Moderator: 0:01

Welcome to the Empowering Healthy Business podcast, THE podcast for small business owners. Your host, Cal Wilder, has built and sold businesses of his own and he has helped hundreds of other small businesses. Whether it is improving sales, profitability and cash flow; building a sustainable, scalable and saleable business; reducing your stress level, achieving work life balance, or improving physical and emotional fitness, Cal and his guests are here to help you run a healthier business, and in turn, have a healthier life.

Cal Wilder: 0:34

Welcome. In today's episode, we're rejoined by Lindsay Jarosch, Director of Cloud Accounting at SmartBooks. Welcome back to the podcast Lindsay.

Lindsay Jarosch: 0:45

Hi Cal, thanks for having me back.

Cal Wilder: 0:47

So as you know, we've worked with a lot of marketing agencies and marketing-related service businesses. Over the years, it's been been a niche industry vertical for us, where we've had a lot of success adding a lot of value to clients. And one of the reasons I think we've been successful in this vertical is we've provided a really solid accounting foundation on which we can layer as much financial planning and analysis as a given client needs. And so we're going to go through in this episode several different accounting issues and best practices that are specifically focused on marketing agencies, although they probably have a lot of broader applicability to professional services firms in general. One of the first things we want to talk about is the chart of accounts in which our goal-- the Chart of Accounts is the list of general ledger accounts that has all of our assets and our liabilities-- our bank account, our accounts receivable, our accounts payable, our debt, and then our income statements we have, our revenue lines, our expense lines. And ultimately, it's how we organize our reporting. So the the goal with the chart of accounts is to organize accounting data to be able to provide useful management reporting that shows how the business is performing, so that managers can understand areas in which the business is doing well financially, in areas that might need some improvement, and they're in a position to be able to manage the business, right? And so Lindsay, what do you know as it relates specifically to professional services firms and marketing agencies? What have we learned over the years about the chart of accounts?

Lindsay Jarosch: 2:33

Yeah, so that's one of the things that we look at when we onboard a marketing agency, is how it's set up to really tell the story and provide data that's going to be useful in decision making. So, I mean, we could set up a chart of accounts that's really simple, has one revenue line, one expense line, with the difference being the profit on the third line and at the bottom, it would be very simple, but it wouldn't be helpful in giving us the information we need to make decisions. So we like to really look into the chart of accounts. Often we start by referencing the financial operating system, which is a book that Cal himself has written, and we use that as a framework and a methodology when we're setting up the chart of accounts, to really understand what it is that the business owner wants to do with the business. If the business owner wants to grow the marketing agency, we may set up a chart of accounts that's focused on really looking at revenue, for example, and that leads me into the next thing about marketing agencies. A lot of marketing agencies have different revenue streams and segments, and so instead of just having that one revenue line at the top, we like to break it out into the different business units so that you can see how each business segment is performing. It's really helpful to see if, you know, you put a lot of energy into developing, for example, the SEO revenue stream, and to see the bit, to see if the results of your efforts have paid off. It's helpful to see if that industry is or that revenue line is growing or not, and also just to see which segment is most profitable. If there's one that maybe isn't profitable and the other one is extremely profitable, maybe that's where you need to focus your efforts to grow the business. And so that's that's just one of the things that we do in the chart of accounts to start helping us tell the story, start giving us the information we need to then calculate metrics that are in line with the business owner's objectives.

Cal Wilder: 4:54

So we've segmented revenue. And then, of course, probably we want to segment expenses so we can see how each business unit is doing from a profit perspective, right?

Lindsay Jarosch: 5:05

That's correct. One of the one of the first things that we try to segment is the labor costs. We also look at training, third party media, subcontractors, and we move all of those items into direct costs. So if we can separate any labor, for example, that's revenue-producing labor, we want that to be a direct cost in the cost of goods sold section, segmented preferably by the different revenue segments, so that we can see how profitable each segment is.

Cal Wilder: 5:46

Let's talk about labor. Because I know oftentimes we engage with a new client, and they've tried to do their payroll accounting, but all of their wages and payroll taxes and benefits costs get booked to, you know, one segment in QuickBooks, and that doesn't really help us understand the gross profit or the contribution margin, right? So what's, what's the best practice for payroll accounting?

