Login or Join

Search ALP episode archive: 

Calculating your agency’s labor costs correctly

As much as we all proclaim that we are really selling outcomes and results for clients, the reality is that all agencies sell time at the end of the day. How you package it up may be different, but from a cost perspective, it’s all about the labor hours that you commit.

But how do you correctly calculate your real labor costs? Marcel Petitpas of Parakeeto and Chip Griffin of SAGA break down the simplest way to calculate the effective hourly cost for your team members — and how to use that to analyze your profitability correctly.

Marcel emphasizes the need to focus on accuracy more than precision (and explains the difference). Chip explains how you can gather more detailed information on a periodic basis without overwhelming your team and generating reams of unused data.

Key takeaways

Marcel Petitpas, on accuracy being more important than precision: “All of that other more precise measurement is still available to you, but it’s like the difference between owning a suit and wearing it 365 days a year versus owning a suit and pulling it out when it’s time to wear a suit. You don’t have to carry all of that complexity around with you all the time.”

Chip Griffin: “We always preach, get the data, use the data, but don’t over-complicate it. Don’t collect data you don’t need, don’t make it more difficult to collect the data than it absolutely has to be. Just get enough information that you’re making smart decisions.”

Marcel Petitpas: “A lot of founders think they’re being tricky and smart by taking less salary because it’s going to make their profit look better. And I just want everyone to know, I’ve never met an acquirer incompetent enough to miss that.”

Chip Griffin: “The biggest driver of your overall agency profitability and individual client profitability is how you compensate yourself and the work that you’re actually doing.”

Resources

How to Calculate Your Billable Employee Cost- Per-Hour (Parakeeto)

Parakeeto’s agency profitability toolkit

How to build an agency project budget (SAGA)

The following is a computer-generated transcript. Please listen to the audio to confirm accuracy.

Chip Griffin: Hello and welcome to another episode of the Small Agency Talk Show. I’m your host Chip Griffin, the founder of SAGA, the Small Agency Growth Alliance. And I am delighted to have here one of our regular panelists and a really smart and nerdy guy, cause we can nerd out on stuff. And I love that. Marcel Petitpas of Parakeeto. Welcome to the show again, Marcel.

Marcel Petitpas: Thank you Chip always. A pleasure to be here.

Chip Griffin: It is exciting. We’re going to be talking about things today that aren’t necessarily the sexiest, but are really important to the profitability of your agency. And so I’m really looking forward to the conversation we’re about to have, but before we do, if someone is tuning into the podcast or the live stream for the first time or the first time that they’ve seen you tell us a little bit about yourself.

Marcel Petitpas: Sure. Yeah. I’m the CEO and founder of a company called Parakeeto, and we exist to help digital and creative agencies be more profitable by helping them measure and improve their performance. So if you want to learn more about all of that head to parakeeto.com, I’m also the host of a podcast called the Agency Profit Podcast, where we talk about a lot of things that are not very sexy, similar to what we’re going to discuss today.

And I’m also the fractional chief operating officer at an agency called Gold Front, out of San Francisco, which, you know, it’s cool to watch them work with brands like Uber, Nike, Adobe, Slack, et cetera. So this is what I do. I care about agency profitability and it’s my sole focus. And I have the pleasure of being able to talk about it, lots on stages like this.

And with other smart people, like yourself.

Chip Griffin: And everybody who listens to the show knows that I love talking about profitability. I love diving into the areas of running the agency business that aren’t necessarily the things that everybody talks about. Right. I, and I always harp on the fact that you should stop talking about revenue and head count when you’re measuring the success of your agency.

Those things are irrelevant. It’s profitability, particularly in a small agency because the profit goes where? Into your pocket as the agency owner. And so we’re going to help you understand a little bit about how better to do that. And part of that is by understanding what the profitability of your existing work is.

And key to that in any agency is how much you’re spending on labor to get work done. And this is something that I, that I know that people love to look at P&L’s. Well, they don’t love it, but, but they look at P&Ls on an agency wide basis and they talk about their profitability and oftentimes their P&L is wrong.

