Advertising is a business

Advertising is a business, and hey, we want to stay in business. right? This is why I can't stress enough, protect yourself and your agency. Make sure you have a contract in place. Things change. It's inevitable, it's going to happen, if things are in writing, your can make it out of sticky issues a lot easier. Especially on project and production work,  treat any and all scopes of work as a real, honest contract. 

In writing, set clear definitions, clear expectations, explicitly stated and agreed to by both parties in a contract. Make sure the client and you understand what everyone is agreeing to in a written down and dated, signed contract.

If goals change, beyond minor things - stop the job. I mean it, the old job is done, over, kaput. Now it's a new project, the original contract is over (that jobs has ended), time for you to have them sign a new one. Most importantly, don't just grab things from here or the internet, get real about it.

“It’s not just a matter of trust, your client probably just has better lawyers (so lawyer up).”

Go find yourself a good lawyer, they make you money and they save you money. You need to protect yourself and your specific needs and requirements, so you can have a good contract in place, reviewed by a lawyer.  

Besides, contracts aren't evil, they are just necessary in the business world. And contracts go both ways, protecting both you and the client. 

Remember;

Don't start work without a signed contract. 

Don't blindly accept their terms. Negotiate, make it fair. 

Don't back down on the important stuff;

Make sure you own everything till final payment (Upon full payment...), make sure you have a termination or kill fee in the contract & review all liability.

Be specific and confident about money & terms. 

It's all about relationships. At the end of the day, they can fire you, and you can fire them. When everyone is on the same page, things get less messy if things go south if both sides are in agreement. Happier you, happier them.

Value vs. Time based accounting - How do we charge for innovation?

There is nothing necessarily wrong with charging for time, or even shooting for a fixed fee or even fixed fee "plus" approach. However, in this ever-changing, advertising technology landscape, the concept of being able to charge enough for our innovation and creative ideas can be lost in the shuffle.

“When we talk about collaborating or being a partner with our clients, what we can bring to the table as value (and perceived value) is extremely important. ”

If we charge $150,000 for a website that brings in an increase in business for the client by $15 million dollars, the client got an unbelievable deal. What seemed like a pretty good sum at the beginning, doesn't seem like a lot of compensation for such a big improvement. It was a great win for the client from a financial perspective, but a loss for the perceived value of the agency. Sure, the agency may get an award or two out achieving such results, but the agency lost out. How will the client perceive the agency in the future? Did innovation happen at some point in this process that caused the large jump in revenue? And if so, what perception does the client have of that innovation?

I think sometimes it even goes back to the way we frame what we do. Even our creative briefs sometimes focus more on the what than on the why. Our clients (and us) often focus on doing the newest thing, rather than discussing the why we should be doing it. So we often lose focus on the real ask by focusing on tasks. 

Did this $150,000 project create a new way of closing a sale that didn't exist before, for the client, the category or the technology? Was it more efficient? Did it empower users with a new way of purchasing?  What was the disruption that occurred? This answer to the questions is the value that was brought to the table. 

As we embrace innovation in how we work (through rapid prototyping, agile & lean PM, our embracing of new technologies and embracing cultures and processes that allow innovation to flourish) we need to be mindful that innovation is something more valuable than just a budget of hours. 

When we use to talk about bringing value to the table, it was in the form of the "big idea." Now when we talk about value, we talk about business changing ideas, that are reductive, fluid, disruptive, expansive (and yes, creative). This is the true value that we can bring to the table. 

Agencies can provide value and innovation to a client in several ways. Innovation can happen at the product, process, marketing and organizational level. Be mindful of the way you present your work, how you frame your projects with a client, and how you present strategy & planning. Each step in this process enables you to support for charging the true value of your work. Be innovative in your approach to contracts and don't short change the value of your ideas for the sake of meeting a budget. 

Many of today's agencies are living the concept of charging for ideas instead of time. They are taking risks for the potential of greater rewards. They have a sense of DIY, and place value in the statement "we make stuff." The also collaborate with their employees, and share ownership of initiatives and unique projects.

