Measuring Practice Group Profitability

A number of surveys today compare the profitability of one law firm against another. Unfortunately, the reporting is often flawed due to a number of factors, from self-reporting to comparing the profitability of apples to oranges, e.g., comparing a litigation practice firm with a real estate practice firm. While such broad survey reporting may be suspect, that is not to say that measuring your own firm's profitability by practice group should be off the table. If done properly, it can provide important input when deciding where dollars should be invested and where your current operating model can be improved.

With the profitability analysis computer software available today, a firm's profitability can be measured by department, by practice group or even by lawyer. This article focuses on the profitability of practice groups. The software does not do everything, but it can generate relevant data for management planning. The key is to avoid distortions caused by temporary circumstances. Accordingly, any profit analysis by practice group should be done over at least three accounting periods. In addition to leveling out extraordinary factors that might affect a particular year, it highlights important trend lines for each group.

The Starting Point: Revenue

Like any profitability analysis, the starting point for determining practice group profitability is the revenues properly attributable to the group. How much revenue did the group generate during the period in question? This may not be as easy as it sounds, unless the firm has a clear system in place for reporting revenues by area of law. Tracking revenues by client or by client responsible attorney rather than by area of law can be misleading. A particular lawyer, for example, may be a large originator of business that is performed by lawyers in an entirely different practice group, e.g., an originating attorney in the firm's litigation practice group who generates spinoff securities advice handled by the firm's securities group. To do a useful analysis of any group's profitability, it is important that these “spun off” revenues be attributed properly to the securities practice group and not to the litigation practice group of the originating lawyer.

Allocating Expenses By Group

High-grossing practice groups are important for a firm, but perhaps not quite as important as they may appear when looking at just the top line. What if the cost of each dollar of revenue the group generates is significantly more than costs incurred by other groups? This suggests that it is important to analyze not only revenues, but also the firm's expenses and to allocate them appropriately among the various practice groups. Some of the more significant expenses to be taken into account are below.

Revenue Producer Compensation

The major expense of almost any firm is the cost of compensating its non-owner lawyers, i.e., associates and counsel, who contribute significantly to the production of revenues. The cost of these individuals' salaries, bonuses and other compensation generally should be allocated directly to the practice group to which they are assigned. Where a lawyer is assigned to two different practice groups, such as environmental and litigation, a closer look may be necessary to determine how much of the lawyer's salary, bonus and other compensation should be allocated to each practice group.

Staff Compensation

The cost of secretaries, clerks and other staff directly associated with a particular practice group should be allocated to that group alone. If the secretarial ratio in one practice group is 4-to-1, but in another practice group it is 2-to-1, it would be inappropriate simply to allocate all of the firm's secretarial costs across all groups by head count. In addition to direct staff costs, the compensation of firm-wide staff, such as the chief financial officer, the controller, and the managers in human resources and operations, must be allocated as well. Absent special circumstances, a simple head count of revenue producers by practice group should suffice here. Thus, if the total administrative staff compensation is $1 million, and 20% of the revenue producers (by head count) are in the firm's litigation practice group, $200,000 of total firm-wide staff compensation should be allocated to the litigation practice group.

Benefits and Other Staff Costs

Attorney payroll taxes, staff payroll taxes and other benefit costs generally should be attributed to particular staff and therefore should be allocated in the same manner as the compensation costs of those staff employees.

Administrative Expenses

These expenses include things like firm-wide events, staff development and professional services, e.g., payroll services, auditing fees and special taxes, such as personal property taxes. Absent special needs (extra equipment for special projects), these costs should be allocated based upon the number of revenue producers in each practice group.

Depreciation Expense

Again, head count by revenue producer is the best way to go.

Insurance

General liability, employment practices and similar insurance can be allocated in the same way as are administrative expenses. Malpractice coverage, on the other hand, is directly related to the number of practicing attorneys in each practice group and should be allocated accordingly.

Marketing Expenses

Marketing expenses can run the gamut from a firm-wide marketing campaign to a special seminar promotion for one particular practice group, or the retention of an outside consultant for a practice group project. Assuming good record keeping, expenses the firm incurs to market can be allocated by actual usage of the marketing dollars. Thus, while a general advertising campaign would be allocated among all practice groups by the number of revenue producers in the group, targeted marketing campaigns (environmental, white collar crime, etc.) should be allocated appropriately to just the “user” group.

