Even if it’s hard to track, client profitability is vital information to have to optimize your own business performance. If you don’t know which clients add to your bottom line and which are dead weight, you’re potentially hemorrhaging dollars to service clients that aren’t worth the resources. Even worse, you’re missing out on major business opportunities.
Unfortunately, profitability is easy to misunderstand, which can impede your business from becoming the most efficient and lucrative it can be. Here are four profitability myths that could be hindering your success.
Myth #1: Client Revenue = Client Profitability
Most owners simply look at client revenue as shorthand for client profitability, though it’s anything but. And we get it: without the right accounting team and systems, it’s hard to know how profitable your clients are. While the data to calculate or estimate profitability may be in your systems, unless that system includes someone experienced enough to interpret the data for you, you’re the one who will have to do the legwork.
But solely looking at client revenue is dangerous for your business. All revenue is not equal. Your largest clients might not be your most profitable clients. Similarly, your smallest clients might not be your least profitable clients. Revenue is not the same as profitability. It doesn’t tell the whole story of a client’s profitability, and you don’t want to make a hasty business decision based on misguided information.
Need a shorthand way to understand client profitability? If your agency is doing timesheets, we suggest the easiest way to do this is to compare the billable value of the time spent to service a client vs. the actual fees earned. While this isn’t a perfect calculation of client profitability, it is a good proxy for profitability. This is because your rates include your expectation of profit per hour.
Here’s a quick rule of thumb:
- If you are recovering the billable value of all the time that you spend on a client, then your client is profitable at the rate you expect.
- If your fees are higher than the billable value of the time spent on your client, then you are more profitable than you expect.
- If your fees are less than the billable time spent on the client, then you are less profitable than you expect to be.
We do this for our clients via what we call the Efficiency report. It compares the billable value of time spent vs. the actual fees + mark-up (AGI) recovered from clients. This allows management to quickly see:
- Where the business is doing the best job of recovering time invested on clients (anything 90% or better)
- Where the opportunities for improvement are (anything below 90%)
- The relative size of each client (more on this later!).
If you look at the efficiency of each client, you can see that the range is between 61% on the low end (almost 40% of time invested has not been recovered), to 275% on the high end (the client is paying almost three times what the agency’s billable value is).
Any client performing at 100% (+/- 10%) is performing optimally. Any client outside that threshold is performing better/worse than the target. In this example, Xbox is the agency’s second biggest client but only 85% of the time invested in this client has been converted to AGI. This agency would want to continue to monitor Xbox’s financial performance with the goal to improve this outcome.
Myth #2: All High Profit Margin Clients are Good Clients
A good profit margin at a client level isn’t the worst outcome, but it still doesn’t mean it’s a good client for your business.
As your business grows, it is helpful to get the benefits of scale. But if you have many clients, which means even more contacts, it is very difficult to get the benefits of scale.
Here’s an example:
Account Director #1 has a book of business of $1M in annual AGI coming from two clients.
Account Director #2 has a book of business of $1M in annual AGI coming from seven clients.
Account Director #1 is more likely to be able to achieve the benefits of scale because she has far fewer clients to manage. Account Director #2 likely struggles to give a good service to all of her seven clients because she is pulled in many directions each day. It also makes it really difficult for her to grow clients in her portfolio when she is most likely struggling to get everything the team needs to do for each client done in a day.
This is why we believe it’s important to understand the relative profitability of each client, and the absolute profitability.
If you refer to the table above, the total AGI for the agency at that point in time is $613k across 8 clients who range in AGI from $8k YTD to $265k YTD.
While Sick Kids Hospital performs well from a profitability point of view (all time invested is recovered), the absolute $$$ it generates for the agency is small on a relative basis. If this client doesn’t have the ability to grow, or doesn’t serve any other strategic priority for your agency, it might actually be preventing you from achieving better performance in some of your other clients.
In that sense, profitability isn’t the only metric to evaluate. You must factor in the cost of losing bigger business, even if a client’s profit margin is technically high. It sounds trite, but time is money. Spend it as efficiently as you can.
Myth #3: You Need to Drop Your Low-Profitability Clients
By now we should be aligned that all revenue doesn’t contribute the same way to your bottom line. This is why it’s so important to understand both the revenue of your clients and the profitability of your clients. If you have high revenue AND high profitability clients, they need to be protected as losing one of these clients is much more punitive to your business than losing a high revenue, low profitability client.
Should you drop your low profitability clients?
Not always. All clients should serve some strategic value for your business. Low profitability clients should be evaluated to understand whether:
- The profitability could be improved with changes to your delivery model (streamline processes, better manage scope, lower the labour cost if it can be done without diminishing the quality, etc)
- The are a good source of referrals to other opportunities
- Having them in your portfolio helps you get opportunities with other clients you want to work with
- Provide interesting work opportunities for your team
The bottom line is that if you do decide to work with a low-profitability client, you need to do it with your eyes wide open. Know why you’re working with that client, despite its being less profitable. What are you prioritizing instead of profitability? Is it networking? Creative license? You won’t know the answer unless you have all the information in front of you.
Myth #4 You Can’t Change Your Client’s Profitability
The more you know about your clients’ profitability, the more you know where your opportunities lie, and that can spell the difference between a profitable and unprofitable client. If you have a low-profitability client, there are some ways to optimize their profitability, including:
- Changing your resource mix to lower your cost
- Increasing your pricing
- Managing your scope better
You can even optimize high-profitability clients, and high-profitability clients can indirectly assist low-profitability clients, too: you can apply the lessons you learned servicing them to low-profitability clients’.
Regularly Monitoring Your Clients’ Profitability is Essential for a Successful Business
If you want to increase your own business’s profitability, you need to be proactive about managing your clients’. Good quality reporting on your overall business and the contributions each client makes to revenue and profitability is imperative to improve your overall financial outcome.
You need good information to make good decisions. However, regular reporting takes time and resources — and knowing where to look. That’s hard to do if you’re already maxed out on the day-to-day responsibilities of owning a business.
The right outsourced accounting firm will systemize your accounting and your financial reporting so that you have all the information you need regarding your clients’ profitability at-a-glance, whenever you need it.