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Now back to the old skool of agency billing; the next few articles below feature some simple formulas (sans EV/EBITDA & PE) for figuring out how much to charge people for your services. 

Agency Basics - Profit = Revenue - Cost

Basic, quick equation for figuring out costs. (This short cut is, well, a short cut. Go use a real accountant).

Profit = Revenue - Cost

Profit is calculated by taking your billable hourly rate multiplied by how many hours work and subtracting your fixed overhead costs plus your cost per hour for an individual.

P = Profit
R = Revenue (in this case your actual billable hourly rate)
C = Fixed cost (your overhead) + Hourly Cost (hourly amount it is costing you for the individual)
And let x = # of hours worked

So to figure out how much profit you would make on an individual that you bill @ $200 an hour, but costs you $100 an hour and has a fixed overhead cost (i.e. annual portion of rent, equipment, utilities, etc divided by the number of employees) for the individual would be (imaginary value, say your overhead / break-even is 100,000 and four people are in your shop so one person's cost equals) "C" or 25,000, the equation would be;

P = 200(x) - 100(x) - 25,000

Your profit would on the individual would then equal $100 an hour multiplied by how many hours worked, subtracted by your fixed costs.

Thus if the person worked 1600 hours;

P = 200(1600) - 100(1600) - 25,000

P = 320,000 - 160,000 - 25,000

Total profit = $135,000.

Flip through the site for more articles and charts for calculating hourly rates.

Agency Basics - Calculating the Agency Fee by using FTE's

Agency compensation is often based on a formula that tries to cover the amount of time the agency is going to spend on the client’s business. Although the agency may get commission on media or production purchasing, or even additional income from the creative services area, the agency fee is typically the main form of agency compensation. 

In earlier articles I mentioned how the agency might figure out it’s hourly rate and the amount of chargeable hours an employee is billable. This rate multiplied by the hours is equivalent to one agency FTE billable cost. (Keep in mind that the FTE doesn’t mean you are locked into a dedicated staff member, the FTE is used as a time equivalent.)

Here are some examples of fee arrangements that vary hourly rates and overall billable hours per FTE. In some cases, it may be better to lower or raise your rate depending on the amount of hours you think will be billable to the client.

For example, if the agency thinks that they will need 5 people on the account (5 FTE’s) for one year, then the cost would be figured out by the following:
Fee Formula:
Agency blended rate = $175 an hr.
Agency billable hours = 1400 hrs.
1 FTE = $245,000.
5 FTE’s = $1,225,000 yearly fee.
or about $102,000 a month,
or 7,000 billable hours a year.

A second example, if the agency thinks that they will need 5 people on the account (5 FTE’s) for one year, then the cost would be figured out by the following:
Fee Formula:
Agency blended rate = $200 an hr.
Agency billable hours = 1600 hrs.
1 FTE = $320,000.
5 FTE’s = $1,600,000 yearly fee.
or about $133,333 a month,
or 8,000 billable hours a year.

Third example, if the agency thinks that they will need 10 people on the account (10 FTE’s) for one year, then the cost would be figured out by the following:
Fee Formula:
Agency blended rate = $200 an hr.
Agency billable hours = 1600 hrs.
1 FTE = $320,000.
10 FTE’s = $3,200,000 yearly fee.
or about $266,666 a month,
or 16,000 billable hours a year.

or the reverse,
Client’s budget is $3,000,000 yr.
1 FTE is equivalent of 1600 hours
Agency blended rate = $200 an hr.
1 FTE = $320,000
which equals 9.375 FTE’s.
or 15,000 billable hours a year.

This is by no means the only way of figuring out how to price your time. But it does show a quick way to figure out the old skool agency fee structures.

Agency Basics - Setting Hourly Rates

In the past, traditional agency management felt that their compensation for their company would be higher if they convinced their clients to hire them on a fee basis.

