Why Raising Salaries Each Year for Agency Employees is Hard

As an agency owner, you know that the people in your team are a huge factor in your long-term success.

In the early days, maybe it was just you doing the work. You had a unique creative gift that you used to help other businesses.

But as the demand for your services increased, you started adding people around you.

At least, that was my experience with Jakt. And we’re now at 20+ people between employees and contractors. You’d expect to face many challenges as you grow the company. I sure did.

But one that I didn’t expect is this:

It’s hard to raise salaries when you run an agency. And not because we’re cheap 🙂

In this article, I will discuss the reason behind it and how we’re approaching this at Polpo in a way that it makes sense financially. So let’s dive in.

Why is raising salaries in an agency so hard:

Whether people say it or not, if you have employees, your prices are always pegged to some sort of hourly rate.

“But we charge a retainer. So we’re not based on time.”

You are.

Even if you charge a “retainer,” how do you pay your people?

If they are employees, they get a salary, which is based on TIME. So, naturally, you calculate your profits by seeing what you pay them hourly vs how much time it took them to do the work and for you to get paid.

The difference is your profit margin, but it can all be boiled down to an hourly rate.

Example:

Customer A pays you $10K. You estimate it will take your employee 100 hours to do the work. Therefore the hourly rate is effectively $100 per hour.

If you pay someone 100k salary, if you break down their salary into an hourly rate, it’s about $50 per hour. So good, you are making the margin you were looking for.

If you don’t calculate it like this, you are completely guessing if you will make money or not.

So yes, it still boils down to an hourly rate when having full-time w2 employees.

Note: This same principle doesn’t always apply when you use contractors, but that’s a topic for another blog post.

Now…

Let’s say you run a digital marketing agency. And imagine your target gross margin is 50% (that’s ours).

You sign a contract with a client for $6,000/month. You know that $3,000 will go to pay for your employees.

You’ve hit your target margin. All good for now.

The problem comes when you start raising salaries… but you keep charging your client the same $6k.

So now, you’re paying $3,500 to your employees instead of the $3,000 from before.

You margin has declined. It’s not 50% anymore.

And here’s the thing:

You can’t always go to your client and start charging them $7,000/month.

I mean, you could sell them on the increased value or that you have more demand or something like this.

And maybe it works…

But what if they say no?

I mean… it’s not like you’re adding more services on top of what you were already offering.

You’re just essentially telling them: “I’m going to do the same amount of work but charge you more.”

From experience, that’s a hard pill for customers to swallow. Again, sometimes it works, but sometimes it doesn’t. And when it doesn’t, that’s where the issue of raising salaries comes into play.

If you can’t manage to raise your prices, you —the business owner— will be the one losing money when salaries are increased.

And what if your employees ask you for more money?

If you want to keep the same profit margin, you can’t give it to them.

And if they decide to leave you and go somewhere else, you run into another issue:

You have to pay the cost to replace them. You now need to go and find another person. Hire them. Train them. Get them up to speed on how the systems work, etc.

And that’s very expensive in itself, both in terms of money AND time.

When your team stays together over time, they get better and better. But when there are people that leave, you lose consistency.

So, the question is…

How in the world can you pay your employees more without fucking your margins up?

How using bonuses and profit shares can work for your agency:

At Jakt, we keep salaries the same every year unless someone moves into a higher paying role.

The reason behind it is that we don’t want to increase our fixed costs.

If I agree to pay someone an extra $5k/year, I’m obligated to do so no matter how well the company does.

But, ideally, you’d like the vast majority of your costs to be variable instead. That way you can protect yourself and be profitable at all times.

That’s why I’ve found profit shares and bonuses to work the best in this situation.

They de-risk it and give you control.

If your company makes a profit, you know coming in that you’ll pay a percentage to your employees. You can plan around that.

Or if you are able to actually charge more to clients, the company will make more profit and you can then share that with employees. But you protect your downside if the clients aren’t willing to pay more.

It becomes a win-win with the employer and employee instead of a win for the employee and a potential loss for the employer.

This also aligns your interest with your employee’s, right?

If they do well, you do well. And if the company does well, your team does too.

It’s a win-win scenario.

Let’s talk numbers:

I established a profit share of 20% at Jakt.

That means that 20% of our net profits ($774k in 2018) is distributed between employees and management team.

I personally prefer this method instead of raising salaries by 5-10% just because time went on.

And that’s not to say you’re going to underpay people. You’re giving them a nice salary in the first place.

You’re just incentivizing and rewarding high performance.

Over time, we’ll increase the percentage to 25%, 30%, and so on. And we do this yearly, but you can even do it quarterly. It’s the same concept.

The goal is for your expenses to be variable.

If you have a bad month, you can’t lower your employees’ salaries. But what you can do is hold onto the profits and, if there are any, distribute them periodically.

This lets you be flexible and keep a solid handle on your finances. Which would be impossible if you had increased your costs on a permanent basis.

Those are the advantages of a financial model built on profit shares over raising salaries. If you want to us to help your agency implement and similar system and maintain the types of profit margins I mentioned, we spun out a new company to do just that: check this out.

When raising salaries each year won’t work: Use these takeaways 

1. Raising salaries in agencies is hard because of the mismatch between your fixed costs and your capped rates. Giving a raise to your employees equals lower profit margins for you.
2. Profit share pools allow you to work around the fixed-expense problem. Your interests are in alignment with those of your employees. And they get rewarded when the company makes more money.
3. The more variable your expenses are, the more flexible your finances become. You can scale up and down without adding fixed costs and losing money.