Lindsay Jarosch: 6:12

Yeah so often we'll see it lumped in all kind of in one line item. But what we really want to do is break it out, sort of like I mentioned. You can leave some, maybe the owner's salary, in G&A, or maybe an admin person who does billing or accounting type stuff. We generally leave that in G&A, but everyone who's creating revenue, we want to move that labor cost up to cost of goods sold, or cost of sales, so that we can start calculating contribution margin, which is a little bit different than gross profit. And QuickBooks doesn't do it justice, because it doesn't break out contribution margin, but in the financial operating system, that's incredibly valuable to have revenue less cost of goods sold, excluding the labor, to get to your gross profit. And then separately, as sort of a separate item of the cost of goods sold section, we right below gross profit will take out and or will account for and separate as a separate line item in the Chart of Accounts direct wages. That way we can calculate contribution margin, which is gross profit minus the labor costs. So we'll put those labor costs in there, and it gives us that extra layer of an extra ability to really look at the core profitability of the firm. And by doing that, by separating out the labor, we can look at metrics such as labor value multiple, which really drives contribution margin and can be really powerful in making decisions like hiring or staffing.

Cal Wilder: 8:41

Right, right. Because that that ratio of revenue or if reselling third party products, then revenue minus third party media resale equals gross profit. That ratio of net revenue, or gross profit, however we define it with our nomenclature, that ratio of of net revenue divided by direct service labor equals the labor value multiple. And that's, as Lindsay said, is really profitable in terms of analyzing the business, being able to price new engagements with new clients and make staffing decisions right. If we're trying to manage to a labor value multiple of, you know, say, 2.5x and we need a gross profit equal the 2.5x the direct wages of the people doing the work, then that can help us price new engagement to make sure we're getting that 2.5x multiple. And then when we think about and then when we think about making a new hire, say, Okay, our labor value multiple has gone up to 2.7, 2.8 people are saying they're feeling a little overworked, starting to burn out. Then the numbers, combined with the anecdotal data from our people suggest, yeah, we definitely need to hire somebody. But if the labor value multiple is down to 2.1 and the gross margin and the contribution margin below target, then, you know, it indicates we just need to either, preferably we we grow revenue and grow gross profit to be able to spread that across our existing wage rate. Or, worst case, maybe we need to make a cut to wages. But once we start to get these segmented cost centers in the Chart of Accounts, we're in a position to do that kind of analysis and make management decisions.

Lindsay Jarosch: 10:24

Yeah. I mean, it's incredible when we create those metrics and show them month over month and really, um. To see the owners of these marketing agencies light up where they can finally use data to make decisions on like if they should hire a new person next month or not, it's incredible.

Cal Wilder: 10:45

Right. We spend a lot of time talking about contribution margin, because that's the core profitability of the business. But if we keep going down the income statement, then we get down to marketing and sales expense, right? And so with some agencies, there might not be a lot of distinct marketing and sales expense if the owners and the partners are doing all the selling themselves when there's not a lot of extra marketing going on, and the owner compensation is usually reported down in general and administrative expense. But sometimes you might want to split the owners between maybe cost of service and marketing and admin. I'm not a huge fan of a lot of complicated allocations in the financial statements, but sometimes there's a good reason to do that. But ultimately, once we can analyze the marketing and sales expenses on its own as a segment, we can then calculate the cost to acquire a new client and determine if we're getting our return on investment on our marketing and sales expenditures. And then if we keep going down below marketing and sales, we get down to general and administrative, and we like to look at G&A expense as a percent of revenue or as a percent of gross profit. And you have to gear that. Usually there's an economic model for a firm in the professional services space that looks something like 40% gross profit or contribution margin. So 100% of revenue minus 60% is our cost of goods sold, and then cost of direct labor equals a 40% gross profit or 40% contribution margin. And then below that, we might spend 10% of revenue on marketing and sales, we might spend 20% on G&A. So 40% minus 10% minus 20% equals 10% more or less. So that kind of leaves 10% for operating profit. We can tweak that based on the individual situations of our client. But if we have that logically segmented chart of accounts, we can do that kind of analysis to be able to track and manage costs by segment and manage pricing accordingly. At some firms the percentages will differ some, and we can find the right model that will work for your firm. The starting point is having that organized, segmented Chart of Accounts.