Recently their has been a trend towards alternative agency/client compensation. However, in most cases, agency’s will still use a fee system that is comprised of an estimated cost that calculates X amount of hours at an hourly rate of Y.  Although an agency fee might be comprised of multiple hourly rates for individual staff members, one way to reduce, or discount the hourly rate, is to take the average hourly cost for the staff (or what is often referred to as a “blended” rate) and apply that cost to all of the estimated time. Although the blended rate is often used, the agency will still set out to determine the individual rates for each staff member.

Agencies will often not have the same internal calculated rates, since each business will have it’s own unique overhead and salary costs that would apply to only that company. However, agencies centered in certain geographical locations may have rates that are comparable. 

This standard for configuring agency/client fee agreements is often based on the number of FTE’s assigned to the client’s account.  One FTE stands for “fulltime employee equivalent.”

Billable Hours
Before we can review the formulas, we first need to determine the number of billable hours for your staff. We start with the number of billable hours in a year. In a normal work week you have 40 hours. (However, if you discount one hour for lunch you have 35 hours.) When you multiple the 40 hours by 52 weeks a year you get 2080 hours per year. Now we adjust the total hours to arrive at the billable hours. This compensates for the fact that some of the time we are sick or on vacation or taking the day off for July 4th or Christmas. Naturally, we would still like to be paid for those days, even though we can't bill for them. So we have to look at just the number of billable hours we really have. Traditionally, ad agencies have reduced 2080 to 1600 and use a number between 1600 and 1400 that will be used as the standard number of billable hours. Remember, the larger the number of base hours, the longer it takes fullfill those hours. A higher hourly rate and a low count can equal a lower hourly rate with a higher count.

When calculating the total number of billable hours, you may want to consider what percentage of a particular person’s time is billable. Although a creative or production person may be 100% billable, an account executive working on new business or administration person may not be. Industry average of billable time seems to be around 60% to 80% billable. However, I recommend that you set a goal of 1600, which is close to the 80% billable figure of 1664 hours.

Calculating Overhead
Next, we must look at the real cost that each person represent to the business. That is, not just the person’s salary, but any associated overhead that the business incurs. This would include some personnel related expenses such as employer share of payroll expenses or self-employment tax, health insurance, disability, life insurance, and other "non billable" expenses that are vital to the business. Other things in this category may include the prorated cost of computers, and other office equipment and furnishings as well as a prorated cost of the office space. In calculating the hourly rate for the person you need to add up their "contribution" to overhead to set their rates. As many accountants will tell you, a rule of thumb was devised whereby you figure the employee's overhead at 100% of the salary amount.

Formula 1-
Quick Overhead Calculation
A quick way of determining hourly rates for staff members is by using the formula below. This formula over-simplifies the calculation of overhead, by simply stating that the part of the agency’s overhead assigned to the individual is equal to that person’s salary plus 20%. (Only use this percentage if it covers your costs for the person’s benefits, insurance and annual bonuses.)
In order to figure out the hourly rate, you first need to determine the number of billable hours for that person. Next take the annual salary and add 20% (for the cost of benefits), and double the costs for your overhead. Take that number and add 0-40% for your agency profit. Divide the total number by the number of billable hours and you will get to your hourly rate.

Example A:
Person’s salary is $50,000,
multiply & add 20% = $60,000,
multiply by 2 = $120,000,
multiply & add 20% (profit factor) = $144,000
divided by 1600 hours =
$90 an hour.

Example B:
Person’s salary is $75,000,
multiply & add 20% = $90,000,
multiply by 2 = $180,000,
multiply & add 40% (profit factor) = $252,000
divided by 1600 hours =
$157.5 an hour.