But let’s assume it’s absolutely spot on correct. The problem is that what they’re not looking at is the individual client profitability, which can vary widely. And typically you have a few clients that are subsidizing others. Yeah. And no matter how much we all want to say, you know, we’re not selling time, we’ve got to sell the value of what we do.

We’re selling outcomes, we’re selling results. Okay. That’s all great sales spiel. And, you know, with apologies to all my biz dev friends that are also regular panelists on this show at the end of the day, we’re selling time. Yeah. Right. I mean, that’s, we don’t have widgets to sell. We’re not selling software. We are selling time. So what we’re going to talk about today, Marcel is how do we figure out the cost of that time correctly? How do we calculate our labor costs? So we know the true profitability of the work we’re doing.

Marcel Petitpas: It’s a great question. And one that I talk about, I mean, I was just telling you this week, I think I’ve got three emails about this, this week on two client calls.

You know, we spent a lot of time talking about this. It’s a point of a lot of confusion and you know, a lot of the questions that are probably coming up when people work through this exercise is what is included in that number and what’s not? Right. So there’s, when you think about the measurement that the formula for cost per hour, it should be very simple, right? What does somebody cost and then how many hours, and then we should do a division of those two numbers. But the reason it’s complex is the same reason that utilization is complex, simple formula, capacity and hours. But what is capacity? Just like, what is somebody’s salary?

What is their total cost? And then what is the basis of number of hours that we use to divide those two numbers out and get to the ultimate outcome, which is cost per hour. And the reason I think this is tricky is because it requires us to be able to zoom out and have an understanding of what is the way in which we’re going to actually use that metric.

How is it being applied in other formulas throughout the business? And that should determine how we do or don’t measure the costs or calculate the cost of somebody’s time. And so I have a point of view, an opinion on what the right way to do this is, and it might conflate. And I’m not here to say that it’s the right way to do it, but I will make a case today, hopefully for why my way of doing it is the best balance of cost and complexity relative to insight, which is something that I am very conscious of because I think I see a lot of agencies trying to be extremely precise in their measurement and it’s actually coming at the cost of accuracy. Which sounds like a crazy idea, but it’s actually very easy to understand how that happens when we were reading into that idea.

Chip Griffin: Yeah and I agree with you entirely on that and it, you know, it seems like more often than not I see agencies that go to one extreme or the other they’re so sloppy with it they don’t really have anything resembling accurate information. Then others where they try to get so granular, so detailed and just as you say so precise that they, you know, they lose sight of things and end up you know, creating more problems than they solve.

And I should say before we dive too deep into this, that you’ve actually got a great blog post from a couple of months ago where you actually walked through in, in some considerable detail, how to think about this. So I, I certainly would recommend that people go through and look at that so that they can take some of what we’re talking about here and operationalize it with some specific examples.

But, you know, for the purposes of this discussion, you know, let’s start high level. How do we figure out what an employee actually costs us?

Marcel Petitpas: Yeah. So, before I answer that question directly, I want to set some context around this. So, and this is my POV on how this metric is generally going to be applied or how it should be applied to actually getting insight from the business. And in order to do that, I think we have to start with understanding, you know, how do we define delivery margin? Because in my mind, the most common application of employee cost per hour is trying to get insight into how profitable a particular area of the business is, whether that is a subsection of clients or projects, or perhaps even phases or milestones or deliverables like different granular levels of a particular portion of client work or particular time period within the business.

And so if we think about it that way, then what I’m going to make the argument for is that we probably want to strip out all of the complexity from that measurement that isn’t actually specific to a client, to a project, to a time period. And the thing that is most commonly factored in here that I would argue shouldn’t be is overhead because your overhead doesn’t change based on a single project.

And if we start to try to consider overhead and bake it into how we calculate an employee’s cost per hour, or even how we’re trying to calculate margin on a project, what I would argue is that, that makes it much harder to start to get horizontal insight in the business, which is critically important. Because we can’t really easily compare one time period to another because our overhead probably isn’t the same.