Lindsay Jarosch: 13:12

Yeah, one of my favorite things to do, which I'll often do with clients on a quarterly basis, is really kind of dig into some of these margins. If we see a 40% gross profit margin, and we know that's as good as it's going to get, we look and we say, that means you have 40% of your revenue left for everything else. And then we start looking at marketing, and we start looking at G&A. And if you know, there's a 35% G&A cost, that's cutting into that profit margin quite a bit. And so then sometimes, you know, we spend some time looking at G&A and looking at cost cutting, if need be to get to increase that net profit margin. So if the chart of accounts is structured properly, it becomes a fantastic tool to really look overall at how the business is doing and set some good goals as to where you want to go.

Cal Wilder: 14:09

So that's a good outline of the chart of accounts, and specifically the income statement, that is where most people start to look. So if we go back to the top of that income statement, back to revenue, a lot of marketing agencies resell third party media. You manage advertising campaigns or ad purchases for clients. You may buy Google AdWords or Facebook ads or, you know, radio or TV spots, right? And so operationally, the agency finds it a lot more operationally efficient to collect funds from clients that are earmarked for that kind of media and then make the purchases in accordance with the associated media campaigns. So we've got cash flowing into the agency's bank account that is earmarked to buying third party media, but that money really belongs to the client in a lot of ways. And so the question is, how do we account for these advanced payments from clients for media purchases? Lindsay, so how do we how do we approach making this determination?

Lindsay Jarosch: 15:18

Normally, when the cash comes in, when you invoice or you receive the funds, it's a liability, as it hasn't been spent on the media yet. It's a current liability on the balance sheet because you're waiting to purchase media. And it's it's always offset by either AR, if the invoice has been paid, or cash. And then after, it's after you spend the money on the media, the question is, how to account for it. Fundamentally, the economics in terms of the bottom line, bottom line dollars of profit are the same, but there could be a dramatic difference in how the P&L looks, and I've noticed this across all of the marketing agencies that we've had as clients at SmartBooks, as to really how companies want to account for it. The first way, and probably the most popular way, at first at least, is marketing agencies report the revenue as gross revenue. So they report it 100% of the cost of media that's on the invoice is reported in revenue, and then the costs are separately reported in cost of goods sold. This results in the largest top line. It looks like you have a ton of revenue in your marketing agency, but usually there's a low gross margin percent of the revenue. Maybe, you know, sometimes you get 40% to 50% gross margin on services provided by your staff, but only a 20% margin reselling to advertising. The other way to do it is Net Revenue, and this has become more popular as you look at truly what the revenue is. And companies don't want to overstate revenue, and really want to show on the financials that it's it's reselling the media. So this reports only the margin from the media as revenue to the agency. So it's reported as net in the revenue section. It results in a much smaller top line, because you're netting out the cost of the media in the revenue section, but usually at a higher gross margin percentage, because the more GP dollars on top of margin produced, because the net revenue has no associated COGS, as the COGS was netted out of revenue right in the revenue section. So it's effectively adding more GP dollars on top of the margin produced by your agency. So those are the two kind of most popular ways. Generally, I see gross revenue. Net revenue, like I said, has become a more popular way to present it on the financial statements. And lastly, the other way, which you don't really see very often, but in some cases, none of the third party media cost is reported as revenue to the agency. This might result from how the client contracts are structured. If there's no markup added to the media purchase or the agency bills a separate line item for media purchasing services that is separate from the actual media. So lots of different ways to account for revenue and look at revenue as you're setting up your marketing agency and accounting for the media costs.

