put whatever it is, 5 to 10 to 15k to put into a customer like that, but that customer might be Procter & Gamble, or it might be GE, whatever it is. So if we take the long view, and we invest in how do we use a project to build as a top of the funnel activity, to create a long term either a retainer client or an annuity of projects, such that I now have a 7 figure relationship, well now I can spend an awful lot more time doing account based marketing activities to really get myself into the tentacles of that entity.
Kelly: So let’s wrap up taking this into that longer term discussion and thinking about it from the agency owners perspective. So most of the agency owners that you and I work with, at some point they want to successfully sell and exit their firm and I often get asked from these agency owners, “What are the things that I need to bolster when I want to start really thinking about acquisition.” Whether that acquisition is 3,5,10 years out, what are the things that the potential acquiring organization are going to want to look at. So where do I need to be to make myself look really valuable and like a good purchase?
Ryan: Yeah, totally, great question. So I’d say it’s two factors. The factor 1 is just building a sellable business. Operationally, is this something that someone is going to want to come and buy right? Is it a highly differentiated offering? Do you have a specific differentiated offering at a specific differentiated niche? Is it unique? I mean, if I’m selling to WPP or Publicis or whomever, they obviously do a lot of things. So they’re looking for point solutions that do one thing really incredibly well. So what are you in that regard? The other bit is have you built a repeatable business that lives independent of you? I like to ask the question, if you literally didn’t tell your team that you were going on a 3 month vacation and you left tomorrow. Over that 3 months would your business implode? Or would it continue to click along? Would you continue to fill the funnel in roughly the same pace that you had been, and would you deliver on clients the same way? If yes, you got a repeatable business. If no, you don’t, and the value is with you and not with the business.
Kelly: Which is not sellable.
Ryan: Which is not sellable right? So it has to be a sellable business, and from a financial perspective, very quickly, it’s really about, it now comes to your lagging indicator, so it does come to profit, what profit margin are you doing and at what growth rate?
Kelly: What do you typically advice in terms of that healthy profit margin, because you know, different agency growth consultants and different financial consultants will have different answers for this question, so I am curious as to what yours is.
Ryan: I, yeah, so I will say, first of all, I usually I would advise looking at profit before owner distributions. Because ultimately what is it? It’s irrelevant right? And so I would say, before owner distributions, a really strong agency is between 20-40%, 20 being on the low bar of a really good agency before owner distributions, and we got clients that are in the 40-45 even touch of 50% range, and those are highly differentiated really strong pricing power.
So I would say, that is a great range and then of course, the other half of that is the growth rate. So very quickly, the public companies use this idea of the rule of 40, and the idea is if you added your profit margin to your growth rate in a year, does that number add up to something that is 40 or greater. If it does, you’ve got a really strong combination of growth and profit, and if it doesn’t, well one of those things are lagging. That’s a good rule of thumb to look at.
Kelly: Awesome take-aways, I think the people who are watching and listening are just going to take so much from this conversation, so I really appreciate all your insights and being here today.
Ryan: Of course! No, happy to do it. Thanks a lot.
Kelly: Thanks Ryan.