And what that also starts to do is it creates the risk that we are actually not allowing ourselves to get certain insights that are very important because when we factor overhead into the cost per hour of an employee, it’s easy to start actually trading the cost of low utilization onto like basically pawning it off into other departments.

So this is one of the reasons why I don’t like doing salary allocations based on time sheets, because what happens is every time the business is slow, then it looks like we’re spending a ton of money on sales and marketing and administration, but the reality is no, we’re just kind of reabsorbing the cost of low utilization that should belong to our delivery department into these other areas of the business.

So with that in mind, if measuring gross margin or delivery margin or contribution margin, whatever you want to call it is the primary application of this metric. Then the way, I think we should be calculating employee cost per hour is taking the fully loaded cost of that employee – so their salary plus whatever benefits and other costs of employing them there are, this would include things like, uh, dental, medical bonuses, you know, any kind of other payroll taxes and so on. What is the full cost of employing that person divided by the total amount of time, the total capacity that they are essentially selling us for that amount of money in the employment contract. And for most people that’s 40 hours a week for 52 weeks a year or 2080 hours per year. And immediately the pushback I get on this is, well, I mean, shouldn’t, we be stripping out vacation and paid time off and holidays and all that other stuff. And the answer to me is, no, I don’t think we should. And for all the reasons I just mentioned, and then also it just makes it way harder, way more complicated and way more um, it adds way more friction to actually figuring out what this number is.

And again, makes it less horizontally consistent. So at a high level, I think that’s the starting point is let’s think about how to make this metric very simple. And that is total cost divided by total capacity. That’s your starting point for employee cost per hour.

Chip Griffin: All right. So let’s, let’s break this down into a couple of different buckets.

And first let’s talk just briefly about your point about overhead, because I think it’s an important one. I think calculating overhead into your hourly employee cost is bonkers. I think there is a place for overhead when you’re doing project profitability. So we can have that a separate conversation at some point, when we talk about project budgets and those kinds of things, but I agree with you, it, it doesn’t belong in your labor costs because that’s not what it is.

So let’s, let’s take a look at the first of all, the top line number, the fully loaded cost of an individual employee. And so you talk about that being salary plus benefits and taxes and things like that. So that can be pretty complicated for people to try to figure out. Right. Okay. I got to sit down here. I got to sit down with my accountant and my bookkeeper and my HR guy, and I got to figure this out.

Look, here’s the thing. It doesn’t have to be complicated, right? Because you can just, you can use some just broad numbers. It doesn’t need to be specific to the employee. Oh, this employee takes health insurance. And this one doesn’t who cares, who cares? Right? Because these are not designed as you said before, to be super precise numbers.

We’re not, you know, we’re not baking a cake here. We need to get exactly the right amount of leavening in there in order to get it to rise the way we want it to, we just need to be in the ballpark. So we have a good sense as to the profitability. So for that, at least here in the United States, I always encourage people if you don’t have any other data to go off of, just add one third to the actual salary, right?

Because typically benefits and taxes are about 30 to 35% here in the US. It depends, I mean, obviously how rich your packages are. And I think you have an example in your blog where you were came out to like 30 point something percent. What – doesn’t matter. One-third is a nice, easy, clean way.

If you’ve got nothing else to go off of as a starting point to get that top line fully loaded number. Yeah. Only in the U S. Other countries may be entirely different. Cause benefit structures are different and that’s a big driver of that number.

Marcel Petitpas: Yeah, it’s pretty close to like, we usually we’re, you know, somewhere in the 20 to 25% range.

So I think if you’re starting at 30 that’s conservative, which is, you know, certainly we want to err on that side of our model.

Chip Griffin: Exactly. Always better to make your labor costs higher when you’re doing this kind of assessment, because almost everybody who’s listening is not charging enough already. Right. So, so if you’re, if you’re going to err, on the side of calculating your costs, err on the side of it costs more because a you’re probably not capturing all the true costs of doing the business.

