How is Law Firm Profitability Measured?
PART I - BACKGROUND
Many readers may think this is easy question – revenue minus expenses. However, in professional services industries, this definition becomes murky quickly when trying to look at profitability beyond firm-wide numbers, such as by practice, office, employee, or client. In other industries, companies are able to compare the cost of making a single widget (raw materials, labor, marketing, etc.) to the revenue generated by selling that widget, and profitability can be easily sliced and diced by location, product, store, etc. However, the second half of the equation becomes trickier when your biggest expense is your personnel.
Due to the complications, lawyers historically bypassed the second half of the equation altogether and simply equated profitability with revenue generation – if you make enough revenue, you should be profitable. Other lawyers equated profitability with realization – if you command your full billable rate (no large discounts or write-offs), you should be profitable. Even those lawyers with a more sophisticated understanding of profitability equated it to the money left over once all the expenses have been paid, but this does not provide much compensation certainty for the equity partners that own the firm or come close to how profitability is measured in more traditional business environments, which is revenue minus expenses, taxes, depreciation, and interest.
Metrics: Margin vs. Contribution
The most common approaches used to measure profitability in law firms are margin and contribution. As indicated above, some lawyers equate revenue or realization to profitability. While they are connected to profitability, they only represent the first part of the equation and do not directly indicate whether a firm, practice, or office is profitable.
Margin is a common profitability metric, often calculated as fees collected (revenue) minus the cost associated with performing the work (expenses). Margin can also be referred to as net income, gross margin, or operating income.
Margin($) = Fees Collected – Cost of Work
A result greater than $0 would indicate a profitable endeavor (or at least mean the expenses included in the calculation are covered). A variant of this margin calculation looks at relative profitability and the result is a percentage – how much profit is generated relative to the total revenue generated.
Margin(%) = ( Fees collected-Cost of work) / (Fees collected)
Typically firms measure revenue on the basis of fees collected (which already incorporates realization levels since it is inclusive of any discounts and write-offs). However, some firms prefer to look at margin on the basis of fees worked or fees billed. All methods have limitations.
- Revenue = Fees Worked or Fees Billed. The margin level using fees worked or fees billed will tend to be higher than that associated with fees collected as they typically do not include write-offs. Since most law firms operate on a cash basis, the ability of margin to predict excess distributions is impaired if calculated with fees worked or fees billed. For example, if you bill a client $10,000, but the client refuses to pay more than $8,000, and you write off the difference, your profit calculation could vary by $2,000 depending on whether you are using fees filled or fees collected as a measure for revenue.
- Revenue = Fees Collected. Calculating with fees collected does have a drawback, though, in that margin will appear negative for longer. This is true because the cost of a matter grows as hours are worked and entered into the time entry system. The matter depicts negative margin until enough collections occur to offset the cost performed to date on the matter. When margin based upon collections is analyzed on a calendar year basis, the most common explanation for negative margin will be uncollected inventory. If you choose this method, you can easily add outstanding inventory to fees collected to get a sense of whether the matter should be profitable. In addition to realization, margin based upon fees collected also incorporates other decisions like how much to leverage non-partners and the impact of write-offs.
Contribution is a less common profitability metric however some firms still use it. Contribution is a way to measure a particular client’s or matter’s contribution to the firm’s target profits per equity partner (PPEP). This can be indexed against a firm’s PPEP target. Firms may use PPEP in this calculation because that is the standard used by the entities that compare law firm profitability, such as The American Lawyer, Citibank, Price Waterhouse and the like. Firms can both project Contribution and generate a number that can be related directly to published profit numbers from peer law firms. Thus, contribution is not only an internal measure, but a means of comparison with other firms. Similar to margin, contribution can be measure based on billings or based on collections. The limitations are similar to those outlined above for margin.
Contribution can be used to compare the relative profitability of matters, practices, offices, or clients. If the overall firm average contribution was 65%, the above matter at a contribution level of 75% would indicate that this matter is above the firm average profitability but still short of the firm’s goal.
Assume the following:
- 100 hours billed
- 120 hours worked
- 20 of those billed by a partner,
- $20,000 billed,
- $19,000 collected,
- Each hour worked costs $100 (or a total of $12,000 in direct and indirect costs for this example)
- Partners are budgeted to bill 1,700 hours per year (average partner hours billed)
- $1,000,000 Target PPEP
- To calculate margin, simply subtract costs from fees collected. Here, the matter yields $7,000 of profit after direct and indirect costs are paid.
Margin($) = Fees Collected ($19,000) – Cost of Work ($12,000) = $7,000
- The margin percentage is a similar calculation but the $7,000 in profits is measured again the relative amount of fees involved.
Margin (%) = [Fees collected ($19,000) - Cost of work($12,000)] / Fees collected ($19,000) = 37%
- To calculate contribution, costs are subtracted from fees collected, and then divided by partner hours billed, which yields a “gross profit” of $450 per partner hour for this engagement. That “gross profit” is then multiplied by the average billable hours per partner to total $733,500, which is 73.4% of the PPEP goal.
Contribution(%) = [Fees collected($19,000) - Cost of work($10,000)] / Partner hours billed (20) x [Av.Billable Hours (1,630)] / Target PPEP ($1,000,000) = 73%
In this example, if every matter in a firm were to yield a “gross profit” of this magnitude and every fee earner reached their budgeted hours, the firm would only reach 73% of their $1,000,000 PPEP goal.
In summary, the contribution metric is intended to show the economic impact of a matter and provide a method to compare the relative profitability of this client relationship to other clients of the firm and also allows attorneys to look for ways to strengthen that performance. However, since margin can provide a similar comparison and is used in more traditional business environments, most law firms are moving to calculate profitability in the same way.