How is agency gross margin calculated?
Start with fee revenue: what clients paid for the agency's own work, with pass-through costs such as media spend, printing and influencer fees removed. Subtract direct labor cost, which is the loaded cost of the hours delivery staff spent on client work. Divide the result by fee revenue and multiply by 100.
Direct labor cost for a salaried employee is their loaded annual cost (salary, employer taxes, benefits) divided by 12, divided by 173.3 hours per month, multiplied by the hours they logged to clients. Contractors and freelancers count at their invoiced cost. Management time spent on client work counts; management time spent running the agency does not.
- Include: delivery staff salaries and benefits, freelancers, contractors, direct production costs the agency absorbs
- Exclude from revenue: media spend, print, influencer fees, software billed at cost
- Exclude from cost: rent, sales, finance, leadership, internal software, marketing the agency itself
What is a good gross margin for a marketing agency?
A gross margin of 50 to 60% on labor is healthy for a services agency. Below 45% there is rarely enough left to cover overhead and still earn a net margin. Above 65% usually means the agency is either underpaying its team, running productized services with very little custom work, or has miscounted hours.
Gross margin should be checked per client, not only agency-wide. An agency at 55% overall can carry three clients at 30% that are subsidized by two at 70%. Client-level gross margin is the number that tells you which accounts to reprice, rescope or resign.
Verbial reports gross margin per client and per retainer from contracted fee revenue and the loaded cost of approved hours.
Why do agencies overstate gross margin?
The most common error is leaving pass-through costs in revenue. A $15,000 retainer with $40,000 of media billed at cost looks like $55,000 of revenue, and the labor cost appears tiny by comparison. Computing margin on the $15,000 tells the truth.
The second error is unlogged time. Every hour a designer works but does not log removes cost from the calculation without removing it from payroll. The third is using billing rate instead of cost rate for labor, which produces a margin figure that measures nothing.
How does gross margin relate to net margin and utilization?
Gross margin covers the cost of delivering the work. Net margin is what remains after overhead is paid from gross margin. An agency with 55% gross margin and 35% overhead earns a 20% net margin, which is why gross margin needs to sit in the 50s for the business to be comfortably profitable.
Utilization feeds gross margin directly. Salaried staff cost the same 173.3 hours a month whether they log 90 or 140 client hours, so every unbilled hour is paid-for labor with no revenue against it. Raising billable utilization from 65% to 75% on a fixed payroll adds roughly 10 points of gross margin.
Worked example
A 12-person agency runs a $15,000 monthly retainer. The three people on the account have a blended loaded cost of $65 per hour (about $135,000 loaded annual cost each ÷ 12 ÷ 173.3 hours). In August they logged 125 hours to the client, so direct labor cost = 125 × $65 = $8,125. Gross margin = ($15,000 less $8,125) ÷ $15,000 × 100 = 45.8%, below the 50% floor. To reach 50% on the same fee, hours must stay at or below $7,500 ÷ $65 = 115 hours. To reach 55%, the target is 104 hours, which is close to the 100 hours the retainer was scoped for.
Questions
Should freelancer costs be included in agency gross margin?
Yes. Freelancers and contractors who deliver client work are direct labor, the same as salaried staff. Their invoiced cost goes into direct labor cost for the client they worked on, which keeps the margin comparable whether the work was done in-house or outsourced.
Is media spend part of gross margin?
No. Media spend billed at cost is a pass-through and should be removed from both revenue and cost before computing gross margin. If the agency marks media up, only the markup is agency revenue.
What gross margin should a retainer be priced at?
Price retainers so the scoped hours land at 55 to 60% gross margin, because actual hours usually exceed scoped hours. A retainer priced at 50% on scoped hours drops to the low 40s after normal overrun, leaving too little to cover overhead.