Are you an ad agency owner who feels like your head is spinning when it comes to managing the financial side of your business? You’re not alone. Successful agency ownership requires more than just a knack for creativity. It also requires an understanding of basic finance principles. With a grasp of finance fundamentals, agency owners can better manage their finances and maximize their overall success.
This blog post will provide an overview of key elements to keep in mind when managing the financials of your agency. And so you can understand what your CFO/accountant is talking about!
Let’s dive in!
Budgeting and Forecasting
First and foremost, it’s important to understand the principles behind budgeting and accounting. Your agency should create a detailed budget that considers expected income from clients and any applicable expenses, such as staff costs (by far your biggest expense), advertising costs, and other overheads.
When budgeting, you should understand the difference between:
- Fixed costs of running your business, such as salaries and rent.
- Variable costs that may change from month to month, such as marketing expenses or cost of goods.
Budgeting is key to understanding how you’ll be able to manage cash flow. This is a proactive way of managing the business and reduces the likelihood of unexpected surprises. Knowing how much you expect to spend each month will help ensure that your business remains financially healthy.
Warning! A budget is an estimate based on certain assumptions, so it needs to be regularly reviewed to ensure accuracy and effectiveness. It should be done at least quarterly, however, given the tools available on the market, it should be done monthly after variance analysis. Speaking of which…
Variance analysis is another important financial tool for any business. It helps you understand the differences between what was expected to happen (the budget) and what happened (actuals.) It provides insight into why those differences occurred, so you can identify and address any issues that arose. In other words, doing variance analysis of actual expenses against planned ones also helps you identify trends that can help you adjust your spending as necessary.
KPIs: Key Performance Indicators
As an agency owner, it’s critical to understand the key performance indicators (KPIs) of your agency. These are your agency’s “vital signs” indicating how healthy it is and how well it performs. Common KPIs for ad agencies should include:
- Client cost per acquisition.
- Client profitability.
- Customer satisfaction score.
- Staff capacity vs planned work.
- Staff utilization & billability
- Project profitability
- Cash reserves (months)
By understanding these metrics, you can get an overall view of your agency’s current financial health and make smart strategic decisions for the future.
Revenue Recognition vs Billing
We could write a whole article about this topic alone but let’s keep it simple. When it comes to understanding finances for an ad agency, it’s important to understand the difference between revenue recognition and billing. This is because most client contracts are based on the effort of the agency’s personnel, but many have terms whereby the agency has either upfront payments or payment on completion of the work. In either case, the billing schedule does not reflect the effort of the team to deliver the project.
Revenue recognition occurs when services are provided, or goods are delivered. In other words, this is based on the work done by the agency staff, freelancers or when hard costs are incurred.
Billing occurs when invoices are sent for payment.
That means that the only time that you can guarantee that revenue and billings are the same is when the project is completed and billed.
Capacity and Utilization
Understanding the capacity of your ad agency is essential to running a successful business. Capacity is the total amount of work that can be completed in a given period. It is either measured in time (hours) but many agencies measure it in $$$ (the number of hours x the sales price of the hours.) This is the maximum amount hours that can be sold and their value.
Utilization is the rate at which the capacity of your resources is used over a given period. This is simply the number of billable hours divided by the total number of hours worked and is expressed as a percentage.
Knowing these metrics helps inform pricing decisions, keep costs down, identify when additional resources are need, and track performance over time.
These 2 metrics are interrelated. You need to estimate the typical Utilization of staff to estimate its Capacity. The higher the utilization of your agency’s staff, the higher its capacity and therefore potential revenue.
Client Profitability and Billing Rates
Understanding the profitability of each of your clients is essential for an ad agency. Knowing the each client’s gross margin helps you determine if a particular client makes financial sense. You can also use this information to evaluate whether or not you need to adjust your billing rates in order to remain competitive and make sure that you are making sufficient profit from each account.
When calculating billing rates it’s important to consider a few different factors. These include:
- Cost of labor and materials.
- Overhead costs.
- Target profit margin.
- Expected utilization.
- Market factors
By taking these factors into account when pricing projects, you can ensure that your agency is charging enough to cover expenses while also turning a profit.
Cashflow and Don't Forget to Plan for Taxes
Cashflow is vital for any business. Without enough cash on hand, you won’t be able to make your regular payments or pay your employees. As part of your budgeting process, you should also factor taxes into the equation – with an ad agency, this includes both small business and corporate income taxes. Make sure to consult with an accountant when planning for these expenses so that you can make sure you’re covering all of your bases!
These are just some of the agency finance fundamentals you need to understand in order to confidently manage your finances. With a better understanding of these topics, you’ll be well on your way to successfully managing your business and focusing on creative work.
Check out this blog from our founder on tracking your agency’s KPI’s.
Also see our blog: 6 tips to Maximize Client Profitability.
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