Calculating Profitability

James D. Cotterman, a member of this newsletter's Board of Editors, is a principal of Altman Weil, Inc., a legal management consultancy headquartered in suburban Philadelphia. Contact Cotterman at 407-381-2426 or e-mail [email protected]. Copyright ' 2011, Altman Weil, Inc., Newtown Square, PA, USA.

All $1 million practices are worth the same. Would you accept this statement? Many compensation decisions operate with this simple convention. Client acceptance and pricing of legal services often begin with this premise. Yet, we all understand that this is a simplification of reality.

Why simplify something as important as understanding where and how you make your living? Several reasons come to mind. For new law firms, such simplicity is generally rooted in a shared philosophy and similar practices/clients. For these firms, the economics and operating style of one practice versus another (within each firm) are not significant enough to warrant closer examination. Another reason is the collegial nature of law firm partnerships. Scrutiny of each practice and client can be a divisive issue. In addition, law firm partners are not generally well schooled in finance and accounting, so delving into cost allocations is outside their comfort zone. Finally, for many years the accounting systems and personnel in law firms were not robust and experienced enough to undertake this analysis.

Much changes with the passage of time. New law firms mature. Individual practices travel different paths, resulting many years later in having quite different economics. Law firms grow (lateral growth has accelerated this aspect), adding new partners, practices and clients. Each addition adds to and blends into the law firm. How well these additions fit together over time are important strategic, cultural and financial considerations. And, of course, the recent recession has increased competition among lawyers and caused clients to be more aggressive in seeking discounts and/or alternate pricing methods. Now the profession has sophisticated financial tools and expert financial staffs to analyze performance.

Understanding profitability will affect law firms in many ways. It will affect hiring and retention of personnel, and the selection and retention of clients. It will affect promotion and compensation decisions. It will affect engagement pricing. It will affect how legal services are delivered, likely becoming as important a consideration as quality and speed of service.

Getting Started

If you are just getting started in profitability analysis, then I recommend that you begin with the simplest tools first. It is better to have something that aids decision making than to struggle with too much detail. Refinement and complexity can be added to the analysis with experience. This simple approach uses overall firm overhead with no sub-allocations of expenses. Some assumptions are used which will aid the reader in applying this method in his/her own firm. The assumptions are:

1. A single-office law firm partnership with a collection of practices that are reasonably similar in their economic models.
2. Partners and associates use/share resources (offices, secretaries, technology and the like) without any significant distinction from group to group. This means that office sizes are very similar, secretarial sharing is equal across groups and that all timekeepers use a similar technology package.
3. Paralegal use/sharing of resources is about one-half that of lawyers. Thus, each lawyer will be counted as one fee-earner, and each paralegal will be counted as a one-half fee-earner. This convention is commonly found in most economic surveys of the profession.
4. Expenses include the net effect of cost advances and recoveries on behalf of clients.
5. Compensation deductions from total expenses for determining firm overhead define compensation as salary, bonus, benefits and associated payroll taxes.

Accordingly, we can take the total expenses of the law firm and subtract the compensation costs of the associates and paralegals. The remaining expenses represent the overhead of the firm. Divide this remainder by the total full-time-equivalent (“FTE”) fee-earners to determine the overhead per fee-earner.

Once overhead is sorted out, we can turn to compensation. Here, there are three assumptions for this exercise:

1. We are looking for internal hourly rates for each group of individuals ' partners, associates and paralegals ' so average compensation for each group is used.
2. Compensation for development of internal hourly rates includes only salary, benefits and the associated payroll taxes. Including bonuses (with their associated benefit and payroll tax costs) is an option depending on your firm's particular philosophy on bonuses. A bonus that is paid only when expected contributions are exceeded is properly excluded. If your firm pays a bonus for performance at or below expectations (profit sharing ' not the 401(k) type, or simply a deferred salary or holdback) then at least that aspect of the bonus is rightly included in this analysis. Keep it simple and go with all or no bonuses ' remember we are aiming for simplicity.
3. A partner's compensation consists of a fair exchange for his/her labor (the portion we need) and the profits earned on the work done by others. There may also be a return-on-capital component depending on whether interest is paid on partner capital or not. Again, for simplification, we will use the partners' draw as a proxy for the fair exchange portion we are interested in for our purposes. Other proxies could be substituted, such as extending the lock-step associate pay scale into the partner ranks or using an outside reference point such as a senior in-house lawyer.

So we now have the total average cost of the group to include allocated overhead and compensation before bonuses. Divide the total average cost by the expected billable hours to obtain a preliminary internal hourly rate. Divide that rate by the expected realization factor for the group to obtain a required internal hourly rate. A sample calculation is set forth in Table 1.