Cal Wilder: 18:51

There are some policies that need to get determined and worked into client contracts around the refundability of media funds. Use it or lose it. Is it applied to other services if it's not used? So, and those can all have some accounting implications. Usually, we're not aiming for 100% GAAP or generally accepted accounting principal compliance, but something reasonably close. And so depending on how your agency operates, we want to make sure we've got a revenue recognition policy that is reasonable based on the terms of your engagements with clients. And while we're talking about third party media, that brings us to the next topic of managing client advertising budgets. We've collected money from clients to spend on media, then we start spending that money. How do we track all that? It can be very manual. Great, Google worksheets and and track it that way, and that's how a lot of lot of clients do it. However, once you get to a certain size, it takes a lot of time to manage client ad budgets. And if we're trying to resell at a certain percentage markup, then we're starting to manage a spreadsheet, trying to do some calculations with markups, turn that into client invoices, somehow get those invoices into QuickBooks. It can be a lot of manual work if the agency does a large volume of third party media resale. And so there's some software solutions out there, like ReportGarden, for example, that could automate the tracking of client media spend, as well as help automate the invoicing for media resale. It can automatically connect to the data feeds from folks like Google and Facebook and connect to QuickBooks, and can help you monitor and manage and reinvoice and rebill those services. So that's something to think about once the agency reaches a certain scale with a certain volume of media resale.

Lindsay Jarosch: 20:53

I've seen some pretty pretty big spreadsheets tracking client ad budgets, some pretty impressive spreadsheets. And I do have to say, the clients that we have that do the best at tracking these ad budgets are usually the most successful. So it's always important to find the best methodology for your particular marketing agency to track these.

Cal Wilder: 21:19

You know, and it's probably clear, but you know this third party media represents client funds that you need to spend for clients, right? And so the more effectively the client media purchases are tracked and reported, the stronger the client relationship can be, because clients want to know where their money went, be able to analyze a return on investment. So being able to really plan and manage and report back to clients on their media spend is really important from a client or license perspective, not just debits and credits accounting perspective, that that we tend to worry about. So speaking of debits and credits accounting, one of the questions we get at a certain point from almost every client is around accrual accounting. So Lindsay, could you briefly outline the difference between accrual accounting and cash accounting, and why most agencies end up needing to do accrual accounting?

Lindsay Jarosch: 22:21

Yeah, sure. So a lot of marketing agencies start out on cash basis. So that just means that revenue is recognized when it's invoiced. Often if there's no invoicing, revenue is recognized when cash comes in the door, and expenses are recognized when they're incurred. So there's no putting things on the balance sheet, prepaids, accruals. It's really very simple accounting, and that way the business owner can put their effort and their resources into launching their business. It's an inexpensive way of doing accounting, since it doesn't take a lot of effort to track things they can, you know, win new clients, do a great job of servicing those clients. Accounting isn't that critical in the early days of an agency, as long as they have a handle on the client media funds, like we were just talking about. And really the finer points of revenue and expense recognition might not matter, as long as the business is coming in and the firm is profitable overall, and there's cash in the bank, and the bank account is growing. Agencies that are growing and scaling definitely need more reporting, more data to manage their business. So we often see, as they continue to grow, the need to switch over to the accrual method, which really aligns the revenue and the expenses in the proper months. So revenue is recognized when it's delivered and the costs are associated with when they're incurred. So it takes a lot more tracking. Instead of just recognizing revenue in the month that it's invoiced, it often-- well under accrual accounting, you then have to track, put the revenue on a spreadsheet and track it as revenue is earned. So it's definitely a lot more accounting, but the benefits are huge in terms of getting the data similar to what we were talking about and some of the metrics in talking about the chart of accounts, the owner of the agency, then is equipped with a lot more data and knowledge about how the business is performing to make those decisions.

