This may be one of the hottest debated topics when it comes to agency math.  Many generalist accountants want to include ALL labor expenses in your cost of goods.  Others, want to just include your billable staff in cost of goods and count your non-producers as overhead.

All of them are wrong when it comes to agency math.  This is why you need an accountant with lots of experience working with agencies.

Before we dissect this… let’s review.

  • Gross billings is everything that shows up on all of your invoices to clients.
  • Cost of goods (COGS) are expenses you incur on behalf of a client (media, printing, photography, influencer fees, contractors/freelancers, etc.). The key to this is… if you didn’t have a particular client or weren’t working on a particular project, you would not just buy these things or give these people money.
  • Adjusted gross income (AGI) is what’s left after you subtract the cost of goods from your gross billings.  AGI is the money you get to keep to run your agency.  You use that money for your loaded payroll/people expenses and overhead expenses, and hopefully, there’s some left over for profit.

ANY employee (not a contractor or freelancer) falls below the line and is part of your adjusted gross income calculations.  It’s the only way all financial metrics/KPIs specific to agencies will work.  But what about contractors?

It used to be very simple.  All contractors, except for outsourced admin resources like an accountant or attorney, were coded as cost of goods.

This will be easier to understand if we get specific.  So, let’s create a cast of characters.

  1. Babette is a W2 (in the US) employee
  2. Jack is a US-based independent contractor/freelance graphic designer who works for your agency episodically – about 40 hours a month.  You send Jack a 1099 each year.
  3. Mabel is an Australian web coder who works 30 hours a week for your agency. If she were US-based, you would send her a 1099.
  4. Jasmine is an independent contractor/freelance writer who works 40 hours a month for your agency. You send Jasmine a 1099 each year.
  5. Doug is your outsourced accountant.  You send Doug a 1099 each year.

From your P&L’s perspective, here’s how you would sort these 5 people.

  1. Babette – part of your AGI expenses (payroll/people)
  2. Jack – COGS
  3. Mabel – COGS
  4. Jasmine – although the IRS might argue the point because you violate the rules of what should be an employee – she’d be a COG.
  5. Doug – part of your AGI expenses (overhead). Imagine Doug is not just Doug but it’s Doug’s accounting firm.  That’s one way to help this make sense.

But today, a new role is emerging.

Many agencies are going through offshore employment agencies and HIRING a full-time staff member who happens to live in a foreign land. They are treated like true employees (get paid vacation, etc.) and are completely dedicated to the agency for 40+ hours. The only reason they do not get a W2 is that they don’t live in the US (or the country that the agency is based in).

Here’s the defining difference.  You pay this person for their 40-hour workweek, whether on vacation, fully billable, working on internal projects, or attending internal staff meetings.  They have a paid benefits package that is part of their compensation from you but supplied by the employment agency because they’re in the same country. They participate in things like agency outings, team meetings, retreats (even if they connect remotely), and your bonus program.

We will call this new type of employee Penelope.  Where would you put her on your P&L?  If Penelope lived in the US (or your country) – she’d get a W2 (or your country’s equivalent like Canada’s T4 slip/Statement of Remuneration or the UK’s For P60 or Australia’s PAYG summary).

The ONLY reason Penelope doesn’t get your government’s version of the W2 is that she is a foreigner. Therefore… her compensation (even though you pay it through a third-party employment company) would be part of your AGI expense (payroll/people).

Going back to our previous example but adding Penelope:

  1. Babette is a W2 (in the US) employee
  2. Penelope is the equivalent of a W2 employee and, for accounting purposes, is considered an employee
  3. Jack is an independent contractor/freelance graphic designer who works for your agency episodically – about 40 hours a month.  You send Jack a 1099 each year.
  4. Mabel is an Australian web coder who works 30 hours a week for your agency. If she were US-based, you would send her a 1099.
  5. Jasmine is an independent contractor/freelance writer who works 40 hours a month for your agency. You send Jasmine a 1099 each year.
  6. Doug is your outsourced accountant.  You send Doug a 1099 each year.

From your P&L’s perspective, here’s how you would sort these 6 people.

  1. Babette – part of your AGI expenses (payroll/people)
  2. Penelope – part of your AGI expenses (payroll/people)
  3. Jack – COGS
  4. Mabel – COGS
  5. Jasmine – although the IRS might argue the point because you violate the rules of what should be an employee – she’d be a COG.
  6. Doug – part of your AGI expenses (overhead). Imagine that Doug is not just Doug, but also Doug’s accounting firm.  That’s one way to help this make sense.

Hopefully, this is helpful as you talk with your accountant about the KPIs that matter to agencies and why you must get this right.