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The sample tells the user that for the firm to make money, it requires an average associate billing rate of $171 per hour in order to yield sufficient fee collections on associate time to cover their costs. Obviously, a law firm employs associates to make a profit, not merely to cover costs. At the same time, most associates expect to earn a bonus each year. This calculation in Table 2 illustrates how the firm moves from an internal rate to a market rate that provides for both associate bonuses and firm profits.

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The underlying data for the sample calculations are averages from publicly available surveys. To prove the analysis, we compared the calculated target billing rates to the survey data for standard billing rates. They matched.

This simple approach can be refined in a number of ways, while preserving much of its simplicity. The first is to weight the allocation of general overhead differently. Some firms may decide that partners absorb a greater proportion of the overhead than associates do. In this instance a partner may be assigned a fee-earner equivalency of say 1.25, with associates and paralegals remaining at 1.0 and .5 respectively. The variations on this theme are vast. What is important is a sense that the allocation reasonably reflects reality.

It may be appropriate to briefly state that it is possible to devise a cost accounting system so detailed as to take any activity and assign it to multiple cost centers ' each of the aforementioned sub-groups. The account numbering schematic for such a system would be quite complex, as would the coding and verification tasks. We will forgo the obvious political challenges involved in selling such a complex system. Therefore, while precision is a possibility, it is largely not a practical approach.

The next refinement is to sub-divide the very broad groupings of partners, associates and paralegals by practice area. General overhead would remain the same. However, compensation levels and billable hour expectations would likely vary, affecting the internal and expected market rates. Another refinement could be to divide the associates by class or class groupings (first and second years, third and fourth years and so on). Each of these refinements yields more tailored information. Finally, it is possible to create an internal rate calculation for each timekeeper. In such cases, the compensation and billable hour expectations are unique to a single person, while the allocated overhead is the common number shared by all.

Allocating Costs

Once the cost rates are settled, one can move on to allocating costs. This requires applying the appropriate cost rates to each timekeeper and allowing the financial system to attach costs to each individual timekeeper, class, timekeeper status, task, matter, matter type, client, client industry, practice area, department and office. The cost rates will follow the recorded hours based on the coding profiles established when a matter is opened and when time is recorded.

If your timekeepers are disciplined time recorders, it is possible to learn much about how legal services are delivered ' from leverage employed, to costs incurred, to timing of tasks, to variability of results. This information (accurate hourly histories and reasoned cost data) can help you to price non-hourly projects.

In some firms, the timekeepers do not record time well or perhaps not at all. In these instances, it may be necessary to allocate costs to an assigned practice area, office or billing lawyer, depending on how your firm is organized. Thus, cost rates on an hourly basis are not used. The ability to look at client and matter profitability is lost, but overall portfolios, practice areas and office data may still be relevant.

Profitability can then be determined by comparing the fee receipts to the costs assigned under each tracking category ' timekeeper, class, matter, client, practice area and the like. I have avoided getting into accounting technicalities, but here it is important to discuss cash and accrual basis accounting. Law firms primarily operate as cash businesses. Revenues are reported as cash is collected, and expenses are recognized as cash is disbursed. (Let us set aside for the moment fixed assets and depreciation, client costs that are supposed to be capitalized, bank borrowings, debt repayment, capital contributions, the return of capital, the year-end pension accrual that is paid in the following year and other minor distortions of pure cash basis accounting.)

Four Important Factors

This very simple approach to examining profitability does not isolate four important factors that affect how well your firm is operating. The first is the propensity to discount price. It is the most commonly requested pricing adjustment asked for by clients. The second is the efficiency at delivering services. Much discussion is underway in the profession about legal project management and the write-downs that occur before billing and the write-offs of accounts receivable after billing. The third is how long it takes to bill a client. The fourth is how long it takes the client to pay. Because of this, critical information may be overlooked or misunderstood.

A better method incorporates these factors. Such an analysis begins with the standard value of time recorded (standard rates) and shows pricing variances to yield the actual value of time recorded (actual rates). This value flows into unbilled time. Value leaving unbilled time comes from billing adjustments (write-downs) to reflect inefficiencies and billings, which flow into accounts receivable. Accounts receivable is relieved when cash is collected or accounts are written-off. Bill Brennan, one of my partners, and I have collaborated on an illustration of this activity, which is shown in Figure 1.

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The best match of expenses to revenues is the cost data previously developed, compared to time value added, adjusted by reserves for anticipated write-downs of unbilled time and write-offs of accounts receivable. The reserves can be determined based on actual experience of adjustments based on the age of the unbilled time and accounts receivable.

It is important to return to the beginning and remember that these efforts are designed to provide reasoned information upon which better decisions can be reached regarding how the firm prices, manages and delivers legal services. This information is not absolute, nor is it without some distortion. But it does provide a solid foundation.