Cal Wilder: 24:45

So let's think about a hypothetical, very simple example, where there's a marketing design project that's going to take three months to do, and the agency bills the client for half of the project up front, works for three months, delivers the final product, accepted by the client, and then bills the second half of the project. And so we've got a number of issues there. But if we start with revenue recognition, it was a three month project. Assuming work was done pretty steadily over three months, from a revenue recognition perspective with accrual accounting, 1/3 of that project revenue should be recognized each of the three months. Although from a cash perspective, you've invoiced half of it up front, maybe got paid half up front, and then you invoice and we get paid three months later for the other half. And month two might have no revenue, right? So, from a cash perspective and an invoice perspective, it's very lumpy. From a revenue recognition accrual perspective, it should be very steady, 1/3, 1/3, 1/3. And then on the cost side, we need to think about how do we account for the costs associated with that project? If all the employees are getting paid semi monthly, twice a month, then and all the work is getting done by w2 employees, then that's pretty straightforward, because we're already recognizing our payroll cost on a monthly basis, half of it every two point, you know, three weeks or whatever. But let's say you've, you've got payroll that's getting paid out on a weekly or biweekly frequency. Now we've got, we don't have exactly two or four payrolls per month, we've got, you know, most months we've got two to four payrolls, but a couple months out of the year, we're gonna have five payrolls or three payrolls per month, and that's gonna really skew the numbers. Or we might have some subcontractors who submit bills when they get around to it. And so we really need to think about, what are the associated costs for that revenue? We've already figured out we need to be recognizing a third of that revenue each month over the three months term of the contract, of the project. But we also need to think about how do we recognize our w2 payroll cost to make sure we're recognizing that on a monthly basis accurately. And we want to think about, how do we recognize any subcontractor or third-party costs so that we're also recognizing those on a monthly basis as we go? Because ultimately, we want to be able to produce and deliver monthly financial statements that are accurate to our client.

Lindsay Jarosch: 27:32

Being able to review trends to see if revenue is growing or if costs are growing or shrinking, and really overall profitability, it's really hard to do if it's lumpy under a cash basis. And so again, that's why companies switch to the accrual basis, so that they can really use the data to assess the business performance.

Cal Wilder: 27:56

In terms of assessing business performance, we end up talking about how do we use these, these financial statements are great. We've got an income statement, a balance sheet, a cash flow statement, nice to look at, interesting, but translating or distilling those down into a key shortlist of financial performance metrics can be really powerful. It's one thing to say the company had X dollars of revenue and y dollars of direct cost and Z dollars of contribution margin or gross profit. But what is gross profit as a percentage of revenue? What's our labor cost as a percentage of revenue or gross profit? What's our G&A overhead as a percentage of revenue? How are those trending over time? How is our accounts receivable collections going? How many days sales outstanding do we have at any given point in time? If we look at cash in the bank, what does that represent as a multiple of our monthly fixed operating expenses? So there are a lot of multiples we could care about, and part of you know, part of the financial operating system process and framework is determining what's the short list of financial metrics that are most important for a given business. But ultimately, want to take these financial statements, try to get the financial statements as accurate as possible using some basic accrual accounting, and then distill those down into some financial metrics that clients can use to really understand and manage the business, and quote, unquote, "go beyond the financial statements." You can get into some more operational metrics, like utilization, for example, which is not going to appear in QuickBooks most of the time. You're not going to know the number of payroll hours and the number of billable hours necessarily in QuickBooks. So there may be a need to kind of integrate some third party data sources like Harvest or other professional services automation systems with the financial data in QuickBooks to be able to calculate some of these operational metrics to really provide more of a full picture of the financial performance of the business and what is is driving it.

Lindsay Jarosch: 30:04

This is by far my favorite step of the financial operating system framework that we use here at SmartBooks. It's the most meaty section. After you do all the work to set up the chart of accounts and set up accruale accounting and really get the financials in shape, then you can start finding the actionable information so that owners can make great decisions.

