The Root Causes of Unprofitability

Okay, your firm isn't profitable...or maybe not as profitable as you'd like. This article is for you. I hope you can read this as more "thorough" than "pedantic" because that's definitely my intent. If I was writing for a product firm, I'd write about materials cost, distribution paths, and franchise/chargeback fees. But most of you are running dev shops, creative firms, digital firms, and so on, and your businesses are different. And some of this might be newer to you, so I'm intentionally going to include some basics.

What Does "Profitable" Mean

Let's start by informing expectations. Normally you'll aim for 20% profitability, with a few caveats:

• Individual project profitability doesn't matter all that much. You'll always want to invest more, from time to time, or you might misjudge an estimate entirely.
• Client profitability—across all the projects—is quite important. You're normally aiming to attract and nourish clients who represent at least 4% of your fee billings, yearly, and not more than 25%, so that they don't represent a dangerous dependency where you lose control of your firm.
• That 20% is calculated against the AGI (agency gross income) and not the total revenue. So if your total revenue is $10M and $2M of that is pass-through (media, e.g.), then 20% profitability would be $1.6M (.2 x $8M).
• There's one expense that you have to normalize in order to arrive at a fair representation of profit, and that's the compensation of all the partners. If you underpay yourself in order to hit the target, it's not going to count. Conversely, if you're paying yourselves more than average, you'd want to think of your actual profit as higher than it might be showing. Our ReCourses Valuation Model takes this into account. To illustrate, a firm with 9-12 people, total, would expect to pay a normal principal comp of $210k. If there are two partners, each of whom owns 20% or more, the expectation is a combined $310k, usually split evenly. Here we're talking about whatever regular comp shows up on a P/L (and not distributions). Compensation for larger firms is correspondingly larger.

Why Does Profit Even Matter

Well, even asking that seems strange, but I'll bite. I like to think of money-related ventures in three categories:

• A hobby costs you money and makes no commercial sense. You might sell something from time to time, but it doesn't come close to covering the time and expense you put into it. The hobby I personally enjoy the most is woodworking, and there's no financial justification for it except that I enjoy it and it challenges me. I'm not good at thinking in 3D, and this is how I challenge myself.
• A job is an even exchange between an employee and an employer. I do this and you pay me the agreed amount.
• A company yields consistent profit after paying all expenses. This profit compensates the owner for risk and provides a cushion to reinvest, where necessary, should the business hit a tough time.

Even if your expectations are more modest and this level of profitability doesn't matter as much to you, personally, your best employees won't be impressed with tight margins, limited growth, or accepting suboptimal clients to keep things going. And if you ever intend to sell one day, your EBITDA (which isn't the same as net profit, but which is based on it) will be the single most important element of the transaction price, and maybe the terms, too.

The Key Pillars of a Profitable Operation

Okay, if we can agree that profit is generally good, what are the best ways to achieve it? What are the common characteristics that profitable firms consistently get right?

• Good Financial Reporting. Like you've heard, you can't improve something if you don't measure it. I'm experimenting with an Oura ring at the moment. Last night my sleep score was 94/100. The night before, at a campground in an RV with noisy neighbors and an oversized dog climbing on me, it was 74/100. I rest my case. But back to this. Your financial reporting should always be on an accrual basis, and there should be enough cost accounting data to give you a good sense of profitability.
• Dating Only Marriageable Prospects. I'm not saying that you followed this mantra in college, but business is different. Having a small and/or unprofitable client means you probably can't get into their situation deeply enough to make a difference, but it's also unlikely that you'll cover your costs—much less make a profit. So clients below a certain threshold (4% of your AGI) are going to adversely affect your profitability.
• Account Managers Who Can Grow Accounts. Yes, account managers. Yes, even if you're a dev shop...or a PR firm...or any other segment that's under-indexing the role of account managers. Whether they are called AMs or not doesn't matter—what matters is that they are predisposed to finding and exploiting opportunities that are both good for the client and good for your firm. The wrong kind of AM is one driven to meet all the promises that have been made and leave it at that. Their perspective is to "not lose" the account, and finding more work in the crevices just means more opportunities to disappoint the client. The best AMs are making promises that the rest of the firm views as too far out in front of their skis.
• Project Managers Who Protect Margins. There are two things that project managers—whether you call them producers or operations or whatever—must control. The first is setting pricing objectively, and that has a significant impact on profitability. (The second is to protect margins while also protecting the work/life balance of the team.) This is where timekeeping can come in, too. I think the default at your firm should be no timekeeping, and you'll seldom get rich "buying" whole bocks of 1,760 hours of time by developing an exclusive relationship with an employee (that's what you're doing when you hire someone) and then finding clients who want to buy some of those hours. But, sometimes timekeeping can be temporarily useful as a kind of pricing checksum, provided that you understand that the only purpose of timekeeping is to improve the next estimate. Once you bring everything in balance, you can drop it.
• Under-Budgeting Your Compensation Allowance. I realize that the way I've just phrased that seems silly. What I was tempted to say is that overpaying employees is a sure way to be less profitable, but that might lead you to think that the primary issue is that you are paying employees too much and you need to swap them out for less expensive ones. That's seldom the issue, though. Instead, what it usually comes down to is that you are underpricing and over-servicing your clients, leaving all that money on the table. If you captured it like you should, the extra money would more than cover an appropriate employee cost. Lots more detail in an article here, and check your firm's utilization with this calculator.
• Overspending on Facility. Thankfully, this is more and more rare. But there are still some firms in high-priced metro areas that are spending more than they should. By the way, cutting your HQ loose and having everyone remote should not save any money, since all that money you would have spent should be redirected instead to building culture by funding regular get togethers and maybe supporting their remote work environment with desks and faster internet and so on.

Finally

I don't want to imply that this industry has a huge problem with profitability because it doesn't. There's a larger percentage of solidly profitable firms now than there ever has been, at least in the last two decades. But while an unprofitable or less-profitable year or two might slip in from time to time, it should not be optional.

And apart from above, here are the characteristics I see...consistently...in profitable firms:

• Confidence in what they do.
• Disciplined in how they do it.
• Self-Awareness when they analyze their decision-making.
• Steady Lead Generation to give them options.
• Switched from saying "Yes" as they build their firm to saying "No" as they mature it.
• Lots of good fortune. Personally, I'm terrified of drawing a straight line between my abilities and the results. It's arrogant and doesn't account for lots of things.