Profitability Analysis: The First Steps

How profitable is your firm? This is typically an easy question to answer. Total up all firm revenues and then subtract all firm costs. The net result is the profits of the firm. Stated another way, it is what the partners of the firm have earned for the period under measure. When you then divide the profits by the number of partners, the average profit per partner has been determined. The basics of law firm partnership accounting 101.

The picture is not as clear, however, when the strategic decision is made to analyze a specific portion of the firm's practice. If your firm has a number of legal departments, how does one determine the profitability (or economic contribution) of each? Delving further into a specific department, how do you measure the profitability of a practice area? At my firm, we have 150 lawyers who have been assigned to six departments. In some of these departments, there are up to seven practice areas.

Profitability also can be measured at both a client and a matter level. Over the years I have been asked by management, who are the firm's most profitable clients? Or, for particularly large matters, how profitable was that case? Some firms have even attempted to analyze profitability by both class of lawyer as well as an individual lawyer. How profitable are the “Counsel” lawyers at your firm? Or how does the profitability compare for all first-year associates versus fifth-year associates? The permutations are endless.

We have also seen firms analyze a select type of business, or area of law, within a practice. For example, if Initial Public Offerings are a part of your business practice, how profitable is this work? And how does the IPO profitability compare with the Compliance work provided for your corporate clients? These are all great questions for which there are no easy answers.

Two Types of Analyses

A word of caution before proceeding further: Profitability analyses can be segregated into two types: 1) the high-level (10,000-foot look) at departmental or office profitability, and 2) the detailed (500-foot look) at client, matter, and lawyer profitability. The former can usually be accomplished with spreadsheet assistance. The latter can be extremely time consuming, and is often better produced with sophisticated software that is available in the marketplace. These software programs, however, are expensive to purchase. They will also require an initial investment of accounting time in developing and building the very detailed information that will be needed to analyze results at such an in-depth level. Therefore, if you are proceeding down the path of profitability analysis, it is important to manage the expectations of firm leadership. The high-level analysis can be accomplished with some work, but it can be done without impacting the operations of your accounting group. The detailed analysis should not be attempted without the aid (and the related costs) of the software programs.

Analysis of Legal Departments

At my firm, we determined that the first substantial foray into profitability would be an analysis of legal departments. As a first step in the analysis, how do we determine the revenue for each department?

When selecting an appropriate method to determine revenue allocation by department, there really is no wrong choice. Your choice will depend on what your financial system currently measures and what your firm is comfortable reporting on. Our first thought in revenue measurement was to consider the accrual method, the billable value of the hours worked. We realized, however, that this method had two drawbacks. The first is that it would not match expenses, which are on the cash basis, to revenue, which of course would be accrual. After reviewing the data in our time and billing system further, we also learned that our accrual results would not be an accurate reflection of revenue, because we do not factor in both the discounts afforded to clients at the time of billing, and the write-offs of AR that result from the billing process. We wanted to measure both revenue and expenses on the cash basis.

After we narrowed our choice to cash-basis accounting, we had to determine the appropriate cash measurement. The first choice was to measure cash receipts by timekeeper, and then summarize all timekeepers within the department. We also track time and receipts at the matter level by the lawyer responsible for the matter (or LFM). Our second choice in revenue measurement was to determine all cash receipts by LFM attorney, and then summarize by department.

In our first draft of each department P&L, we measured revenue by the LFM method and quickly learned that the results did not always reflect the actual contribution of the department. We noted, for example, that one department produced negative results despite the fact that its attorneys' hours were above the firm average. Further review of the attorneys' activities revealed that many of the lawyers were working on matters in which the LFM was in another department. Thus, the economic contribution of the work was benefiting and overstating other departments, while at the same time understating that department's performance. By process of elimination, we were left with cash receipts by timekeeper in terms of revenue recognition.

Assigning Expenses

Assigning expenses to a department can be done in one of two ways: by direct costs, or on an overhead-allocation method. Through years of careful planning and design, our general ledger tracks many costs by department. Salaries for all lawyers, paralegals, and other timekeepers are recorded by department. In addition, salaries for secretaries and other department-specific support, such as docketing clerks and litigation support analysts, are recorded by department. Other costs that are recorded on a departmental basis include travel, marketing, sponsorships, membership dues, meals and outings, seminars, and placement fees (and many others not noted here).

Indirect costs are defined as all costs not charged to a specific department. Rent, general insurance, supplies, computer maintenance, and service department (such as accounting) salaries are just a few of the expenses requiring allocation. For each specific general ledger account that was considered indirect, we allocated the expense across legal departments on either a timekeeper FTE basis or an all-headcount FTE basis, which includes both lawyers and secretaries. As an example, we allocated general insurance on an FTE timekeeper basis. Thus, if one department had 20% of the FTE timekeepers, it would be assigned 20% of the general insurance expense total. Human Resource salaries, which are considered indirect, were allocated on the all-headcount FTE basis. Every expense considered indirect was allocated in one of the two methods.