Cal Wilder: 30:34

Clients will often ask us around about benchmarking. You know, How do my mark metrics compare to the metrics of other agencies? Or, you know, what are the targets that we should all be aiming at in this industry? And you know, I can tell you from answering that question a lot of times, the first answer is, you can go out and buy benchmark data. And sometimes that can be valuable, but a lot of it's kind of junk, because there's no uniform benchmarking. If you're not reporting your metrics to somebody, why do you think all your peers are reporting their metrics to somebody? So it can be hard to get accurate pure data. But having worked with a lot of marketing agencies over the years, and a lot of general professional services agencies over the years, we generally know what these economic benchmarks need to be, and we can work with you to tweak them for your own business model and take into consideration factors like we talked about with the revenue recognition policy, right? Because if we're recognizing 100% of third party media as gross revenue with a relatively low gross profit margin percentage on resale margin and markup, that can be very different than if we're recognizing net revenue, where we've netted out the costs associated with the revenue, and effectively 100% gross margin revenue on the P&L, that's gonna make the financial statements look a little bit differently. And so I'm hesitant to just throw out general numbers without understanding the specifics of an agency. However, if we're gonna throw out some general numbers, generally, you know, we're looking for about, you know, 40%-plus contribution margin percentage, or the way QuickBooks reports it, it's called gross profit margin percentage. We want to see about 40% of revenue or better. And that leaves about 30% of revenue to get spent on marketing and sales and G&A overhead, and that nets out about 10% operating profit to the bottom line. So that's kind of the default benchmark that we work toward. But again, a lot varies depending on your financial objectives as an agency and how you are accounting for third party media and so at the company level, we can set these benchmarks and report metrics and everything. But ultimately, you can't really manage at the company level. What you can really manage at is the client level and the project level, right? Lindsay, so how do we, how do we think about, you know, operationalizing this with client and project profitability?

Lindsay Jarosch: 33:15

Yeah, often my marketing agency clients ask for a margin by client report, and we start looking at the margins by client which is really helpful when we start comparing the payroll costs that go into each of those projects. So it's really easy if an agency is using a time tracking system, because then we can get really accurate client project cost data agencies that don't want to use time tracking systems, it's it's harder to estimate the client costs. But when we're looking at when we can estimate the labor costs that go into each project, it really becomes a powerful tool in looking at the margins and assessing whether the costs are too high, the labor isn't efficient, maybe there's a pricing issue and we just can't make enough on certain clients or certain engagements in the marketing agency. So it becomes really valuable to be able to look at it on a project by project basis, especially if you have accurate cost reporting for those clients.

Cal Wilder: 34:33

And then once we get accurate cost information, that can then feed back into our pricing decisions and pricing models, whether we bill hourly or fixed price. If it's hourly, we got to make sure we've got the right hourly pricing based on the role that's doing the work. And if it's fixed price, we got to make sure we've underwritten a fixed price based on our internal cost structure. And once we really dig in and report on cost per client and cost per project, then we've got the data we need to make good pricing decisions that will result in achieving target profit margins. Lindsay, something else you've mentioned to me is the need to track referrals fee referral fees and commissions. What's that all about?

Lindsay Jarosch: 35:23

Yeah, so we'll often see referral fees or commissions paid to sales people to bring in business. The marketing agency. I think pretty much every marketing agency that I've seen has some sort of referral for your commission to generate business. And so often, marketing agencies will need to track the respective salesperson on their invoicing. We'll use classes in QuickBooks to do that frequently so that they can assess whether one salesperson or assess the amount of sales each sales person has created. Often, we'll have to create some customized reporting, especially for referral fees, to ensure the invoices are paid before the fee is dispersed. So there's definitely, they're very common, and there's different reporting requirements around paying these referral fees and commissions accurately.

Cal Wilder: 36:23

Makes sense. Another question we often get is around, can I afford to hire an employee? In a professional services business, we've got work to get done. People might be saying they're too busy. Maybe we'd like to hire somebody with a particular skill set instead of some contracting it out. So we've got these staffing and capacity management decisions that we need to make. Lindsay and I cover this question in some detail in Episode 17 of the podcast, if you want to check that out. But if we were to distill down this question, a lot of it comes down to the labor value multiple metric, which is our gross profit divided by the direct labor cost of the folks doing the work. And whether it's getting done by w2 employees or subcontractors, there's a cost to do the work. There's a price to the client. The difference between the price to the client divided by the cost to do the work is our labor value multiple. So we might do the do the analysis and and realize we need to get a 2.5x labor value multiple. So we need to be generating net service revenue of $2.50 for every $1 of salary or or subcontracted billing. And so figuring out what that right LVM is really important, but once we figured out what the right LVM is for your agency, then we can apply that to answer the question of, can I afford to hire somebody? Right? Because if we know we need a 2.5 LVM, then the answer is always, you know, yeah, we can hire people, as long as we maintain a 2.5 LVM. So if revenue is growing, hopefully, then you know for every X amount of dollars of revenue growth, we've got, you know, two point, you know, divide that by 2.5 that's how much more salary we can afford. So maybe, based on our existing staff, we can get a two point, you know, 2.7, 2.8 LVM, and then people start to break, start to burn out, you know, hit their capacity limits. We need to hire somebody. And we might hire somebody, might drop our LVM to 2.3 or 2.4, so we might be below target for some period of time until we add more revenue and get back to that 2.5. That's how LVM can be used when revenue is going up, or conversely, if revenue is shrinking, layoffs are never, never fun, never desirable, but the LVM metric can help inform what we might need to reduce our staff costs down to based on our our current book of business to maintain that 2.5 LVM or whatever it needs to be for your business. And Lindsay, we also see clients grappling with strategic questions around subcontractors versus full time employees versus part time employees, and so there's some issues around that. What are agencies considering around those issues?

