April 11, 2017 en_US Cash is king for small businesses. Here’s a look at how overhead affects the margins of a growing agency. https://quickbooks.intuit.com/cas/dam/IMAGE/A6yI7K4nY/7cf9aa55714a3166fd2d309882507d55.jpg https://quickbooks.intuit.com/r/accounting-finance/maintaining-margins-gets-harder-business-grows Why Maintaining Margins Gets Harder as Your Business Grows

Why Maintaining Margins Gets Harder as Your Business Grows

By Jimmy Daly April 11, 2017

“Generating and maintaining margins is really important.”

New entrepreneurs may see that statement as obvious, but experienced business owners know it’s sage advice. Most entrepreneurs will tell you that margins can get more difficult to maintain over time. An increasing headcount, more office space, a larger warehouse—expenses like this make it harder to stay profitable.

It’s important to keep the main thing the main thing, even as your business grows in size and complexity. As Walter Chen, founder and CEO of content marketing agency Animalz puts it, “Don’t lose sight of the simple principles of businesses. Make more money than you spend.”

Like most businesses, the economics of an agency are relatively simply early on. The biggest expense is people, but as long as you bill clients more than you pay employees, the path to profitability is straightforward.

This changes over time. The needs of clients vary and requests start to roll in that are both vertical (“Can you do more of X?”) and horizontal (“Can you create an email campaign for this content?”). Employees evolve too. Not every employee can do the same type or amount of work. The more people involved in a project, the more overhead there is. That variability means it gets harder to bill the right amount for the work done.

Walter relies on a few simple frameworks to decide on pricing and hiring, as well as maintain positive cash flow.

The Unit Economics of a Growing Business

Let’s start with Animalz’ business model. This is different for every agency, but most of the underlying principles can be used for any service business. Customers sign up for a monthly plan. Each month, they pay a set amount in exchange for articles and distribution. The recurring nature of the plans means Animalz can plan ahead for the resources required to do the work—namely employees.

“It’s not so much about cash,” says Walter. “It’s about figuring how out much work each person on our can reasonably accomplish.”

The customers’ costs are set each month—this is counter to the billable hours model that many agencies rely on. The problem with billable hours, Walter explains, is that there is a huge variability in the value of each hour for the customer. An hour invested in client work doesn’t always generate profit since some time gets spent on administrative work, research and editing. (For agencies that do bill hours, see this detailed post on how to achieve a billable ratio.)

Instead, Walter thinks of each article as a unit of value. Customers pay for articles, not hours, so this is how he approaches both the workflow and the accounting. Using these basic building blocks, he can arrange them in a way to ensure margins stay healthy. It also gives him an easy way to analyze his revenue and expenses.

New employees, however, aren’t as productive, meaning they aren’t profitable if you measure their output against the revenue they generate. More experienced employees need to be at least twice as productive—and therefore twice as profitable—just to break even.

“Estimating how long it takes to do the work is hugely important,” says Walter. “We need to reduce time it takes to do the work without losing quality. We can roughly measure how long it takes each teammate to complete one article. It’s not a perfect measurement since it naturally varies by length and topic, but it helps us decide how to distribute the work each month.”

The 1099 or W2 Question

It’s notable that Walter has chosen W2 employees instead of freelancers. 1099 workers would give him the flexibility to scale up or back quickly, while W2 employees come with fixed costs and payroll taxes.

“Full-time employees make our business more predictable, but not because of the regular expense of salary. It’s time. I know we have 40 hours per week per person. I can measure that against productivity and revenue generated. It also means we can invest in training and culture, two things that make a big difference in the quality of the work we do. The longer a team member works here, the better the work and the better our margins. I want this to be a great place to work.”

And as one more added bonus, “Hiring full-time employees has forced us to think long-term. It forces us to forecast our revenue and workload so that we can hire to accommodate for more customers.”

Walter recommends using stagger charts to predict monthly revenue, expenses and output. Each month he sits down to make predictions for the coming six months and see how accurate his predictions for the last month were. Fixed expenses, like full-time employees, make his expenses easy to project. Revenue is harder to forecast, but he can use the the data to plan out how much new business the company can take on.

Cash Is a Constraint for (Nearly) Every Business

Finding, hiring and keeping good employees is what makes a business like Animalz succeed. It also means they need to hire ahead of growth so that they have employees to do the work when they bring on new customers.

Steady growth is the goal. As a young business, they can’t hire too far ahead of growth because of the cash constraints. And they can’t take on new customers without employees to do the work. This means maintaining a cash balance is imperative to driving steady, linear growth. Raising money is a potential workaround, but it’d be difficult to hire and train a lot of new employees at once, which makes the idea less enticing.

Instead, Walter is optimizing the rest of the business to make sure they aren’t spending where they don’t need to be. They, for example, used to automatically bill customers’ credit cards once a month. Credit card fees were insignificant at first, but soon grew to account for thousands of dollars every month. They are now moving to an invoicing system where customers can pay via ACH transfers or checks.

When it came time for a bigger office, Walter searched long hard to find a landlord that would agree to a one year lease with a small deposit instead of the more common three-year leases with a six-month security deposit that is common in New York City.

More customers, more revenue and more employees has made it harder, not easier, to maintain the margins they’ve worked so hard to earn. “Be stingy about expenses early on because they add up over time. Some, like leases, can affect the business for years so it’s really important to think long-term when you spend money.”

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Jimmy Daly is the Editor of the QuickBooks Resource Center. Read more