Perhaps it is because I spend almost every day calculating, benchmarking and negotiating agency compensation, but it always surprises me how often people get these calculations wrong. Sometimes it is marketers, sometimes their procurement team and sometimes even the agencies makes mistakes on how to calculate their own fees.
To navigate this maze, lets takes a mythical agency as an example to make the numbers easier and therefore the process easier to follow.
Billable (Direct Salary Cost) versus Non-Billable (Indirect Salary Cost)
So the agency has ten staff. Three are accounts and admin and therefore non-billable. Seven, including the CEO are billable, but the CEO is billable only 50% of his time. Therefore they have 6.5 FTEs as billable and 3.5 FTEs non-billable. (FTEs = Full time equivalents).
Lets assume everyone gets $1,000 per year. Therefore their direct salary costs are 6.5 x $1,000 = $6,500. Their non-billable salaries are part of the business overhead costs so this is 3.5 x $1,000 = $3,500 per year.
The agency also has another $3,000 per year in overhead costs such as rent, utilities and other costs of business, making the total overhead cost $6,500 per year.
Overhead Factor or Multiple
Comparing the overhead cost to the billable or direct salary costs we have $6,500 / $6,500 = 100%. That means that for every hour worked the agency needs to bill double the direct salary cost to recoup their total cost. This is known as a 2 times multiple. But it also means that the agency would make no profit.
Agency Profit Multiple
If the agency wanted to make a 20% profit mark up on costs it means they need to bill 2.4 times on the direct salary cost. So for each $1 in salary there is $1 in overhead totalling $2 in agency costs plus 40 cents profit which is 20% of the cost.
Therefore the agency needs to bill $6,500 x 2.4 = $15,600 per year of which $13,000 is cost ($6,500 direct salaries and 100% overhead).
This assumes that all of the agency billable staff are working on the client business. If only 2 of the staff are working on a particular client’s business then the calculation still applies. 2 x $1,000 per year = $2,000 x 2.4 = $4,800.
Although this is obviously fairly straight forward there are some common mistakes.
Some of the areas of confusion and mistakes are:
1. Applying the profit to the direct salary cost only so the multiple above is 2.2, but this effectively reduces the agency’s profit by half.
2. There is a difference between gross profit margin and profit mark up. The example above is mark up where the profit margin is marked up from the cost. Margin is the percentage the profit is of the total fee paid, so in this example the gross profit margin is only 16.6% being $800 profit / $4,800 fees.
3. Indirect or non-billable salaries need to be accounted for in the overhead. Often some people think that agency overheads are high, but this is because often the more senior and therefore the most expensive resources (eg. Senior Management) are not included as billable staff.
If you are having problems with the calculation check out our online calculators or download our free Resource Rate Calculator iPhone business app available soon from the iTunes App Store.