Lindsay Jarosch: 39:30

I feel like questions around staffing and capacity management are some of the most popular questions that we get and can be the most easy to figure out and provide appropriate data for decision making when we can structure the chart of accounts the way that is helpful, like we discussed above, and really getting some good data. So often, you know, we'll look at LVM and we'll decide, should we use w2 employees or contractors? We'll look at fixed fixed versus variable cost issues. We'll look at legal compliance, effective hourly costs, loaded employee cost burden rates. Especially depending on the type of marketing agency, where there may be certain times during the year that you'll need more labor. Sometimes seasonality can be a factor to hire contractors instead of w-2 employees. Or if the loaded employee cost is just too much, sometimes that can be an indicator to hire a contractor versus a w-2 employee. So it really just depends on sort of what the objectives are for the business and what makes sense based on the data.

Cal Wilder: 40:52

Right. You know, usually if you can keep a full time employee fully utilized, at least, you know, 70%-80% utilized, which is pretty much fully utilized in the professional services world, then it's going to be less expensive to have a full time employee. But if you can't keep that individual fully utilized, then if some months they're gonna be like 20% utilized, and some months they're gonna be 70% utilized, but the average utilization is going be relatively low, then that increases the effective hourly rate quite a bit, and it might make more sense from a financial risk management perspective, to outsource some of that work or utilize a subcontractor. So those are some of the decisions that agencies grapple with around hiring as well. One of the things we like to do is help clients plan and analyze their financial performance. You know, a lot of what we do is basic day to day bookkeeping and monthly financial statement reporting, but where I feel like we can really add a lot of value is kind of taking the next step and helping clients with budgeting and forecasting. And so let's think a little bit about the definitions of budgeting and forecasting, what these things mean, right? And so in our world, we try to define a budget as the plan that we're trying to accomplish this year. It's typically set at the beginning of the year. Maybe it gets updated mid year if actual results are running significantly differently than we thought at the beginning of the year, but it's pretty much a static a static plan. And then we compare how we're actually doing against that plan. And then forecasting is something different. Forecasting represents our current best estimate of how we're doing this year based on all the information we have at a disposal right now. And so a forecast can be updated anytime we have new information, typically at least monthly. And so the full year forecasting is the most valuable thing, because it's, you know, what do we think we're actually going to do this year? The budget is, what was the plan? So coming up with a plan is easy. Reporting actual against that plan is important, but it doesn't necessarily tell you how you're going to do. And so forecasting is the most valuable. It can also be the hardest thing to do, because it relies at the top of the forecast is revenue, and so we need a sales forecast. And if the sales cycle is relatively short and the deal size is quite variable, it can be pretty hard to forecast revenue. We forecast revenue, and then we forecast the cost associated deliver that revenue, and kind of everything flows from revenue. And so full year forecasting is great, and we encourage that, but it can be hard. And so Lindsay, short of a full year forecast, where is it that we're really adding a lot of value with forecasting?

