AN INCREASING AMOUNT is being written and reported about law firm profitability. Profitability information is different from more traditional financial statistics: It is not just hours worked, or billed amounts, or fee receipts or available cash. Profitability information subtracts from revenue the expense related to generating the revenue in order to calculate net income, or profit. Most of the written materials focus on defining profitability, explaining how profitability is calculated or suggesting ways to report profitability information. All of this is helpful to those of us who strive to apply profitability concepts to make our law firms more profitable. However, I’ve found few written materials that describe what firms actually do with profitability information—especially how the information is applied to make key decisions. This column identifies a number of the possible uses of profitability information. As an owner of a private law firm—whether partner, shareholder or solo practitioner—why would you care about profitability as one more financial yardstick by which to measure the performance of your firm? Noted below are some questions to which I would seek answers if I wished to know where and how my firm was profitable.
WAYS TO APPLY PROFITABILITY INFORMATION
For your overall financial reporting, do you have a standard index or metric, such as profit margin, by which you measure profitability in your law firm? Do most of your partners know that index well enough to recognize when the current year’s performance is better or worse without looking at any benchmark report? The following sections, from budgeting and profit analysis to partner profitability, illustrate more specific applications of profitability information to key decisions you face regularly.
Budgeting and profit analysis.
When you are developing your annual budget, do you know what the target profit or profit margin is for each of your timekeepers, and have you determined if that profit is adequate compared to the benchmarks you use? Moreover, if the profit is inadequate, what is preferable and what variables would you change with the timekeeper to revise the budget to be preferable? If you have calculated a break-even rate for each partner, associate and paralegal, this can be very helpful information when you are deciding the hourly billing rate for each and, for example, when you are deciding to accept work at a discounted billing rate.
When the new fiscal year begins, do you compare your actual profitability performance to the budgeted performance every month to understand how well your assumptions are being realized? If you are tracking the actual-to-budget variance and are able to explain it for each timekeeper, you might also, in the process, be refining and improving the accuracy of your assumptions, so each subsequent year’s forecasts become more accurate.
Do you know if any of your timekeepers are planned to be unprofitable? (Not deliberately, of course.) Most managing partners would be surprised to know how often the budget revenue and cost for a given attorney would result in a loss when analyzed through a profitability calculation. If you have tracked profitability information, you know this is not an unusual revelation. For your timekeepers who are the most profitable, do you know what factors make them more profitable than other timekeepers? Also, have they always been the most profitable, or are trends over recent years affecting the relative profitability of individual timekeepers in your firm?
Alternative fee arrangements.
When considering the profit that would result from your proposed alternative fee arrangements, do you also know how far you can reduce your fee during negotiations and still make an acceptable profit? This is essential to understanding the risk versus reward of the engagement. When marketing your services, do you calculate what it costs your law firm to provide the legal service you are selling so you know if you would make any profit, or enough profit, for the related risk and effort?
Hiring and salary decisions.
When you hire a new associate, do you use your profitability information to understand whether the combination of salary, fringe benefits and overhead is too high? Many hiring decisions are based on market salaries with little regard to whether the firm would make a profit at a given salary. What is a reasonable profit margin for your different levels of attorneys and paralegals? Although these are important considerations for hiring an associate, they are even more essential for hiring a lateral. Do you incorporate expected profit (first year, second year, etc.) into the negotiation with a lateral attorney? When you decide salary increases or bonuses for associates, does your decision include an understanding of the effect it will have on that associate’s profit contribution to your firm? Finally, more experienced associates tend to be more profitable. If this is true in your firm, do you incorporate that knowledge into your hiring and promotion decisions?
Do you measure your individual clients’ profitability? If so, have you decided on a “preferred” profitability value, such as a certain profit margin percent? If you are measuring profitability by client, you know that some clients create a net cost and your firm loses money every time an hour is worked for those clients. Analyzing the unprofitable clients can guide you to determine what changes are needed for those clients to become adequately profitable to your law firm. Would you like to know how much more profitable your law firm would be if you eliminated the losses from unprofitable clients? In your monthly review of pre-bills, when you approve a write-down on a client invoice, do you have at your fingertips the data to determine the resulting net profit or loss?
Originating partner profitability.
Do you know the profitability of the group of clients that is originated by each of your partners? The profitability information can help you to understand why some partners originate more profitable clients than other partners. With this information you could identify possible improvements to increase the other originating partners’ profitability.
Practice area profitability.
Practice areas almost always vary in profitability. Com-paring your practice areas by their relative profit might lead to decisions to make changes that impact that relative profitability, or to emphasize or de-emphasize certain practice areas.
At the end of every year, your firm likely distributes all or most of the net income that is produced during the year. Profitability information can help you understand the net effect from each partner—which partners contributed more, or less, than they were paid as compensation. While this information can create controversy if improperly used, when applied appropriately it can provide insight into which partners are producing a more beneficial financial effect on your firm. This can guide a number of management decisions.
Your methods for reporting profitability information are the foundation for applying the information. The availability of timely and pertinent information can greatly affect your ability to make truly informed decisions. If you are responsible for overseeing the reporting of profitability information, does your financial software generate that information automatically and quickly? Time-consuming processes to generate profitability information often have a detrimental effect on a firm’s willingness and readiness to regularly use that information for decisions.
If you do not yet have the data and programs to produce profitability information, there is some urgency. If you begin today to capture the data and develop a methodology for regularly calculating and reporting your firm’s profitability, it may take you a few years to produce results that partners sufficiently understand and trust. Trust is essential if you desire that partners support decisions based on the information. Collecting the needed data, defining an accepted method for calculating and reporting profitability information and developing partner trust in the assumptions and ultimately the related analyses and conclusions are parts of a long process. This seldom happens quickly. It is time to get started.
Profitability information can provide answers to many of the preceding questions that would enable you to measure profitability. It can also reveal underlying factors that drive profitability improvement and identify opportunities to increase your net income per partner. I hope the questions effectively illustrate a number of the opportunities available to apply profitability information in your law firm.
I’ll end by noting that if this discussion bored you because your answers were “yes” to each question I raised, I urge you to write about the ways you apply profitability information to make decisions in your law firm. It would help all of us become more effective.