Why You Should Resist the Temptation to Cut Staff

By Tim Williams

Agencies are likely facing their most challenging year ever. The confluence of an unpredictable economy and the disruptive impact of AI are making revenue forecasting a daunting task for even experienced managers.

But the one thing that has not changed is the wrong-headed instinct most agency leaders have when faced with a troublesome income forecast.

When expenses appear to exceed revenues, the knee-jerk reaction is to reduce headcount. This is especially true among professional service firms, who have mistakenly followed a business model that sells “head hours.”

Cutting staff is undoubtedly the easiest way to reduce your operating expenses, but it is not the most effective way of improving your profits, which is the real goal of a cost-cutting exercise. This topic has been well researched, but most agency leaders have never seen this data.

What the research says

A study by McKinsey offers four different ways professional service firms can repair their income statement:

1.   Reduce fixed costs. This involves reducing your office space (not an easy task), finding ways to save on utility costs, office supplies, computer hardware and software, etc.

2.   Reduce variable costs. The major line item here is staffing, and in most agencies this represents about 60% of total operating costs.

3.   Increase revenues. This means new business — organic growth from current clients or landing new clients.

4.   Improve pricing. This doesn’t necessarily mean charging more, but charging differently.

Of these four choices, one is the clear leader in terms of effectiveness, and it’s the one action that most agency leaders wouldn’t consider as an immediate remedy to profit problems: improving your pricing.

Here’s the data:

·      A 1% improvement in reducing fixed costs improves profits by 3%.

·      A 1% improvement in reducing variable costs improves profits by 4%.

·      A 1% improvement in increasing revenue improves profits by 7%.

·      A 1% improvement in pricing improves profits by 11%.

No other remedy is more effective than improving your pricing. Do you think you could improve your pricing by 1% in the coming year? Of course you can, and the result will be a 10+% improvement in your profitability.

The book “The 1% Windfall” by Rafi Mohammed makes the same argument with extensive data across a wide breadth of industries. 

The bottom line?  Your primary profitability issue isn’t how much you’re spending; it’s how much money you’re leaving on the table.

Not charging more; charging differently

When we say “improve” your pricing, we don’t necessarily mean increasing your prices. This isn’t about charging more; it’s about charging differently.

Instead of charging for inputs (hours), your firm must adopt the practice of charging for outputs and/or outcomes. Instead of setting your price based on the cost of your inputs, charge for the value of the outputs.

There are well-established price ranges for most of the outputs produced by agencies, based on decades of historical data from agencies of all types and sizes. Agencies who have migrated to an output-based approach have created databases of these deliverables in the form of a “pricing guide,” which their internal teams consult as they develop pricing for projects and engagements.

Pricing “differently” also means diversifying the agency’s sources of revenue. Beyond fees tied directly to deliverables, agencies can also derive income from the great stores of intellectual capital that reside within the organization.

This knowledge, experience and expertise can be monetized in the form of free-standing products, platforms, software applications, and knowledge bases that can be sold via subscriptions or licensing. Up to 70% of the revenues of many major business consultancies are now derived in this way.

You have a cost structure, now develop a revenue model

In effect, agencies must develop an actual revenue model that transcends just charging for project-based services. Agencies must develop their own version of a “pricing stack,” which can include such pricing methodologies as:

1.   Outputs. Pricing tied to the value of defined deliverables.

2.   Commission. A percentage of spend or transaction value.

3.   Points / Sprints. Units of work with predictable effort and value.

4.   Outcomes. Tied to achieving a desired result or metric.

5.   Co-Defined Pricing. Jointly defined view of the value at stake.

6.   Percentage of Value. Pricing as a share of value created.

7.   Assessed Value. “Pay what this is worth.”

8.   Usage-Based. Billed according to actual consumption.

9.   Two-Part Models. A base fee plus a performance or usage component.

10. Subscriptions. Recurring billing for ongoing access or enablement.

11. Phased Billing. Tied to defined milestones or transformation stages.

12. Bundled Services. A unified price for a consolidated offering.

13. Prepaid / Deferred Use. Pay now, use later.

14. Add-On Components. Modular extensions billed as the solution expands.

The current consolidations we see in the advertising industry are an attempt to solve our industry’s profitability challenges by cutting costs. Few of the major players in our business are attempting to address margin problems by actually changing their revenue models.

It should be obvious to everyone in our business that we can’t save our way to success.