How the Billable Hour Limits Your Profit Margins

Posted   Productivity

Which pricing model is best for your agency–hourly or subscription billing? In this post, we compare the two systems and look into the reasons why more agencies are opting for value-based pricing to increase predictable revenue.


Per-hour billing isn’t the best way to increase revenue for a growing agency.

Billing per hour places a hard ceiling on how much your agency can earn. Regardless of how quickly your employees work or the successful outcomes they produce, you can only charge for the amount of hours they spend on each project, each day.

It’s hard to scale your agency effectively because increasing the quality and efficiency of the work you do doesn’t positively impact your profits. Instead, your margins come from an arbitrary billable ratio that can vary wildly from month-to-month.

However, subscription billing–where clients pay for a certain amount of deliverables per month–has cropped up as a viable alternative. With a subscription system (or a retainer fee), profits are determined by a predetermined output, instead of by a variable billable ratio. It’s easier to scale because it’s easier to plan and so your earnings aren’t limited by the number of hours in a workday.

We compared the subscription system against the hourly billing industry standard to help you choose the best way for your agency to charge.

The Risks of Billing Per Hour: You Can’t Predict Your Revenue

The billable hour is an easy way to make sure that your agency gets compensated for every minute they invest in a project. Creative work is inherently unpredictable, and you need to be paid for the extra time your agency puts into revisions or the additional hours of writing that produced exceptional ad copy.

But the billable hour is a risky business model. It’s impossible to predict your revenue because the number of billed hours differs from month-to-month. One month, you could have three major deadlines on big accounts, and the next might include a lot of non-billable administrative overhead and employee vacation time.  You can’t scale because you can’t make hiring decisions or take on new clients if you’re not positive what your agency’s six-month trajectory looks like.

For example, let’s look at a small, healthy agency that bills per hour.  To keep things simple, let’s use these numbers:

  • Everyone makes $60k per year
  • One sales and operations team member doesn’t contribute to billed hours
  • Creatives work 6 hours a day, leaving one hour for lunch and another for administrative tasks
  • Each employee works 22 days per month–a business average

Here’s what your numbers might look like.

How the Billable Hour Limits Your Profit Margins


14.96% is great–Jason Blumer, a Certified Public Accountant that specializes in agency metrics, says that 10%
profit margins for an agency is “good,” and 15% is “outstanding.”

Agency health-o-meter


But the problem is that this income isn’t reliable, even if your agency is growing and thriving. In addition to client acquisition and cancellation, here are all the factors that affect your agency’s profits in the billable hours model.

  • Time off. Because you can only profit from the time your employees log, a regular vacation (or even a month with a few national holidays) can cause your profits to take a serious dip.
  • Personal productivity. You can’t expect your employees to be at 100% all the time. Their productivity, no matter how many steps you take to maximize it, will always vary.
  • Non-billable administrative overhead. Clients are unpredictable, and your job often involves time-consuming, last-minute adjustments to please them–and the more clients you have, the more of those expensive adjustments you’ll have to make. Administrative overhead only increases as you grow, and it dips into your billable hours.
  • Sales efforts. You need to use non-billable time in order to get those billable clients, but not all your proposals will get you clients–each failed proposal represents potential billable hours lost. 
  • Amount of work assigned. You could tally up your hours at the end of the month and realize that there wasn’t as much work assigned per client as the last few months. Without knowing that in advance, you wouldn’t know that you need to acquire more clients.
  • Employee onboarding. It takes a while to get new employees up to speed, which means their billable ratio will be low as you train them. Plus, your long-term employees will end up sacrificing some of their billable hours to train new hires.

Let’s say just one of these factors impact your agency during one month. You hire someone new, and while they’re learning the ins-and-outs of your agency, they work half the amount of billable hours as your long-term employees. A senior employee invests one hour per day training them. 

Here’s what your numbers might look like.

How the Billable Hour Limits Your Profit Margins


As you can see, a single new hire can temporarily reduce your profit margin.

Agency health-o-meter


Now imagine if you combined two of these factors. If you have a month where you hire someone new and a long-term employee takes a one-week vacation, or you have a big proposal and a slow month at the same time. It could put you in the red. The problem with billing per hour is that each of these everyday factors can significantly reduce your bottom line.

The Case for Subscriptions: Value-Based Pricing Helps You Scale

With subscription billing, you know exactly how much money is coming in every month ahead of time. Having a predictable recurring revenue makes it easier to scale, because you can plan to take on new hires when you know that revenue is increasing.