And secondly, you’re probably charging too little anyway, so this will help you get closer to a reasonable profit margin.

Marcel Petitpas: Yeah. So that’s, and that’s the way that most of the time when we’re working with clients that don’t like have a lot of precision again, or a lot of, you know, like they’re not super in tune with what this cost is exactly that, Hey, let’s just like work with a percentage to start.

It doesn’t have to be perfect. We’re just trying to get some directional accuracy here.

Chip Griffin: And if you want to get more, more accurate for your own business, you can add up the total costs of all of your benefits and payroll taxes and those kinds of things, and figuring out what percentage of your gross salaries that is.

And so now you’ve got a number that you can still apply and you don’t have to go calculate it by an individual employee and what they do or do not take for benefits. So keep it simple.

Marcel Petitpas: That’s exactly right. That’s exactly right. Yeah. And I just want to take a moment here, because this is a concept that I think we’re going to keep coming back to, but I want to just like articulate it clearly, which is we lose sight so much.

Like I think there’s this assumption that precision equals accuracy, but those two things are not completely tied to one another. So like, I’ll give you an example, the cost and complexity of going from agency-wide accounting to project based accounting. It’s probably two, maybe three times more expensive to start doing project based accounting.

When you consider all of the additional things that you now have to do, you now have to break your invoices down at a project level. You now have to be pulling in time expenses, allocating salaries. You have to make decisions about how does a person’s costs change based on the time that’s coming in, the bookkeeping costs goes up like it’s significantly more complicated.

Relative to the additional insight or the additional accuracy, which is maybe like, you know, instead of now being 85% sure of how profitable project are assuming that you’re measuring it in a spreadsheet somewhere using average billable rates, for example. Right? So like the alternative is moving to a project based accounting.

It’s maybe 10% more precise, but it’s easily twice as expensive. So like, just understand that there’s this, these points of diminishing return that often happen very quickly when we talk about getting more precise on agency metrics. And I think this is one of those things that we’re talking about, right?

Like the cost of being precise on this agency’s benefit package far outweighs the additional accuracy that we get from all the cost that is baked into the time required to do that when it’s like, if we can just get 90% of the way there with this simple math on the P and L and apply that to everyone, we get the insight that we want for far less cost.

And as the company scales, having less costs, less drag in your operations becomes like really, really important.

Chip Griffin: And I think the other thing is, you know, when you’re, when you are calculating the costs to service a particular client or project, you can use banded salaries, you don’t need to say, okay you know, Marcel makes 52 and Chip makes 56.

So those numbers are going to be different by a couple bucks an hour. You don’t need to do that. Just, just have some, I mean, typically for most small agencies, three bands, high, medium, and low salary would be enough to get you the numbers that you need, because here’s the thing. It’s not that you’re trying to get a very specific profit percentage at the end of the day.

Okay. That I’m, I’m working for, you know, Acme corporation. And my profit margin is 23.6%. And I’m, I’m working for XYZ corporation and it’s 26.9%. This is not what you need to do. Right. You need to know. Generally speaking, roughly speaking what your profit margin is on certain kinds of work, certain kinds of clients.

So you can make intelligent prioritization decisions about the kind of business you want to be getting in the future. Right? That’s the most important use of this data in my mind is it helps you figure out who your ideal clients really are, so you can get more of them.

Marcel Petitpas: Yeah, absolutely. So we’ve talked a little bit about the calculation here for average cost per hour cost per hour per employee.

And I think what would be interesting is to talk about like, okay, let’s, let’s actually apply that to a situation like let’s apply that to a project, for example, estimation. Because I think it’s important to talk about, like how does overhead actually get factored into this. It’s the same thing that we just talked about with employee benefits.

