How to Calculate Overhead Costs for an Agency
We’ve all got them: overhead costs. They’re all those invisible elements that keep our businesses, well—visible.
Yet, in the agency and service business world, is overhead only what we commonly believe it to be? We’re talking about workspace rent, utilities, cleaning services, office supplies… All those expenses do fall into a typical company’s overhead bucket. However, agencies generate many non-billable expenses that must also be labeled as overhead.
Why? Because overhead greatly affects agency profitability. Keeping a close eye on your overhead costs (and otherwise non-billable activities) helps you rethink the rates you’re charging, the quality you aim to deliver, and the growth you desire to achieve.
Whether business is running smoothly, or most of your staff suddenly switched to remote work, overhead is unavoidable. You’ll never get rid of these expenses, but you can reduce them by planning, monitoring, and deciding to see certain costs as investments.
We’ll start off with the basics of agency overhead and help you understand the benefits of having all your company’s expenses, data, resource planning, and communication in one place.
What Are Overhead Costs?
Overhead costs are all your agency’s costs that don’t directly generate revenue. Since overhead directly influences your agency’s profit, it can easily drain your business if not monitored in real-time. So how do agencies typically allocate overhead?
The Variability of Agency Overhead
Unlike different industries, it’s essential for agencies and service providers to see parts of their overhead as variable investments for their long-term growth (e.g. marketing and sales activities, event and networking organization, training, education, etc.)
Example: Some agencies decide not to contribute to pitches for new projects or clients because using time on pitching is too big of a non-billable expense for them. Sure, they may be saving money in the short run, but in return, they don’t compete with other agencies and surely don’t get as many opportunities to expand their business. But how about all those agencies that do pitch for new projects? Is it that those agencies do that same work for free? Probably not. Neither should you.
Agencies with a growth mindset see pitching for a new project as an investment. Whether it be acquiring new knowledge and skills throughout the process or really winning that new deal, pitching can be a win-win for your agency if you start including this expense into your overhead costs.
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Fixed, Variable, Semi-Variable Agency Overhead Costs
What your agency’s fixed overhead will likely include:
Facility costs (office space rent, equipment, interest on mortgage payments, business insurance, property tax, regular cleaning services)
Salaries of non-billable employees and professional services (sales, human resources, office management, and marketing teams taxes, bookkeeping and accounting services, etc.)
Licenses and plans (Web hosting, software licenses, landline and mobile phone plans, and more)
Variable overhead costs:
Salary or benefit components and support staff wages (e.g. employee vacations, hiring freelancers, contractors, consultants or seasonal support, annual medical check-ups, staff bonuses)
Equipment maintenance (hardware repairs, vehicle maintenance, building repairs, vehicle insurance)
Marketing (investing in advertising, PR, organizing or attending external events)
Training (education, team building, workshops)
Here are some more factors you may want to consider that will influence your agency’s overhead variability:
1. Agency Service Types: Say next quarter you decide to start offering a new service that you think you could sell to client or two. That could mean buying new licenses, rapidly acquiring new knowledge, or getting more sophisticated tools.
2. Location: Imagine you land a new client overseas. This project could be a three-year contract. You’ll start investing more in travel, equipment, maybe satellite office space, maybe new software licenses. This, too will become your variable overhead.
3. Customer Operating Preferences: Try to image that same client overseas has preferences that you didn’t expect prior to closing the deal—such as allocating your entire delivery team within one isolated office space to ensure maximum collaboration and privacy. These types of preferences could easily lead to renting more office space for a certain period of time, and will generate variable overhead costs for your agency in the short to medium term.
4. Customer Business Practices: As a service provider, you know that most times you’ll go the extra mile to cater to your potential or existing customers’ business practices. That can mean, for example, acquiring additional servers to make sure all your clients’ operations are running smoothly.
5. Annual variations: Just as you adjust wages for inflation annually, you need to do the same for your overhead.
The Standard Overhead Rate Myth
A misleading myth is that there’s an industry standard ratio for calculating overhead known as Standard Overhead Rate. It’s supposed to be a general formula for calculating the ratio of overhead costs to your professional services cost.
Though this is a widespread term, there is no official industry standard rate to calculate overhead. What’s more, using a generic formula like that can lead to revenue gaps.
One reason for this is that in countries where salary rates are low and living costs are high (e.g. real estate costs), overhead is automatically higher than in markets with higher salaries. Another way to look at it is that the bigger the agency, the more non-billable staff you have (administration, HR, communications, etc.). Big agencies also have bigger clients and longer sales processes.
How to Calculate Overhead in Productive
Many agencies out there don’t have real-time insight into their company’s financial situation. If your agency is using spreadsheets, you can probably agree that they are often visually complicated, un-user-friendly, time-consuming to update, and can present a security risk for your agency. To top all that off, because of their nature, spreadsheets make it almost impossible to extract real-time reports.
To solve the nightmares that come with spreadsheets, Productive was built so that you can check your agency’s financial pulse at any time. For that, you need company-wide and granular views of your:
1. Expenses (fixed and variable overhead)
In Productive, one key agency metric does not exclude another—or get ignored, for that matter. But before we get into how Productive factors overhead costs into your profit margins, let’s remind ourselves of the major expense categories that agencies are faced with.
Project expenses are going to be unique for every single project. Things like travel, software licenses, and advertising budgets can all fall under the category of project expenses. So the main thing you need to be aware of is that project expenses can be:
1. Billable (with or without markup)—which means they will increase revenue and generate profit (if marked up), and they’ll appear on an invoice.
2. Non-billable—meaning they will not increase your revenue, but rather lower your agency’s profitability, and will not appear on an invoice.
