GROSS PROFIT MARGIN VS. LABOR MARGIN: WHY AGENCIES SHOULD TRACK LABOR MARGIN
Two agency founders can pull a "gross profit margin" number from QuickBooks Online, both technically correct, yet land 25 percentage points apart—not because one business is healthier than the other, but because their bookkeepers categorized costs differently. That's not a hypothetical. It's one of the most common reasons agency financials are hard to compare, even with your own numbers from a year ago.
Quick answer: gross profit margin was built for businesses that sell physical goods, where "cost of goods sold" is obvious—materials, manufacturing. An agency sells people's time, so what counts as "cost of the service" is a judgment call, not a fact, which makes gross margin slippery to track consistently. Labor margin—total labor cost (everyone's pay, including yours) divided by revenue—is unambiguous, harder to miscategorize, and a more reliable number to run your agency on.
WHAT GROSS PROFIT MARGIN ACTUALLY MEASURES
Gross profit margin is:
(Revenue − Cost of Goods Sold) ÷ Revenue
In a business that sells a physical product, COGS is clean: materials, direct manufacturing labor, shipping. Subtract that from revenue, and what's left is gross profit—what's available to cover everything else (rent, marketing, admin, owner pay) before you get to net profit.
The concept came from retail and manufacturing, where "the direct cost of making the thing you sold" is a natural, obvious category.
WHY THIS BREAKS DOWN FOR A SERVICE BUSINESS
An agency doesn't sell a manufactured product—it sells people's time and expertise. So what exactly is "the cost of the service"? Different bookkeepers, and even the same bookkeeper in different years, answer this differently:
Some categorize only direct contractor and production costs as "cost of services" and leave all salaried staff in operating expenses.
Others include the fully-loaded cost of anyone who touches billable client work—project managers, designers, strategists—as cost of services, and leave only true overhead (rent, software, ops/admin staff) as operating expenses.
Both are defensible bookkeeping choices. Neither is "correct" in any universal sense. Which means your gross margin number is really a statement about how your books are categorized, not a stable fact about your business.
A quick illustration. Imagine an agency doing $1,000,000 in revenue. If only direct contractor and production costs ($250,000) are categorized as COGS, gross margin comes out to 75%—looks fantastic. If a different bookkeeper instead includes the fully-loaded cost of everyone touching client work ($500,000) as COGS, the same business shows a 50% gross margin. Same agency, same year, same $1,000,000 in revenue—two very different "correct" numbers, depending entirely on a categorization choice nobody flagged as a decision.
WHAT LABOR MARGIN MEASURES INSTEAD
Labor margin (sometimes called labor cost ratio) is:
Total labor cost ÷ Revenue
"Total labor cost" means everyone: salaried staff, hourly staff, contractors, and your own pay. There's no judgment call about what counts as "cost of service" versus "overhead"—it's simply what the business spent on people, divided by what it brought in.
Using the same illustration: that $1,000,000 agency with $600,000 in total people costs (across every category, including the founder) has a 60% labor margin—one number, calculated the same way regardless of who's doing the bookkeeping or how the chart of accounts is set up.
WHY LABOR MARGIN IS THE BETTER NUMBER FOR AN AGENCY
It's a people business, so the people cost is the business. For a company that sells time and expertise, labor isn't one input among many—it's the primary cost driver, full stop. Tracking it directly is more relevant than tracking a "cost of goods" concept borrowed from businesses that make things.
It's consistent over time. Because labor margin doesn't depend on categorization choices, you can compare this year to last year, or one client engagement to another, without wondering whether the comparison is actually apples-to-apples or just an artifact of how something got coded in QuickBooks Online or FreshBooks.
It's directly actionable. "Improve gross margin" is vague—does that mean renegotiate contractor rates, reclassify some salaries, or something else? "Get labor margin from 68% to under 60%" points straight at the actual levers: pricing, headcount, capacity, and how much you're paying yourself. This is why it's the number we track most closely with Le Chéile clients, with a 60% ceiling as the target—see What's a Good Profit Margin (and Labor Cost Ratio) for how that benchmark plays out against net profit margin.
It closes the loophole gross margin leaves open. A founder who isn't taking a real salary can make gross margin look healthier than the business actually is, simply because their own labor cost is understated or missing. Labor margin, done correctly, always includes owner pay—see Founder Pay 101 for why that's non-negotiable.
SO SHOULD YOU IGNORE GROSS MARGIN ENTIRELY?
Not necessarily—it can still be a useful lens if your bookkeeping is consistent about what counts as cost of services, and you're tracking your own trend over time rather than benchmarking against another agency's number. But if you only have room to watch one percentage closely, make it labor margin. It's the number that's hardest to accidentally distort, and the one that maps most directly to decisions you can actually make this month.
FAQ
Is labor margin the same as labor cost ratio? Yes—same calculation (total labor cost ÷ revenue), different name for the same metric.
What's a healthy labor margin for a creative agency? Keep it under 60% of revenue, including owner pay. Above that, profit margin gets squeezed regardless of how strong your pricing looks on paper.
Why do two agencies with the same revenue show different gross margins? Almost always a categorization difference in how each business classifies "cost of services" versus "operating expenses"—not necessarily a real difference in profitability.
Does labor margin include contractors and my own pay, or just employees? All of it. Contractors, employees, and owner pay all belong in the labor margin calculation— leaving any of them out understates your real labor cost.
Building a forecasting tool that tracks the numbers that actually predict trouble—not just the ones your accounting software defaults to—is core to every Le Chéile engagement.
About the Author Meredith Fennessy Witts
Founder & Strategic Growth Advisor at Le Chéile and Co-Host of
With a background in financial and operational consulting and a successful track record of founding and scaling her own agency, Meredith brings deep expertise in strategic growth for indie creative and digital agencies.
Her company, Le Chéile, helps agencies scaling toward and beyond 5M+ in revenue to rightsize teams and payroll, increase founder pay, scale offers and packages and more. She helps clients to achieve their goals while clarifying their business strategy and finances.
She is a trusted authority on building mindful, profitable businesses—especially for underserved founders in the women, LGBTQ+, and BIPOC communities.
Beyond Le Chéile, Meredith co-hosts , a podcast for creative agency founders, and its companion . She also runs , a community for fractionals and consultants in the agency space.
View full bio and connect with her on or listen to her podcast, .