So the question I get a lot is like we, I just had a call yesterday with an agency that is doing great, but again, they’re, hyper-focused on precision. So they’re trying to estimate all of their projects when they scope them out to a net profit number. And the argument that I made to them was just similarly, you’re growing super fast. This is adding a ton of drag to this process. Instead of taking 20 minutes to scope a project. Now you got to take two days. Why don’t instead you set a gross margin or delivery margin target simplify the cost per hour calculation, simplify your utilization calculation.

So everything’s based on gross capacity. Everything’s based on this kind of larger number that’s much easier to calculate. And then when you’re setting your delivery margin target for a project, you just kind of have these rules that you apply. So like we know we’re going to spend about 30% of our agency gross income on overhead.

And we know that there’s going to be about a 15% loss of margin from a project level to the profit and loss statement because of, you know, utilization gaps in over-servicing and vacation and these other things. So if our objective as a business is to net 25% this year, then we should set a 70% delivery margin or gross margin target on a per project basis.

And if we can consistently be setting that, then it’s very likely that on the P and L we’ll end up kind of where we want to be. So you can still consider these things. But you don’t have to actually do the math and bring all that complexity into the exercise of scoping. You can abstract that number, give yourself a much simpler set of modeling to do while still considering things like overhead, things like inefficiency and utilization and time off in the assumptions that you make.

And I think that’s the big idea.

Chip Griffin: Yeah. And I think that’s key. It has to be factored in, in some fashion, but it doesn’t need to be mathematically factored in every single time you do the calculation. Right. But you know, you do need to understand the importance of your overhead costs to your profit margins. Right.

Because if you, if you say, okay, well, you know, I’ve got my 25% profit margin on this work and you have not yet calculated it in that, that you do have an overhead expense. Now your profit margin really is more like, you know, Probably 10% at best. And so, you know, you do need to factor it in somewhere along the way.

It’s just understanding where it is and, and how you can do it most efficiently so that it doesn’t become an obstacle, right. Because all of these things, and I think you, and I would both agree on this. We always preach, you got to get the data, you’ve got to use the data, but don’t over-complicate it. Don’t collect data you don’t need, don’t make it more difficult to collect the data than it absolutely has to be. Just get enough information that you’re making smart decisions that aren’t just based on, you know, I feel like today.

Marcel Petitpas: Yeah. Yeah. Because like, what ends up happening to your point is like, when you take this metric and you make it that much more complex, like utilization is one that I constantly come back to.

If you’re trying to measure utilization based on the actual amount of time that was available in this week. Well, now you’ve got to figure out that. Okay, well, Johnny had a dentist appointment on Tuesday afternoon. It took a half day and you know, one of our team members is in this religion that I didn’t even know existed and had a holiday on this week that isn’t anywhere in my calendar.

And like, you now have all of these additional data points that you need to collect every single week when you calculate that metric. And you have exponentially increased the resistance to doing it, the cost of doing it and the likelihood that you’re not going to do it consistently because it’s that much harder.

And so I think there’s a really strong argument to be made, to say, okay, let’s sacrifice that extra 8% of precision that we get, but save ourselves 90% of the work by making it something that we can set values in a spreadsheet. And based on a simple model, basically automate the calculation of that just by pulling a time sheet and saying, this is how many billable hours we have.

We do. We run the macro and say, this is how much capacity we had. And now we know our utilization. And if we want to get more precise to answer a specific question about like, oh, that’s strange. Design utilization seems a little bit low, all of that other more precise measurement, it’s still available to you, but it’s like the difference between owning a suit and wearing it 365 days a year versus owning a suit and pulling it out when it’s time to wear a suit.

Right. Right. Like that’s the difference. You don’t have to carry all of that complexity around with you all the time.

Chip Griffin: Right. And I think more important than anything else is just being consistent in how you do the calculations. Right? So, you know, whether, whether you calculate the total number of hours with, or without vacation time with, or without, you know, administrative time, I don’t really care.