In Productive, we label overhead costs as one of two categories:
1. Facility cost: your office space, utilities, equipment, etc.
2. Internal cost: the cost of time spent on doing internal work
Salaries / Cost Rates
This expense category will typically take the biggest bite out of your agency’s overall profit margin. This is why a high percentage of billable utilization is paramount. Productive handles cost rates very easily. Every single user will be set up with either a monthly or hourly cost rate.
Here’s an example of a person with:
A fixed monthly salary (cost rate) of $5,000
A 40 hour workweek
Based on these numbers, we get to the estimated hourly cost of $25.
This means that if we sell a service to a client that is billed at $100 per hour and the person from the example above spends time working on that service, they will take a $25 bite out of every hour’s profit margin. Like so:
However, there’s a third category of expenses that will further reduce that profit margin: overhead costs themselves.
How Productive’s Overhead Algorithm Works
Productive uses a proprietary algorithm that calculates an agency’s overhead cost as a combination of facility cost (office, supplies, utilities) and time spent on internal or non-billable projects.
Finance, marketing, and office management teams are good examples of employees who should track time on internal projects. The facility cost is going to be a monthly ballpark figure that you most likely already have in a spreadsheet. It’s basically an aggregation of all your agency’s monthly expenses, excluding employee salaries. This figure will most likely include your fixed (and certain variable) overhead costs mentioned above: office rent, utilities, etc.
What Productive’s algorithm does is pretty amazing because it calculates overhead per hour, adding the cost on top of employees’ standard cost rates. This spreads your agency’s overhead costs across all projects, giving you a much better understanding of true profit per project.
In the example below, the agency has a $5,000 monthly facility cost. Productive’s algorithm has calculated $10,24 of overhead cost per hour.
Based on this information, we can safely say that the profit margin from the previous example is no longer accurate. This one:
What really happened was this:
As you can see, overhead should by no means be ignored, as it can make a significant impact on an agency’s profitability. Productive makes it easy for you to calculate and understand the impact of overhead on your business.
The example above is based on a single person and one single hour. You can imagine how useful this is when factoring in multiple users that have different salaries, as well as projects with different billing rates.
All of these calculations are happening in real time, making it incredibly easy to see what’s truly going on with your profit margins. All this, without messing around in spreadsheets that you can’t really trust—no matter how much you tweak them.
In Productive, you can even run a report that shows how much time a colleague has spent, for example, this month and what the total cost of that time was (work cost + overhead). If you want, you can also add columns that break that cost down into pure salary (work cost), or pure overhead.
Billable Vs. Non-Billable Hours
Billed to your customer
Expenses that will show up in your invoices
Not billed to your customer
Expenses that will not show up in your invoices
Instead of not billing your agency’s time spent on researching, learning new technologies or training staff, agencies with a future-facing mindset embed these costs into their overhead.
Example: You secure a new deal and your agency needs to develop a new multimedia platform for your new customer. To do this, your employees need to do additional research and learn how to deliver new technologies. Not only are you catering to your new customers’ requests, but including this type of otherwise non-billable work in your overhead costs can be seen as adding long-term value to your services.
With time tracking, you see exactly how much time is spent on the non-billable part of this new project, and how many hours were actually spent on labor. Time tracking will easily demystify which customers tend to request more non-billable hours and enable you to adjust overall rates accordingly. Extensive negotiations, out-of-scope requests, and ad-hoc servicing can all fall under these otherwise non-billable expenses.
How to Include Overhead Costs in Your Prices
By understanding overhead costs in real time, you can calculate the total cost it takes to run your agency. In other words, you’ll know exactly how much money your business needs to bring in each month to remain profitable (and grow).
Remember: to get the most accurate overhead rate, it’s key to add in non-billable work (sales, marketing, human resources) and your typical fixed or variable overhead (such as facility expenses). By having a realistic view of your overhead, you’ll be able to factor that percentage into your service rates.
Here are two ways to calculate your overhead percentage into your prices:
1. You can include all overhead costs (including those identified as non-billable) into your employees’ hourly rates. That would mean, for example, that you’ve already calculated that you need to bill $100 per hour for your senior designer instead of 30% less ($70), because earlier you identified 30% is your overhead percentage.
2. In Productive, say you have your monthly revenue for a project is $150,000 and as your employees track time, the overhead is automatically factored into your profitability calculation per each hour. That way, you have a clear overview of your project’s profitability and overall agency profitability.
Why Managing Overhead Leads to Greater Profitability
Once you start managing your overhead in real time, you will have accurate insight into the profitability of projects, teams, services, clients—whichever custom view of profitability you choose.
In Productive, your agency reduces the amount of hours that typically get wasted on:
Inefficient communication across multiple tools
Resource management information across multiple tools
Financial data in multiple places
Compiling utilization, profitability and project progress reports
Administrative work connected to invoicing, billing and payroll
Overhead Shouldn’t Be a Bad Word
Since generally overhead isn’t completely billable, we can get the idea that we should aim to reduce it in any way possible.
Keep in mind that overhead isn’t a bad word, it’s inevitable. Non-billable hours can be profitable. More than looking for ways to save on overhead costs, it’s crucial to identify how certain expenses play a role in your agency’s future. Also, being able to check your agency’s pulse at any time will help you forecast profitability and keep variable costs from inflating beyond reasonable levels.
Need Help With Calculating Overhead?
No matter if you run an agency of 300, 30, or three people—calculating overhead will keep you aware of what your costs are and give you perspective on how you can reduce them or adjust your service rates.
Productive’s philosophy revolves around profitability. It considers that each cost, be it fixed or variable, will influence your agency’s financial health and growth. If you want to learn more about calculating overhead costs and getting an accurate picture of your agency’s profitability, contact us.
Optimize Your Agency’s Profit Margins
Get the most out of your resources with Productive’s integrated time tracking and resource planning features.