Occupancy Expenses

While not a perfect measure of usage of the firm's offices, allocating occupancy expenses by revenue producer is generally seen as a fair way to account for these costs. While there may be some differences in staffing needs for one particular area or another, e.g., extra file clerks in intellectual property, and therefore literally more square footage required by the group, the differences usually are not so great as to call for a greater allocation of occupancy expenses to that particular group.

Technology Expenses

Does a practice group have any special needs in technology that boost the firm's costs in technology spending? If so, the direct costs of that technology should be allocated specifically to the practice group benefitted by the purchase or lease of the technology. More general technology expenses, such as the firm's general-operating, time-keeping and conflicts-checking systems, will call for a more general allocation by revenue producer.

Office Operating Expenses

This category of expenses includes items such as electricity, cleaning and food services. Like occupancy expenses, these should be allocated by the number of revenue producers in each practice group.

Distributable Income

Subtracting the expenses allocated to a practice group from the revenues generated by that group will produce what is commonly referred to as the distributable income of the practice group. At this point, the data already may highlight differences between practice groups in how much of each dollar of revenue realized by the group makes its way to the bottom line. But the story should not stop there.

Unlike most businesses, a law firm's net profit is a proxy for the compensation paid to its partners. In other words, after taking into account distributions to its partners each year, the law firm should show a zero net profit. Accordingly, to determine the true bottom-line performance of a practice group, it is important that the amount of distributions made to the equity partners in that group be subtracted from the distributable income of the group to determine whether the group is a net contributor to the overall profitability of the firm, is neutral or comes up short on an after-partner distributions basis.

When undertaking this exercise, it may surprise some to learn that a group that on its face appears to be a profitable practice group due to the revenues it generates in fact operates at a “loss” when one measures its overall contribution to what all of the partners of the firm take home. In theory (and in theory only), each of the practice groups would net out to zero after this last step, but almost always some practice groups end up “in the hole,” while others tend to show strong positive results. The question to ask next is why that is the case for a particular group. There often are valid and important reasons for the result; but if not, a closer look at where the firm should invest future growth dollars will be in order.

Michael E. Mooney, a member of this newsletter's Board of Editors, is the managing partner of Nutter McClennen & Fish, LLP, in Boston. His firm maintains an active tax and business practice, representing and advising domestic and international corporations on a broad range of tax issues, reorganizations, business combinations and divestitures. He can be reached at [email protected].

A number of surveys today compare the profitability of one law firm against another. Unfortunately, the reporting is often flawed due to a number of factors, from self-reporting to comparing the profitability of apples to oranges, e.g., comparing a litigation practice firm with a real estate practice firm. While such broad survey reporting may be suspect, that is not to say that measuring your own firm's profitability by practice group should be off the table. If done properly, it can provide important input when deciding where dollars should be invested and where your current operating model can be improved.

With the profitability analysis computer software available today, a firm's profitability can be measured by department, by practice group or even by lawyer. This article focuses on the profitability of practice groups. The software does not do everything, but it can generate relevant data for management planning. The key is to avoid distortions caused by temporary circumstances. Accordingly, any profit analysis by practice group should be done over at least three accounting periods. In addition to leveling out extraordinary factors that might affect a particular year, it highlights important trend lines for each group.

The Starting Point: Revenue

Like any profitability analysis, the starting point for determining practice group profitability is the revenues properly attributable to the group. How much revenue did the group generate during the period in question? This may not be as easy as it sounds, unless the firm has a clear system in place for reporting revenues by area of law. Tracking revenues by client or by client responsible attorney rather than by area of law can be misleading. A particular lawyer, for example, may be a large originator of business that is performed by lawyers in an entirely different practice group, e.g., an originating attorney in the firm's litigation practice group who generates spinoff securities advice handled by the firm's securities group. To do a useful analysis of any group's profitability, it is important that these “spun off” revenues be attributed properly to the securities practice group and not to the litigation practice group of the originating lawyer.

Allocating Expenses By Group

High-grossing practice groups are important for a firm, but perhaps not quite as important as they may appear when looking at just the top line. What if the cost of each dollar of revenue the group generates is significantly more than costs incurred by other groups? This suggests that it is important to analyze not only revenues, but also the firm's expenses and to allocate them appropriately among the various practice groups. Some of the more significant expenses to be taken into account are below.

Revenue Producer Compensation

The major expense of almost any firm is the cost of compensating its non-owner lawyers, i.e., associates and counsel, who contribute significantly to the production of revenues. The cost of these individuals' salaries, bonuses and other compensation generally should be allocated directly to the practice group to which they are assigned. Where a lawyer is assigned to two different practice groups, such as environmental and litigation, a closer look may be necessary to determine how much of the lawyer's salary, bonus and other compensation should be allocated to each practice group.