Lindsay Jarosch: 44:06

Yeah, marketing agencies and really, most small businesses, are really interested in cash, and they closely monitor cash. And those types of businesses often find that a 12 week rolling cash flow forecast is most useful. Like Cal said, often the sales pipeline is more accurate over a 12 week period than a longer amount of time. So usually in that 12 week forecast, it's pretty easy to look at the pipeline and have an accurate idea as to what sales are going to look like. And it's especially valuable for marketing agencies that cater to industries like, for example, politics or campaign advertising that are specifically project based, so they know what projects are coming up in the next 12 weeks. And that tends to be most helpful to be able to look at what sales are going to come in the door. Generally, expenses are pretty easy to predict based on margins. Fixed expenses are fixed expenses. So we know those we can generally get a really accurate 12 week rolling cash flow forecast to provide some insight as to what the next few months are going to look like.

Cal Wilder: 45:26

Yeah, and so once we get that forecast in place, you know, we can figure out what the metrics need to be around things like gross margin, contribution, margin, labor, value multiple, overhead G&A as a percentage of revenue. So we come up with what the metrics need to be in order to for the business to yield its target profit. And then we can start to compare the forecast against those metrics, right? Accountants are good at reporting on the past. CFOs tend to focus on trying to plan and predict the future. And controllers are somewhere in between. But I feel like if we can at least start with an agency where we've got a financial model that's geared to 3,5,7 financial performance metrics, and get a 12 week rolling forecast we know for the next three months, this is approximately what we predict. And then we can say, here's what we predict. Here's how it compares to the target metrics that we really need to be achieving. Here's where they align. Here's where the shortfalls and gaps are. And here's how we can start to manage the business around the forecast, against the metrics, and now we can make management, management decisions. So we're talking a lot about accounting and management decisions and metrics, but I'd be remiss if we didn't also talk about taxes. Because most small to mid sized marketing agencies are entities with pass through taxation. They're s-corps, they're LLCs taxed as partnerships, they're LLCs taxed as s-corps, where the taxable income of the business flows through and gets reported on the personal tax returns of the owners. And so tax planning and projections are very important, or else there's the risk of that surprise year-end tax bill which is never pleasant. You get the bad news from your CPA. Oh, by the way, you owe X-thousands of dollars of taxes, and then you didn't expect that, you didn't put that aside, and now to come up with money to pay the tax bill. And there might have been opportunities to implement tax saving strategies over the course of the year, if you had a good tax plan in place. And so what we try to do is help clients plan and project and manage their tax liabilities to avoid those year enterprises and make sure they're in a position to take advantage of tax saving strategies over the course of the year as they come up. You could refer back to one of our first episodes, episode number three of the empowering and healthy business podcast, top tactics for small business owners to pay less tax. A lot of those tactics in that episode would be directly applicable to the marketing agency with pass through taxation. So it's important to really plan and manage over the course of the year, make accurate quarterly estimated tax payments, and don't just wait until the end of the year and have your CPA tell you what you owe. And increasingly, since you know over the past few years, especially probably before covid, but covid was a catalyst for a lot of firms-- a lot of the employees are living in multiple states, we're hiring employees with particular skill sets who live outside of the home office geography in other states. And so being able to understand and be compliant with tax rules when the employees live and work in multiple states is also increasingly important. And so I would encourage some proactive thinking around tax planning as well, not just financial reporting and metrics. So Lindsay, what anything else we want to make sure we cover while we're chatting about accounting issues related to marketing agencies?

Lindsay Jarosch: 49:28

I think we covered almost almost all of them Cal from the chart of accounts at the beginning, to thinking about accrual accounting as you grow, to really reviewing some of the metrics that are helpful, and thinking about tax planning along the way so that you don't get caught off guard with the surprise tax bill. But yeah, I think we've covered all of the topics for today relating to marketing agencies and accounting.

Cal Wilder: 49:59

Well, great. I look forward to speaking with you again on other topic Lindsay.

Lindsay Jarosch: 50:03

Thanks for having me.

Cal Wilder: 50:05

Reference show notes and find other episodes on EmpoweringHealthyBusiness.com. If you would like to have a one-on-one discussion with me, or possibly engage SmartBooks to help with your business, you can reach me at Cal@EmpoweringHealthyBusiness.com or message me on LinkedIn where I am easy to find. Until next time, this is Empowering Healthy Business, the podcast for small business owners, signing off.