Finally, partner compensation was the remaining component to be charged to each department. Because the period under measure for our analysis was the most recent fiscal year, we totaled and summarized the actual compensation of each partner by department, and assigned that amount to the department.

When the analysis was completed, we did one final check. We knew that after paying out partner compensation, the bottom-line result should equal zero ' income less expenses equals partner compensation. We then added up the various contributions of each department, which also summed to zero, so we knew that our allocations had been done correctly from a mathematical perspective.

There are some pitfalls anyone should be aware of in analyzing profitability, especially at the department level. How does one treat the time spent by management on firm-related matters? Our managing partner spends about 35% of his time on non-client issues. Shouldn't we spread a portion of his compensation to all other departments? We have a risk management partner in our litigation group who spends about 25% of his time on firm issues. His compensation must also be dealt with. You will face similar issues with other lawyers who devote substantial time to firm work, which would include the hiring partner, training partner, practice development partner, and new business partner.

One must also take a long-term view in analyzing profitability. A one-year snapshot of performance may be misleading. As an example, approximately 3% of our firm hours are devoted to contingent matters, with the majority of the work on these matters handled by litigation. In our current fiscal year, we do not anticipate any of the contingent matters to be resolved, which would result in legal fees for the firm. Next year, we are forecasting substantial firm revenues from contingent matters. While the current year for litigation may not look all that profitable, certainly next year could be a very positive picture. Is it fair then to analyze litigation for just one year? Or any department for that matter? Probably not.

Finally, from our perspective, the current revenue measurement chosen does not consider an important aspect of business generation. What do you do with the business partner who, through a long-term relationship with his client, was able to bring to the firm a substantial real estate deal? Under our method, this scenario would be entirely attributable to real estate, with business deriving no economic benefit. The generation of business across departments is an issue that requires scrutiny.

Using the Results

Once this analysis is completed, what do you do with the results? The best advice is to proceed slowly with your management group in order to fully understand the economic picture that has been presented. At my firm, we discussed the departmental P&L with our Executive Committee and reviewed each legal department's performance and the reasons behind its economic result. In one instance, we learned that a department had revenue issues and was discounting bills too heavily. That same department had the lowest collection realization of any department. Another department, due to the nature of its work, had very high infrastructure and support costs that were required to service its clients. Its pricing models, however, did not reflect these higher costs; so although the hours of the department were above the firm average, the contribution was not.

Conclusion

If handled with care and used as a management tool to increase efficiency and the resulting income, profitability analyses can be an integral tool in improving results.

How profitable is your firm? This is typically an easy question to answer. Total up all firm revenues and then subtract all firm costs. The net result is the profits of the firm. Stated another way, it is what the partners of the firm have earned for the period under measure. When you then divide the profits by the number of partners, the average profit per partner has been determined. The basics of law firm partnership accounting 101.

The picture is not as clear, however, when the strategic decision is made to analyze a specific portion of the firm's practice. If your firm has a number of legal departments, how does one determine the profitability (or economic contribution) of each? Delving further into a specific department, how do you measure the profitability of a practice area? At my firm, we have 150 lawyers who have been assigned to six departments. In some of these departments, there are up to seven practice areas.

Profitability also can be measured at both a client and a matter level. Over the years I have been asked by management, who are the firm's most profitable clients? Or, for particularly large matters, how profitable was that case? Some firms have even attempted to analyze profitability by both class of lawyer as well as an individual lawyer. How profitable are the “Counsel” lawyers at your firm? Or how does the profitability compare for all first-year associates versus fifth-year associates? The permutations are endless.

We have also seen firms analyze a select type of business, or area of law, within a practice. For example, if Initial Public Offerings are a part of your business practice, how profitable is this work? And how does the IPO profitability compare with the Compliance work provided for your corporate clients? These are all great questions for which there are no easy answers.

Two Types of Analyses

A word of caution before proceeding further: Profitability analyses can be segregated into two types: 1) the high-level (10,000-foot look) at departmental or office profitability, and 2) the detailed (500-foot look) at client, matter, and lawyer profitability. The former can usually be accomplished with spreadsheet assistance. The latter can be extremely time consuming, and is often better produced with sophisticated software that is available in the marketplace. These software programs, however, are expensive to purchase. They will also require an initial investment of accounting time in developing and building the very detailed information that will be needed to analyze results at such an in-depth level. Therefore, if you are proceeding down the path of profitability analysis, it is important to manage the expectations of firm leadership. The high-level analysis can be accomplished with some work, but it can be done without impacting the operations of your accounting group. The detailed analysis should not be attempted without the aid (and the related costs) of the software programs.

Analysis of Legal Departments

At my firm, we determined that the first substantial foray into profitability would be an analysis of legal departments. As a first step in the analysis, how do we determine the revenue for each department?