Staff Compensation

The cost of secretaries, clerks and other staff directly associated with a particular practice group should be allocated to that group alone. If the secretarial ratio in one practice group is 4-to-1, but in another practice group it is 2-to-1, it would be inappropriate simply to allocate all of the firm's secretarial costs across all groups by head count. In addition to direct staff costs, the compensation of firm-wide staff, such as the chief financial officer, the controller, and the managers in human resources and operations, must be allocated as well. Absent special circumstances, a simple head count of revenue producers by practice group should suffice here. Thus, if the total administrative staff compensation is $1 million, and 20% of the revenue producers (by head count) are in the firm's litigation practice group, $200,000 of total firm-wide staff compensation should be allocated to the litigation practice group.

Benefits and Other Staff Costs

Attorney payroll taxes, staff payroll taxes and other benefit costs generally should be attributed to particular staff and therefore should be allocated in the same manner as the compensation costs of those staff employees.

Administrative Expenses

These expenses include things like firm-wide events, staff development and professional services, e.g., payroll services, auditing fees and special taxes, such as personal property taxes. Absent special needs (extra equipment for special projects), these costs should be allocated based upon the number of revenue producers in each practice group.

Depreciation Expense

Again, head count by revenue producer is the best way to go.

Insurance

General liability, employment practices and similar insurance can be allocated in the same way as are administrative expenses. Malpractice coverage, on the other hand, is directly related to the number of practicing attorneys in each practice group and should be allocated accordingly.

Marketing Expenses

Marketing expenses can run the gamut from a firm-wide marketing campaign to a special seminar promotion for one particular practice group, or the retention of an outside consultant for a practice group project. Assuming good record keeping, expenses the firm incurs to market can be allocated by actual usage of the marketing dollars. Thus, while a general advertising campaign would be allocated among all practice groups by the number of revenue producers in the group, targeted marketing campaigns (environmental, white collar crime, etc.) should be allocated appropriately to just the “user” group.

Occupancy Expenses

While not a perfect measure of usage of the firm's offices, allocating occupancy expenses by revenue producer is generally seen as a fair way to account for these costs. While there may be some differences in staffing needs for one particular area or another, e.g., extra file clerks in intellectual property, and therefore literally more square footage required by the group, the differences usually are not so great as to call for a greater allocation of occupancy expenses to that particular group.

Technology Expenses

Does a practice group have any special needs in technology that boost the firm's costs in technology spending? If so, the direct costs of that technology should be allocated specifically to the practice group benefitted by the purchase or lease of the technology. More general technology expenses, such as the firm's general-operating, time-keeping and conflicts-checking systems, will call for a more general allocation by revenue producer.

Office Operating Expenses

This category of expenses includes items such as electricity, cleaning and food services. Like occupancy expenses, these should be allocated by the number of revenue producers in each practice group.

Distributable Income

Subtracting the expenses allocated to a practice group from the revenues generated by that group will produce what is commonly referred to as the distributable income of the practice group. At this point, the data already may highlight differences between practice groups in how much of each dollar of revenue realized by the group makes its way to the bottom line. But the story should not stop there.

Unlike most businesses, a law firm's net profit is a proxy for the compensation paid to its partners. In other words, after taking into account distributions to its partners each year, the law firm should show a zero net profit. Accordingly, to determine the true bottom-line performance of a practice group, it is important that the amount of distributions made to the equity partners in that group be subtracted from the distributable income of the group to determine whether the group is a net contributor to the overall profitability of the firm, is neutral or comes up short on an after-partner distributions basis.

When undertaking this exercise, it may surprise some to learn that a group that on its face appears to be a profitable practice group due to the revenues it generates in fact operates at a “loss” when one measures its overall contribution to what all of the partners of the firm take home. In theory (and in theory only), each of the practice groups would net out to zero after this last step, but almost always some practice groups end up “in the hole,” while others tend to show strong positive results. The question to ask next is why that is the case for a particular group. There often are valid and important reasons for the result; but if not, a closer look at where the firm should invest future growth dollars will be in order.

Michael E. Mooney, a member of this newsletter's Board of Editors, is the managing partner of Nutter McClennen & Fish, LLP, in Boston. His firm maintains an active tax and business practice, representing and advising domestic and international corporations on a broad range of tax issues, reorganizations, business combinations and divestitures. He can be reached at [email protected].