In Focus: Staff cost to fee income ratio

Many creative firms operate with the same intent – “to have great people doing great work for great clients”. This is very commendable but I always think that the phrase needs a couple of words added at the end – “delivered profitably”.

Profit can often be an afterthought but ultimately it is the fuel for your business. Being profitable should translate into more cash in the bank and gives you the freedom to make longer term decisions about how you want to run your business, rather than lurching from problem to problem and having to make knee-jerk reactions.

So how should you go about setting your design business up to be profitable? And what key metrics should you be looking at? I was asked to pick my favourite and settled on the staff cost to fee income ratio. 

So what does that actually mean?

People costs are normally the largest cost within an agency or studio. Getting the alignment correct between your fee income and your people costs is the single biggest driver of achieving profit within your business. If you can get it right, it solves a lot of other issues in your business. Get it wrong and it doesn’t matter how hard you work, you’ll never make any money. So what is it and how do you calculate it?

It’s important to define each of the financial terms so that you can apply it consistently within your own business. Different people have different ways of calculating some of these figures – the important thing is to pick a method that you are comfortable with and then stick with it.

The first thing is to establish the difference between gross billings and fee income.

• Gross billings – everything that you invoice to clients. This will include any pass through costs and media buys and will be the total revenue that your agency invoices to clients.
• Fee income – this is what is left for your agency after you have deducted any pass through costs. It can be a grey area as to what you include in the pass through costs but I would advise you limit it to third party costs i.e. anything that your agency doesn’t do as part of its ordinary internal activities, so things such as media buys, location costs etc would be stripped out. However it shouldn’t exclude freelance costs where the freelancer is providing a service similar to your own internal staff.

The reason for using your fee income rather than gross billings is that this is the actual revenue that belongs to your agency and sits against your controllable costs. To use an extreme example, if you have invoiced a client for £500k but that includes £400k media buy, then your fee income is only £100k. Likewise if you have a £100k design project for a client being delivered entirely by your internal team, then this also has fee income of £100k.

Now that the fee income has been established, it should be compared to your total people costs, which I define as your internal staff costs plus freelancers plus a market rate salary for the founder (if they use a combination of salaries and dividends to pay themselves).

The historic agency model suggested a ratio of 60:20:20 i.e. for every £100 of fee income, £60 should go on people, £20 on overheads (your remaining costs) and that leaves £20 of profit. Or in other words a staff cost to fee income ratio of 60%.

If your staff cost to fee income ratio is significantly below that, it indicates either that you’re potentially running your team into the ground and at risk of burnout or that you have hit the sweet spot of being able to charge higher prices to your clients.

If your ratio runs significantly higher than that, you’ll likely find that everyone is busy but you’re not actually making any money. You’ll need to dig further into your finances to understand what is causing it – it might be pricing (a ratecard issue), it might be overservicing (a scoping/delivery issue), it might be that your recovery rates are too low (a scoping issue). The important thing is not to ignore it.

One of the main ways I’m seeing agencies manage their people costs more effectively has been to operate a leaner model with a smaller core internal team, supplemented by a roster of experienced freelancers. The bulk of agency revenue is project based and adopting this approach allows you to scale the team up and down as needed, without having to carry the additional cost in months where revenue is lower.

If you can keep your staff cost to fee income ratio consistently in the 60%-65% range then the profits should follow.

Other expert perspectives:

In Focus: Where agency margins are won – or lost in delivery: DBA Expert Manish Kapur

In Focus: The people story behind the numbers: DBA Expert Aliya Vigor-Robertson