How is Law Firm Profitability Measured?
PART II - Cost Allocation
In professional services industries, such as legal, the revenue side of the profitability equation is usually easy enough – multiply billable hours for the practice, office, employee etc. by the applicable billable hour rate to determine revenue. This can be measured by fees worked, fees billed, or fees collected [See Part I for more details]. But, how do you allocate costs to a practice, office, or employee to determine if they are profitable?
An important part of calculating profitability is determining how to allocate organizational expenses to fee earners and which expenses to include. Are all costs divided equally by attorney? Should costs vary by location and title? What about marketing costs or secretarial costs – are those divided equally? Many attorneys would say it depends on use of those functions (i.e. “I never use my secretary, my costs should reflect that”, “I draft my own RFP responses and never use the Marketing Team, you shouldn’t increase my cost for them if I don’t use them”). But how do you practically measure that? What about high volume/lower fee practices (e.g. labor and employment) and lower volume/higher fee practices (e.g. employee benefits).
What Expenses Should be Included?
You can start to see the cost side of the equation can get complicated quickly. Just as accounting is both an art and a science, cost allocation is both too (and falls within the accounting/finance function). While many resources exist that describe the intent of a robust cost allocation model and common practices, they typical are tailored towards public companies and rarely towards professional services organizations.
Although firms take different approaches on including or excluding partner compensation, it is commonly recognized that all other expenses should be included in the cost allocation methodology. Since non-partner fee-earner compensation likely accounts for at least 20% of firm expenses, counsel, associate, and paralegal compensation should be included as an expense, otherwise the predictive value of the profitability metrics would be very low.
Should Partner Compensation Be Included as an Expense?
It depends on what the profitability model is attempting to measure and or/predict. If the profitability model is intended to measure excess distributions (distributions to equity partners after all other compensation and expenses have been paid), then it should include ALL expenses (including partner compensation) [Let’s call this Method 1].
On the other hand, if the profitability model is intended to predict the portion of all revenue available for distribution to partners (including their “base” compensation), partner compensation would be left out of the methodology. [Let’s call this Method 2]
Example: Assume two partners have greatly different salaries and revenue credits. What would their profitability look like under Method 1 v. Method 2? Under Method 1, the excess distribution amounts are the same in this example (i.e. $100,000), meaning each partner generated an additional $100,000 of profit above and beyond all firm-wide costs, including their own compensation. However, under Method 2, the remaining revenue available for distribution varies significantly since overhead does not include compensation. The method would not necessarily impact these partners take home compensation, but illustrates the differences in the two cost allocation methods.
How Will the Profitability Information Be Used?
Consider how the profitability information will be used within the firm before making a determination on how to allocate costs.
- Compensation Differences. Because not all partners are compensated equally, determining whether an individual partner’s practice is profitable (i.e. generating revenue to sustain their current compensation), the model either needs to include partner compensation (Model 1 above) or a different profitability target will be needed for each partner. Including partner compensation as an expense is easier to manage, particularly since the information should be actionable by the partnership.
Example: Using our previous example, under Method 1, the Sr. Partner generated $100,000 in profits but it took $1,200,000 in compensation and overhead to earn that $100,000 (which equates to an 8% profit margin). The Jr. Partner generated the same $100,000, but it only took $500,000 in compensation and overhead to earn that amount (which equated to a 17% margin). Even though they earned the same dollar amount, Jr. Partner would have a greater margin percentage. Both partners are profitable since their profit margin is greater than 0%. Under this method, the firm could set a fixed target percentage (e.g. 10% margin) for each partner. Sr. Partner would have fallen short of the target while Jr. Partner would have exceeded the target.
If we look at the exact same scenario but using Method 2 for calculating margin, we can see the margin percentage results are reversed. [Here, margin over 0% indicates that overheads will be covered, but keep in mind partners still need to be compensated.] While Sr. and Jr. Partners generated the same $100,000 in profits, since compensation is not included in the calculation, the margin is 85% for Sr. Partner and 67% for Jr. Partner. This means 85% of Sr. Partner’s revenue will be available for the partner compensation pool. However, Sr. Partner needs to generate 83% margin to cover Sr. Partner’s own compensation, while Jr. Partner would only need 60% margin to cover Jr. Partner’s compensation. Since Jr. Partner exceeds the target by more than Sr. Partner, Jr. Partner’s practice could be deemed relatively more profitable. These extra steps typically make Method 1 a simpler cost allocation methodology.
- Reporting. So long as there is a common understanding of what constitutes acceptable profitability, the method chosen may matter less from a reporting perspective. The profitability threshold (described above – either 0% for Method 1 or variable for Method 2) should be explained and communicated to the reporting audience, especially if it changes periodically.