Just be consistent. Every time you’re doing the calculation, do it on 52 times 40 or do it based on 1750 a year, do it based on whatever it is just be consistent because that consistency is what’s gonna give you what you need, but, but I also want to touch on time sheets. Cause you mentioned time sheets and, and time sheets I think you and I have talked about this before on, on, I think a couple of episodes of maybe this show or one of my other podcasts or yours. Anyway, we talk about it a lot. Yeah. They’re important. However, you don’t need to overcomplicate those. And the simpler you keep them, the more likely you are to be getting good information out of them.

You can’t ignore them. So all these people who write these articles and say, oh, time sheets are dead. We’re getting rid of time sheets. It gives us a better culture. Rubbish. Rubbish, you still need it. And every time I hear that, I then read deeper into the story and find out, oh, well, that agency got rid of time sheets, but they’re doing allocations of time in some other way. Right? That’s still time sheets.

Marcel Petitpas: You still have the metric.

Chip Griffin: Like you, I mean, I can call it a wllwwrrtt, but that doesn’t mean – good luck with the transcript, Jen, when you’re fixing up this episode, uh, after the fact with that one, but you can call it whatever you want. They’re still time sheets. It’s still time tracking in some fashion.

But here’s the thing, you know, you mentioned the, you know, wearing the suit at the right time of year and not having it on all the time. It’s the same thing with time sheets. I am an advocate of occasionally, if you think there’s a particular issue somewhere that there’s too much time is being spent on something, or you’re trying to get a bit more information for a short period of time, you can gather more detailed information, right?

So most of the year, maybe you’re just collecting it based on client and main project. But maybe every so often for a week, you’ll have a whole team track you know, how much of that time is meetings versus emails versus other stuff so that you can get that information for a particular purpose. And everybody understands why you’re collecting it.

Marcel Petitpas: I couldn’t agree more. And it’s funny. We, you know, in our process that we go through, we’ve actually had to change our methodology for installing operational systems in agencies, because when we were doing it in a, in a more waterfall, waterfall style, you know, of course you ask an agency owner, what do you want to measure?

And they tell you, we want to measure everything. And it was really, really hard to kind of walk them back from that. And so what we would end up doing is, you know, at some point you just kind of have to give the client what they want. We’ll be like, okay, we’ll build your reporting system. Such that it requires this level of detail all the time.

They would pay us to do it. We would build the whole thing. And then inevitably the reality of just how much more operationally complex it was to collect like that one or two additional levels of fidelity on a time entry all the time hit them. And they would capitalize on half of what we built for them.

And then like, that was actually what we would regulate to. So now we’ve moved to this model where we design and build in parallel and install kind of a new report every week and like take this very iterative approach. And it’s funny, I think people realize like, Just how much additional – like that, that first 20% of reporting gets you 80% of the results that you need.

And then you really start running into these massive trenches of the complexity required to get a little bit more detail is so high that it, yeah, to your point, it’s better for us to just do this when it’s necessary or rely more on conversations or, you know, like these other ways of getting underneath the hood and seeing that. Because carrying that complexity around all the time. Just, it hurts consistency. It hurts compliance. It hurts the quality of data. And a lot of times it’s just really not adding value if you’re trying to do it all the time.

Chip Griffin: So let’s talk about the most difficult labor cost to calculate, but perhaps the most important one for small agencies of say five to 10 employees or less.

Yeah, that’s the owner’s hourly cost because the owner is almost always still involved in client delivery to some degree or another, sometimes a lot, sometimes a little but it’s there and it can make a huge difference in the actual profitability of the work you’re doing. But all too often, owners ignore their time altogether, because, because, Hey, I’m keeping the profit, right.

So, I mean, I’ve literally heard owners say to me, well, that, that, that account’s all profit. Cause I do all the work. Huh, I’m confused. But, and, and so, and, and it holds agencies back from scaling. Typically the, the agencies that are not calculating in the owner’s cost of, of client delivery into their pricing, they’re the ones who struggle because they can’t scale.

You can’t hire someone to do the work in your stead because you’re not priced appropriately. So how do you advise small agencies to think about the owner’s cost when you’re doing these calculations?