Let’s take a look at a healthy agency that uses subscription billing. It’s the same as the hypothetical agency listed above that uses billable hours–only this agency bills 6 clients at $8,750 per month instead of using a billable rate. 

Here’s the math behind the subscription model.

How the Billable Hour Limits Your Profit Margins


The profit margins are almost the same as the agency that bills by the hour (14.96% vs. 14.48%). We used the $8,750 subscription fee figure to keep things about even.

Since you plan a standard amount of work every month on the subscription model, you have a reliable income. This enables you to make more strategic decisions which lead to better outcomes. You can take on a new employee when you take on a new client or when your margins are exceptionally high, for example.  

Let’s use the previous example and see how it changes when you add a client and an employee under the subscription model.

How the Billable Hour Limits Your Profit Margins


Instead of a dip, there’s a boost in your profit margins as the time spent training the new employee doesn’t decrease your profits for the month.

This switch to subscription billing is a shift to value-based pricing. Your clients aren’t paying for your time. They’re paying for your results.

Value-based pricing means that your rates are based on how much your work is worth to the customer, not how long it took you to complete an assignment. Instead of calculating solely on hours spent, you’ll use factors like how much time or money you’re saving a client or how much additional profit they will make because of your work.  

Pricing experts at Price Intelligently explain that every cent you charge under the ceiling of what your clients are willing to pay is lost money, and those cents add up. Their research shows that a 1% increase in price causes an 11% increase in profits. With value-based pricing, you don’t max out potential profits at eight billed hours per day–you can scale your prices alongside your agency’s offerings.

Use Your Billing System as a Growth Mechanism

Subscription billing isn’t a perfect system, either. Since it doesn’t have built-in protections for your time when clients demand revision after revision, it’s easy to see your deadlines and profit margins slip away. And per-project pricing can make it harder to raise your rates because you can’t just add on a few extra hours for the additional work you completed.  (We’ll actually talk about these issues and how to mitigate them in an upcoming article–stay tuned for more info.)

But the shift away from billable hours won’t just affect your immediate bottom line. It changes your billing system from a fee-for-service business to a growth mechanism that drives your scaling.

Subscription billing encourages client retention by focusing on ongoing work instead of one-time transactions. Click To Tweet

Retainers and subscriptions also let you package in “upgrades” where you can charge extra for easy-to-supply bonus services. The switch means your profits won’t be limited to your rate multiplied by an eight-hour workday.

Your agency is growing and picking up speed. Let your billing framework be the momentum that pushes your agency forward, instead of the friction that slows it down.  

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8 Comments

Leanne King

Hi Charlie,

Thanks for the comment. Glad you’re liking the posts 🙂

Leanne

Reply
Charlie

Leanne, Is there a way to be notified on the follow up to this specific article? Also, have you all considered a social login for commenting so we do not have to write out our details every time we want to be in the conversation?

Reply
Leanne King

Hi Charlie,

Good idea re the social commenting – I’ll make the suggestion for sure.

The only way to get notified is to sign up to our mailing list on our blog. You’ll be notified of updates through that.

Hope this helps!

Leanne

Reply
Sol

This is great – a very well written presentation of the argument.
This is something our agency has been dealing with.
Our question is not whether to make the transition but on how to make it. If we are currently using the hourly billing model, how do we transition current projects? Or perhaps we don’t transition current projects and only start with new projects?
I’d love to hear more about this in a future follow up blog post.

Reply
Gráinne Forde

Sol,

Glad you enjoyed the post. We actually have an upcoming post about communicating pricing changes to clients — we’ve this scheduled for publication next month! If there are any other articles you want to see from us be sure to send your suggestions our way 🙂

All the best,
Gráinne

Reply
Janel

Good article and I like the approach. Can you distinguish if and how “subscription” model differs from “retainer” pricing? Retainer pricing is still based on hours, and I think it’s a bit messy and confusing. Looking for the right way to package monthly fees that are service and project based without focusing completely on hours served.

Reply
Gráinne Forde

Janel,

It’s great to hear you enjoyed the post! For retainer pricing, you agree to work X hours each month for a pre-set sum of money. You’re still charging per hour, but you know how many hours you’ll bill in advance.

For the subscription model, you agree to complete X deliverables (whatever your agency offers) for a pre-set sum of money.

I hope this makes things a bit clearer.

Gráinne

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