Measurable Results Through Profit Centers

Profit center accounting takes this information to the next level, however, by helping firm managers address a key question: how much is each practice area, department, office, or individual attorney actually contributing to the partners' profits?

Focus on Contribution Margin

Unlike a traditional income statement, the analysis of a selected group or individual as a profit center focuses on determining contribution margin (CM). The profit center's CM is measured both in whole dollars and as a percentage of revenue (fees).

Table 1 illustrates the first type of profit center analysis, in a firm with financial reporting for each of five major practice areas or departments.

Table 1. Profit Center Contribution Margin ($ 000s)

Revenue is captured and reported as fees collected by each department. Compensation and benefit costs for all direct personnel (attorneys, paralegals, legal secretaries, etc.) are allocated to their respective departments. All direct costs associated with a department ' marketing costs, attorney expense reimbursements, CLE, travel, etc. ' are also allocated to that department. Revenue less the costs of departmental personnel and direct expenses determines the contribution margin.

Only expenses that a department or other profit center can control are included in determining its CM. The CM does not include general firm overhead costs for receptionists, internal finance personnel, administration, rent, liability insurance, etc.; managing those expenses effectively should be the responsibility of the firm's administration.

CM Analysis of Profitability

Contribution margin analysis measures profitability better than billed realization and billable hour data alone. In part this is because proper deployment of personnel resources and effective client engagement management are critical components of most firms' strategic plans, and the results of such efforts are often more evident from CM analysis than from traditional time and billing statistics. Let's compare two departments (see Table 2 below). Which of the two departments is more profitable?

We note, at first glance, that both departments are generating similar billed dollars. While it cannot command Department 1's higher billing rates, Department 2 makes up for it by having more billable hours and a 10% higher billed realization rate. (The example assumes all billed dollars are collected.)

What these time and billing facts don't consider, however, is that Department 1 better utilizes paralegals and associates, and works hard at managing its payroll costs. These efforts pay off by generating more profit for the firm, as measured in lines G and H.

Profit center accounting also effectively measures a variety of other practice management initiatives and performance-improvement efforts. A department's strategic plan may call for increasing marketing costs, hiring an associate with specialized skills, or introducing new billing methods. Improving staff utilization may be the performance goal for one department, while another department seeks to improve its personnel leverage with the next hire. No matter what the strategic thrust, profit center CM analysis captures the financial impact of these changes. One report cuts to the bottom-line.

Table 2. Profit Center Contribution Margin as Percent of Revenue

Employing Analyses with Discretion

Firms that measure profit centers use and distribute this information carefully. Usually the analysis is made accessible only to the firm's senior management. Why? Often firms find that the information is very telling about a particular practice unit.

Also, sharing this information on a broad basis may change the current culture. Human nature is to change one's behavior to meet the manner in which one is being measured. This can produce unintended and undesirable results.

For example, many law firms promote cross-utilization of staff. Yet even if some departments have associates with 25% available time, other department managers may still want to hire their own associates because they perceive a benefit in how their contribution margins will be calculated. If departments are allowed to over-hire instead of employing underutilized firm resources, partner profits will be reduced unnecessarily.

Should firms eliminate profit centers with lower contribution margins? It depends. In a new practice area with start-up costs, for example, a lower CM is to be expected. Other times, an area may be of great strategic value to the firm even though it itself has a low CM. In such cases the firm can consider the CM shortfall below its standard amount to be a strategic investment.

Experiment with the use of profit centers. Summarize your assumptions and review them at an executive level within your firm. Track the information over a period of time to gain an understanding of the information trends. You may then find that profit center accounting becomes the primary financial analysis tool in your firm.

[Ed. Note: For additional suggestions on developing data and baseline factors for profit center accounting, interpreting results, and allowing for seasonal and other variations, see Chapter 10 in Law Firm Accounting and Financial Management, 3rd ed., 2001, by John P. Quinn, Joseph A. Bailey, Jr. and David E. Gaulin (Law Journal Press, http://www.lawcatalog.com/).]

John T. Wilke, CPA, is a Managing Director in the National Law Firm Consulting Group of American Express Tax and Business Services. Mr. Wilke helps law firms on the East Coast improve their profitability through strategic planning and diagnostic reviews. For additional information on effective use of profit centers.

Profitability pressures are leading firms of all sizes to create and implement strategic plans. These strategic plans often call for expansion and growth of practice areas, growth through lateral hires, or creation of entirely new practice groups. Concurrently, partner compensation methodologies are being revised to hold individual attorneys accountable for their own results.

How can the combined effects of varied strategic moves be effectively measured? And how can individual performance results be merged analytically with strategic moves to assess their combined financial impact on the overall firm?

Readily available financial measures include billable hours worked, billed realization, billable hours collected, hours and dollars of aged work-in-progress, and aged accounts receivable. Time- and billing-related reports based on these measures yield useful information.

Profit center accounting takes this information to the next level, however, by helping firm managers address a key question: how much is each practice area, department, office, or individual attorney actually contributing to the partners' profits?

Focus on Contribution Margin

Unlike a traditional income statement, the analysis of a selected group or individual as a profit center focuses on determining contribution margin (CM). The profit center's CM is measured both in whole dollars and as a percentage of revenue (fees).

Table 1 illustrates the first type of profit center analysis, in a firm with financial reporting for each of five major practice areas or departments.

Table 1. Profit Center Contribution Margin ($ 000s)