Example: Under Method 2, if partner compensation accounts for 50% of all firm expenses, a profit margin of 50% is necessary to achieve the desired partner compensation pool. The next year, the threshold may be higher or lower than 50%.
- Engagement Pricing. A third, and equally critical, use of cost and profitability information is engagement pricing. Most medium and large firms now have a pricing team and this information is invaluable in determining how aggressively a firm can pursue business development opportunities (hourly or alternative fee). These metrics can also be used to determine how much risk the organization is incurring on prospective matters – and how much estimates of effort can be wrong before the firm starts to lose money on the engagement. Many pricing teams develop sophisticated models with these metrics to help their partners fully understand the opportunities and risks in each business development opportunity. Including partner compensation in the cost allocation methodology (Method 1) improves the accuracy of these models.
- Promises Made. One final reason to consider including partner compensation in the methodology is that most partners consider the amount they are told that they will make in a given calendar year to be akin to a promise. If a firm cannot keep their promises to their partners, the partners will leave the firm. Pricing tools and reporting metrics that increase the likelihood of the firm collecting the revenue necessary to keep these promises is good for the firm’s long-term success.
How Should Expenses be Allocated Per Fee Earner?
After the partner compensation question is answered, the next question is how will other expenses be allocated to each fee earner? The simplest approach would be to take all remaining overhead and just divide by the number of fee earners and allocate a fixed dollar to each fee earner. While this works mathematically, it does not work practically. A junior associate who makes $100,000 and a senior partner who makes $1,000,000 would each be allocated the same fixed amount – resulting in the junior associate always being extremely unprofitable and the senior partner (hopefully) being wildly profitable.
Taking this basic idea a step further leads to some methods that are more practical and continue to be employed by a number of smaller firms. Firms can allocate a fixed overhead amount based on title, or instead, a fixed percentage based on base salary (e.g. all fee earner are allocated 40% times their base salary as overhead). Now, the junior associate is most likely allocated a much smaller amount than the senior partner. While these methods are a good starting point for a firm just starting a cost allocation model, most bigger firms are moving to a more complex approach with each fee earner allocated a different amount based on their individual characteristics (e.g. office, department, business development expenses).
Grouping Expenses to Allocate
In developing a robust cost allocation model, a common approach is to group expenses into a handful of categories that then get allocated to each fee earner.
- Individual Expenses. One easy category to start with is expenses that can be easily attributed back to individual fee earners. This category would include compensation (which we discussed above) but also benefits, employer-paid taxes, bar dues, some other business development expenses, and anything else easily tracked back to the individual fee-earner.
- Location Expenses. This category would include things like building rent, local office staff, secretaries, and many other expenses tracked back to the location.
- Firm-wide Expenses. This could include expenses from firm-wide departments like IT, HR, Marketing, and Accounting. Firm-wide expenses could also include a share of costs from fee earners with firm management responsibilities, like the chair of the firm or its management committee.
- Other. Other categories could include expenses that would be allocated only to lawyers, partners, or paralegals each. For example, a partner retreat could be allocated to just partners.
Fixed v. Variable Costs
An alternative approach is to fully allocate variable costs (direct costs) that are attributable to a fee earner (compensation, computer, portion of a secretary, etc.) and pool fixed (indirect) costs into a separate category. Once the categories are created, the next step would be to decide how to weight allocation to partners, counsel, associates, and paralegals. A common practice is to allocate a higher amount of some categories to partner, a smaller amount to associates and counsel, and the smallest amount to paralegals. Ultimately, all expenses need to be allocated across all of the fee earners, although it is common to exclude fee earners with hours below some threshold.
Example: An easy way to visualize this weighting is through office space. Partners frequently have the largest offices, paralegals the smallest, and associates / counsel somewhere in the middle. It is reasonable to allocate rent on a scale that reflects those differences.
How Frequently Should the Model be Updated?
In order to keep the information accurate and actionable, a monthly calculation frequency right after month-end is logical, particularly if the process is automated. Some of the major accounting systems include profitability modules that will provide this functionality. For those that choose to write their own methodology or do not have an accounting system with that functionality, monthly is ideal, but quarterly or annually is better than nothing.
Should Cost Allocation be based on Historical or Future Costs?
With respect to looking backwards and including costs on a trailing 12-month basis or projecting costs going forward, it is likely easier and more accurate to use the trailing 12-month methodology with a monthly adjustment that accounts for expected inflation. The inflation adjustment is lowered each month as a greater percentage of the allocated costs are based upon the current year. A system that allows specific general ledger accounts to be adjusted for known changes (e.g., adjustment to rent) is even better. Compensation is ideally always based upon the current year amounts.