Running a software or digital agency isn’t a walk in the park. Many entrepreneurs find themselves as service providers after a product exit, by extending support to a client, or simply because they have an in-demand skill. It’s not always the first career choice, but it can be profitable if done right.
The journey for a service provider founder typically begins when they realize their special talent is something clients are willing to pay big bucks for. These talents in the digital world often include development, marketing, branding, or design. The range of services covers the entire product lifecycle, so it’s common for a company to be strong in one area but weaker in others.
Usually, there's that “first client” who takes a chance on the consultant. The entrepreneur, perhaps not fully realizing they've stepped into the service industry, enjoys the good money and happy client. But soon, either the client reduces their demand or the entrepreneur ambitiously takes on a second client.
Before they know it, a third or fourth client comes on board - it's often easier to sell to friends than to do the work. And suddenly, voilà, they're a full-fledged agency owner, managing talent from around the globe, juggling client and contractor demands, and meeting deadlines at 2 am.
As years pass, the agency owner assembles a small but overworked team of 10 talented and committed people. Everyone does everything; there are no rules, just work. The agency's lifeblood is two metrics: Revenue and Profit. Everything else is a mix of guesswork and cool ideas for making more money.
By the third year, with 20 employees churning in and out, the agency resembles a well-oiled machine. New clients come, old clients go, but revenues fluctuate, and profits are still unpredictable.
Wouldn't it be great to have a simple way to gain control of the agency? Because let’s face it, hiring a CFO is way down the list of immediate needs.
The key metrics for every agency are utilization rates and Direct Labor Efficiency Ratio (DLER), but not the old-school manufacturing way - we're talking the modern, Greg Crabtree-style agency methodology.
DLER measures the profit you make for every hour you work on a project. Say a person costs $50 per hour and bills $100. Your DLER is the adjusted profit divided by the cost incurred: $50 / $50 = 1. So, you earn $1.00 for every $1.00 spent.
The flip side of DLER is the Gross Profit Margin (GPM). You can also calculate the previous example as a 50% GPM, but it's not as intuitive because GPM is exponential.
For example, if you bill $150, your GPM is 66%, a nice 16% increase. But your DLER is 2, meaning you earn $2.00 for every $1.00 spent. It’s much simpler to think in these terms, right?
It’s important to note that DLER uses “Adjusted Profit”, which excludes any extra charges on projects.
Utilization cost asks: how much of your team is working on profitable projects versus internal work? It's easy to track if you're monitoring time. (Yes, you should be tracking everyone's time.) Rather than calculating this by hours, like manufacturing companies, compare utilization to other company metrics.
Calculating by cost makes more sense.
The aim of combining these metrics is to provide enough work to support clients while ensuring your team isn’t overcharging. With DLER, you’re using “adjusted profit”, so overcharging a project means the employee is no longer effectively utilized.
In this way, the limits of utilization are billable hours: the more you bill, the more utilized you are. But it’s also about balancing people's hours. No agency survives by constantly hiring and firing. Retaining talent is crucial. There’s always a predicted set capacity each month, and it’s the CEO’s job to fill those hours with billable work without exceeding the budget.
These metrics influence decisions on:
The list goes on, affecting nearly every decision an agency owner makes. Every wrong decision leading to a financial loss, Utilization, and DLER will guide you.
If your team works overtime, DLER is affected. Suppose you hire too many people, and utilization drops. If you need more staff, utilization should be lowered. If you need to shift a team member to a project, DLER is too high.
Every decision can be traced back to these two critical metrics.