Formula 2-
Hourly Rate By Factor
And even quicker formula is to take a person’s salary multiply it by a factor. (Formula 2 just simplifies the math of formula 1.) By multiplying a person’s salary by 2.5 you will get close to the cost of the person’s salary, benefits and overhead. Multiply it by a higher number to add in your profit. For example if you take the person’s salary and multiply it by 3 you get the total costs plus a 20% profit ratio. Or multiply by 3.5 to get to a 40% profit ratio. Once you decide on your factor multiply that number to the salary and divide the entire number by the number of billable hours to get the hourly rate.

Example A:
Person’s salary is $50,000,
multiplied by 3 = $150,000,
divided by 1600 hours =
$93.75 an hour.

Example B:
Person’s salary is $75,000,
multiplied by 3.5 = $262,500,
divided by 1600 hours =
$164 an hour.

Formula 3-
Let your accountant do the math.
The quick and easy formulas have been used in agency’s for a long time, however nothing beats having your accountant doing the homework and actually calculating your overhead so you can properly apply it in figuring your hourly rates. This is important, since all agencies will have varying overhead costs dependent on their rent, leases, electric, administration costs and so on. Feel comfortable at night by having this done. It will give you the most accurate basis for determining which final formula you use.

Finally - Calculate your Agency Blended Rate and apply it to the FTE calculations.

Agency Basics - Alternate Forms of Compensation

In many cases additional forms of compensation will be made to the agency that is on top of the agency fee. This compensation may be in the form of commissions on production or media purchases, charges for the agency’s creative services department or other forms of agency charges.

Commission

No one charges for it anymore.However, in the past, agencies have traditional been able to charge a commission on out-of-pocket client costs in relation to media or production (print) purchasing. Although there has been a trend away from charging commission, agencies will strive to do what is financially in the best interest of themselves and their clients. Some agencies increase their rates to compensate for the loss of 

commission, where some agencies have gone completely away from charging them.

In the past the traditional rate of commission on print or production related purchasing was .17625% and varies from 0% to 20%. Production commission is traditional charged on outside
vendor bills for items such as scans, art purchases, color house work, printing and manufacturing.
Media commission has also varied from 0%, 3%, 5%, and up to 15%. Media commission is traditional charged on purchasing advertising space in print, out-of-home, broadcast and other mediums.

Services not normally included in the fee.

Fee agreements should be very specific about what types of services the agency will provide, and additional services not provided in the fee will then be estimated and billed to the client on a project by project basis. This may be typical of clients who originally asked for traditional ad campaigns, but not internet related work or perhaps PR or research related projects.

Creative Services (Production & Studio Services compensation)

Traditionally, agency fee compensation included all staff members related to the clients work minus the production studio. In some agencies, separate production estimates will be created for the client to include charges for interactive services, content or post-production, studio mechanicals, proofreading, final file creation, final file releases, discs, programming and more. And in a few circumstances, the production estimates may include production management and or project management.

Agency Basics - Keeping Track of Spending

Out-of-pocket or OOPs, are expenses that come in two forms.

One, where goods and services are bought outside of the agency for the sole use of the client, and accordingly, must be billed to the client.

Two, where goods and services are bought outside of the agency for use solely by the agency.
Both forms of expenses, however, should be tracked and approved prior to purchasing.  For your clients, you are contractually obligated to have prior approval, and clients have the right to refuse payment if the costs exceed the pre-approved amount. For internal costs, the agency needs to keep track of what it spends.

Approval of purchases starts by issuing a purchase order request that will initiate an approval process and a generation of a purchase order. In many cases, the production/media manager for the agency can issue approval and purchase orders on behalf of the client/agency by confirming the agency has a signed agreement or estimate from the client the covers the costs on the purchase order request.

Costs for the agency should only be approved by the assigned supervisors and acquired by issuing a purchase order generated by the accounting department (or authorized production person).

This sounds like a rather simple concept, but having worked in many agencies, this is one of the most easiest traps that people fall into. Someone on the staff authorizes purchasing something, doesn't issue a po, the client never gets a chance to approve it, and then the client refuses to pay it.