Marcel Petitpas: Well, actually I’ll tell you how we’re doing it because we’re in that situation right now where my co-founder Ben and I, we don’t need an income from this business.

We’re financially independent, without having to draw money out of Parakeeto. So we’ve made a deliberate decision to say, Hey, like, let’s just keep pushing all this money back into this. So we’re not actively drawing salaries from the company right now. Um, so how are we modeling it actually, because I think the mistake that a lot of agency owners make is they don’t model what it would have costed to do this.

And then when they finally get to a point where they’re like, oh, like I want to start a family, or I’d like to try and take a vacation, or maybe I’m just kind of sick of doing client work or, you know, I’ve hired Chip. And he gave me some really good advice about how, if I wanted to scale, I needed to, you know, spend less time on this and more time on things that create more leverage.

And now I’m realizing that the way all of these client engagements are priced, I can’t actually afford to hire the person that’s qualified to do this work. And now I have a set of golden handcuffs that I put on myself. So the way that I would think about this, there’s, there’s two pieces of this. Number one on a project by project basis, I would model the cost per hour based on what would it cost for me to actually hire a person who’s qualified to replace me in this role.

So that at least when you’re running your calculations on delivery margin, or, you know, however, you’re measuring the profitability of your projects, you’re getting an accurate read and you have a sense of like what it would look like if you were actually paying for that person to do it. And the reason I say that is because especially with founders, there’s a really high likelihood that you’re not actually paying yourself a market rate salary and for tax efficiency reasons, you’re probably using, you know, dividends or other ways of like actually truing yourself up on compensation. But if you’re not like applying this model to the way that you measure the profitability of clients and projects, then you risk setting a trap for yourself that actually pigeonholes you into doing that work or puts you in a position where you either have to raise the price or find a way to dramatically drop the level of competency that’s required to do the work that you’re currently doing. Otherwise, you’re just going to be stuck doing it forever. So that’s kinda how we’re doing it.

We’re saying what is like the, the market rate salary for this role that we play when we step in and decide to do this work, as opposed to hiring someone to do it. And we use that to model our profitability and report on it, to make sure that everything is where it needs to be. So that there’s no questions. When we go out to hire somebody, we know what the salary range is, we know that we’re already profitable.

And it’s just a question of bringing them in and putting them on that work.

Chip Griffin: Yeah. And I, and I love thinking about replacement costs as a sort of a starting point for it. And I, to me, I think you actually need to look at your costs as the owner in three different ways for different purposes. One is the replacement cost.

One is how much you absolutely need to be taking out. What’s your minimum personal crutch. I always say you need to be looking at the higher of your minimum or replacement cost when you’re figuring out what the actual cost is. But the other thing you need to look at is what you’re actually aiming for, for your compensation. Not your pie in the sky, all, wouldn’t it be great if I made a million dollars a year, but you know, your reasonable – this is what I want to get to in the next couple of years, because that the difference between your replacement cost and what you’re actually striving for, for a salary. That’s the, the difference that you could be making up if you were working on something else. Right. And that’s what will convince you to get out of a client delivery and stop saying, oh, it’s all profit.

It’s not. And that difference when you see, you know, okay, I could hire someone for a hundred thousand dollars a year to do this, but I want to be making two 50 that spread in the hourly is the difference, moving your time from that client service delivery to something more valuable.

Marcel Petitpas: That’s a huge insight, or we call that the entrepreneurial scorecard.

Right. And it’s just like, where am I spending my time? And what’s the value of that time? And you know, like being on sales calls, speaking on a stage, being on a podcast like this, like this is $5,000 an hour stuff. And it doesn’t matter if I charge 500 bucks an hour, I’m still 10 X better off doing this.

So the more time I can buy back and deploy against something like this, to your point, that’s what increases the earning potential. The other thing I want to say on this is a lot of founders, especially ones that come in as you do an audit with us, they think they’re being tricky and smart by taking less salary because it’s going to make their profit look better.