When selecting an appropriate method to determine revenue allocation by department, there really is no wrong choice. Your choice will depend on what your financial system currently measures and what your firm is comfortable reporting on. Our first thought in revenue measurement was to consider the accrual method, the billable value of the hours worked. We realized, however, that this method had two drawbacks. The first is that it would not match expenses, which are on the cash basis, to revenue, which of course would be accrual. After reviewing the data in our time and billing system further, we also learned that our accrual results would not be an accurate reflection of revenue, because we do not factor in both the discounts afforded to clients at the time of billing, and the write-offs of AR that result from the billing process. We wanted to measure both revenue and expenses on the cash basis.

After we narrowed our choice to cash-basis accounting, we had to determine the appropriate cash measurement. The first choice was to measure cash receipts by timekeeper, and then summarize all timekeepers within the department. We also track time and receipts at the matter level by the lawyer responsible for the matter (or LFM). Our second choice in revenue measurement was to determine all cash receipts by LFM attorney, and then summarize by department.

In our first draft of each department P&L, we measured revenue by the LFM method and quickly learned that the results did not always reflect the actual contribution of the department. We noted, for example, that one department produced negative results despite the fact that its attorneys' hours were above the firm average. Further review of the attorneys' activities revealed that many of the lawyers were working on matters in which the LFM was in another department. Thus, the economic contribution of the work was benefiting and overstating other departments, while at the same time understating that department's performance. By process of elimination, we were left with cash receipts by timekeeper in terms of revenue recognition.

Assigning Expenses

Assigning expenses to a department can be done in one of two ways: by direct costs, or on an overhead-allocation method. Through years of careful planning and design, our general ledger tracks many costs by department. Salaries for all lawyers, paralegals, and other timekeepers are recorded by department. In addition, salaries for secretaries and other department-specific support, such as docketing clerks and litigation support analysts, are recorded by department. Other costs that are recorded on a departmental basis include travel, marketing, sponsorships, membership dues, meals and outings, seminars, and placement fees (and many others not noted here).

Indirect costs are defined as all costs not charged to a specific department. Rent, general insurance, supplies, computer maintenance, and service department (such as accounting) salaries are just a few of the expenses requiring allocation. For each specific general ledger account that was considered indirect, we allocated the expense across legal departments on either a timekeeper FTE basis or an all-headcount FTE basis, which includes both lawyers and secretaries. As an example, we allocated general insurance on an FTE timekeeper basis. Thus, if one department had 20% of the FTE timekeepers, it would be assigned 20% of the general insurance expense total. Human Resource salaries, which are considered indirect, were allocated on the all-headcount FTE basis. Every expense considered indirect was allocated in one of the two methods.

Finally, partner compensation was the remaining component to be charged to each department. Because the period under measure for our analysis was the most recent fiscal year, we totaled and summarized the actual compensation of each partner by department, and assigned that amount to the department.

When the analysis was completed, we did one final check. We knew that after paying out partner compensation, the bottom-line result should equal zero ' income less expenses equals partner compensation. We then added up the various contributions of each department, which also summed to zero, so we knew that our allocations had been done correctly from a mathematical perspective.

There are some pitfalls anyone should be aware of in analyzing profitability, especially at the department level. How does one treat the time spent by management on firm-related matters? Our managing partner spends about 35% of his time on non-client issues. Shouldn't we spread a portion of his compensation to all other departments? We have a risk management partner in our litigation group who spends about 25% of his time on firm issues. His compensation must also be dealt with. You will face similar issues with other lawyers who devote substantial time to firm work, which would include the hiring partner, training partner, practice development partner, and new business partner.

One must also take a long-term view in analyzing profitability. A one-year snapshot of performance may be misleading. As an example, approximately 3% of our firm hours are devoted to contingent matters, with the majority of the work on these matters handled by litigation. In our current fiscal year, we do not anticipate any of the contingent matters to be resolved, which would result in legal fees for the firm. Next year, we are forecasting substantial firm revenues from contingent matters. While the current year for litigation may not look all that profitable, certainly next year could be a very positive picture. Is it fair then to analyze litigation for just one year? Or any department for that matter? Probably not.

Finally, from our perspective, the current revenue measurement chosen does not consider an important aspect of business generation. What do you do with the business partner who, through a long-term relationship with his client, was able to bring to the firm a substantial real estate deal? Under our method, this scenario would be entirely attributable to real estate, with business deriving no economic benefit. The generation of business across departments is an issue that requires scrutiny.

Using the Results

Once this analysis is completed, what do you do with the results? The best advice is to proceed slowly with your management group in order to fully understand the economic picture that has been presented. At my firm, we discussed the departmental P&L with our Executive Committee and reviewed each legal department's performance and the reasons behind its economic result. In one instance, we learned that a department had revenue issues and was discounting bills too heavily. That same department had the lowest collection realization of any department. Another department, due to the nature of its work, had very high infrastructure and support costs that were required to service its clients. Its pricing models, however, did not reflect these higher costs; so although the hours of the department were above the firm average, the contribution was not.

Conclusion

If handled with care and used as a management tool to increase efficiency and the resulting income, profitability analyses can be an integral tool in improving results.