Agency Basics -The Dreaded, but Essential Time Sheet

Whether the agency works on a fee or project basis, the way the agency makes money is by calculating how many hours the job will take to complete the given tasks. The agency becomes profitable when a fair amount of hours are estimated and a fair an accurate amount of time is used and billed to the client. 

Although the agency can have a idea of how many hours a job may take to complete, it is still an estimated amount of time. Therefore it is in the agency’s best interest to be aware of the amount of time being accrued to a job.  Time sheets and time/task recording are the fundamental source of determining the revenue that the agency earns. It provides important financial, administrative and managerial information. Time entry can show and compute staff time charges for each of the clients, ascertain individual or group utilization and to analyze the profitability of client relationships.

Therefore, the agency should follow some simple guidelines for recording and tracking their time:

• Time sheets should be done daily and handed in at the end of the day (or entered into your agencies accounting system) before 10 A.M. the next morning. The sooner timesheets are done,
the more accurate and fair they will be.

• Time sheets should record a set amount of billable time each day, minus the time for a lunch break. For each work day, a goal of 7.5 hours of billable time should be met. Bill in quarter hour units. If your staff is working on non-billable time, record it, but have them break it down. Did they work on new business? Did they work on the agency portfolio? Having someone putting down 3 hours during the day for "admin" does not show what they worked on.

• If someone works early, late, or on the weekend, the time should be recorded for the additional hours worked for that day. If an empolyee worked 11 hours for one day, they should record all the time spent.

• Make sure that you properly record the correct job number and task on the time sheet. Be aware that the time you put on your timesheet becomes a permenant (and auditable) record that will be used and in some cases, shown to the client.

• Avoid having the staff use any “fee” or “catch-all” job numbers, it is easier to justify and negotiate additional costs with a client if a clearer record of how time is spent on individual jobs during the month. This can be an invaluable tool for estimating future jobs or reporting clear overs or unders to a fee based client. Many clients have "it-will-take-you-ten-minute" requests that turn into "ten hour" billable requests.

• Time spent on meetings should be applied to the jobs discussed. This is important on clients who rely on "project based" work. In some cases, on fee accounts, a number can and should be provided for client status meetings, or client presentation meetings.

• Travel time to a client or for client business is billable.

• Non-billable time would include, time spent working on new business plans, administrative time, company meetings, company promotional projects and time off, such as sick, personal and vacation time.

The Art and Science of Estimating

In every agency there are basic accounting functions and tabulations, from purchase orders to invoices to the basic P&L statements.

Beyond the accounting “science” is the “art” of estimating – and as any successful agency owner will tell you, they consider the entire client/agency financial arrangement as an attempt at a balanced relationship where one is really in a constant state of monitoring and tracking. (And it is an "art" to show how you provide "value" beyond what's on paper as a deliverable.)

Early on in my career I was taught the basics of billing. You see he had a pretty clear idea of what his costs were and how much of a percentage in profit he was willing to make (or not make) on a project, he would often charge less for a client that gave him more business, or less for a client that had an interesting project that could potentially enhance the agency portfolio, but the negotiated rates that he would charge a client was always based in fairness to the agency and the client.

I give him a lot of credit for teaching me that you have to be attunted to the client’s business and understand the each client has their own ideas and values that they put to their work and projects. You have to listen between the lines and learn to make wise choices of when you can charge for something, and when you can't. True "value-added" billing is meant to maintain the overall billing relationship, not to undermind it.

When times are good, you can charge more, when times are bad you charge less or work out alternate compensation. Many a night is spent worried about if we made the necessary judgement call to make sure both sides are in a comfortable, beneficial relationship.

The science in estimating is rather clear, cover your costs, salaries and overhead, the true art is in negotiating how much of a profit you will be able to charge, keeping in mind the worth of the account (and the creative) to the agency’s bottom line.

I wish everyone a happy estimating experience. Just remember, although you can always calculate the true costs of the project vs. your rates, it doesn't mean all of your clients will want to pay them.