And I just want everyone to know. I’ve never met an acquirer incompetent enough to miss that. It’s the first thing we look at when we do an audit. It’s the first thing they’re going to look at when they do due diligence. And, um, you, you will not get away with that. Your markets, your, your salary and your profit will be adjusted based on what it would actually cost to replace you, because that’s the lens that an acquirer has to look at your business through in order to actually get a sense of how profitable it really is.

So, yeah. You’re not fooling anyone if that’s the reason that you’re trying to keep your salary low. Do it for tax efficiency reasons maybe, but, it’s not going to help you in an exit.

Chip Griffin: Yeah. And I’m in no way encouraging you to do something that’s tax stupid. Right? I mean, certainly work with your accountant to, to do your books in whatever way helps you to legally minimize your tax bill.

Yeah, a hundred percent in favor of that. You also need to have books, not just for your own salary, but for other things in it, so that you understand what the real health of your agency business is. And a key, I mean, the, the biggest driver of your overall agency profitability and individual client profitability is how you compensate yourself and the work that you’re actually doing.

And if you don’t get your arms around that you will never be able to break out of whatever rut you feel like you’re in now. So get it right. Understand that replacement cost. Even if you are just a solo right now, price everything as if you were hiring someone else to do the work, it’s the only way you will ever be able to scale without all sorts of unneeded stress.

Marcel Petitpas: Yeah, this is like my biggest piece of advice for anyone who’s kind of really early days, they’re a freelancer, or maybe they’re like freelancer with a small team. Like this is the most important thing that they need to be doing. And it’s like, you know, like I have a video editor on my team that’s trying to start his own business.

And this is kind of what I said to him was just write down the three or four hats that you wear when you’re doing work for us and your other clients. Write down what it would cost you. And then you can make the decision if you want to wear all those hats on this project, but you should also be able to make the decision if it’s really busy, or you would just rather go on a snowboarding trip and take the time off that you can hire somebody.

And you’re still gonna have money left over and hit this profit margin target. And like, it’s not hard math to do. But it’s incredibly important to your point. Otherwise, it’s not that you can’t break out of it, but it’s just so much harder when all of a sudden you have to raise your prices, change your model, start collecting this data and then wait six months to see what it actually looks like.

If all of this has already figured out and clear, then there is no stopping to figure it out. You can just say, okay, I’m going to go hire a project manager and I know exactly what that’s going to cost me, and I know exactly how that’s going to impact my profitability and I’m comfortable with all of that.

Chip Griffin: And that is great advice. It’s a great final word for this topic. We will include a link to the blog post that you wrote for people who would like to look at some more detailed examples and that sort of thing. But if someone’s interested generally in finding more about you or connecting with you, where should they go?

Marcel Petitpas: Well, I think the first place, if you actually want to do some math on this for yourself is go to parakeeto.com/toolkit. And inside the agency, profitability toolkit, we actually have a whole payroll grid modeling template where you can put in your team’s salary and it’ll calculate their cost per hour for you based on the formula we just discussed.

So be sure to go check out the toolkit. It’s just got all kinds of stuff that’s helpful and free. And is really it exists because I believe everyone should be able to do this without spending a dime on me or anybody else, because this is just such important stuff. So check that out for sure. And, uh, yeah, check out the blog post and you’ll find lots of other goodies on the website.

Chip Griffin: Fantastic. I encourage everybody to do that. And, you know, we, we weren’t precise enough with this episode. We went, you know, about three minutes over my target of 30 minutes, but you know what, it’s accurate enough for these purposes. So, uh, with that, we will draw this episode of the Small Agency Talk Show to a close.

If you were interested in seeing or listening to past episodes, just visit smallagency.tv, and you can find more information about SAGA at smallagencygrowth.com. So with that, We will draw this episode to a close. Everybody have a great weekend if you were watching us live. And if you are listening to us, we look forward to seeing you back here again on a future episode.

Like this episode? Share it!

SUBSCRIBE TO THE PODCAST:   Apple Podcasts    |    Google Podcasts    |    Stitcher    |    Spotify    |    RSS