By Jay Erdman, CPA, Principal of Rippe & Kingston
What is it?
Over the years, the term ‘Profitability Analysis’ has meant different things to different people. For example, some refer to ‘Billing Realization or Collection Realization’ as the ‘metric’ for measuring Profitability in the Law Firm environment.
We believe that a different and better measurement can be derived from the traditional ‘cost accounting‘ methodology that evolved in the accounting function in the manufacturing world. In that approach, the cost accountant would produce standard ‘cost models’ allocating direct labor and overhead absorbed to determine the standard cost of a product’s production. From that analysis, companies would price their products appropriately so that a proper gross margin was realized to meet the company’s overall financial goals.
In the service business, the production of ‘products’ is not so clearly defined, so the approach must be different. In a Law Firm, the Profitability accounting analysis is a costing methodology which determines the cost of a revenue stream. The analysis computes the series of direct and indirect rates per hour of the service provider and allocates those costs to the service provider’s (timekeeper) revenue to measure gross and net contribution to Firm profits.
What’s the process?
First, you must identify the revenue method you are measuring:
- Full Accrual – time worked
- Modified Accrual – time billed
- Cash Basis – time collected
Each method has its pros and cons. #1 and #2 may never turn into cash (due to write offs or non-payment) and the client might look profitable under those methods – when the client never paid their bills!! The management committee will quickly lose faith in the profitability analysis as a useful too if this occurs. We prefer #3, as the cash has been received – and the profitability measurement is – ‘what did it cost us to create that revenue stream’?
Second, you must identify what profit you are measuring.
Is the Firm’s profit to be measured:
- Zero, and all of the equity Partner’s compensation is considered part of their direct cost?
a. Note – some equity Partners will have timekeeper costs greater than their billing rate creating a ‘loss’ for everything they work on.
- The equity Partner’s compensation and none of their compensation is considered part of their direct cost?
a. Note – the equity Partners will have no compensation cost and will look very profitable
- The amount distributed over the base monthly draws.
a. Note – this is a generally acceptable approach, as the monthly draw is deemed to be the Equity Partners compensation
When a Non-equity Partner, Associate or Paralegal’s direct cost is calculated, their W-2 compensation is the value used for their salary. But for Equity Partners, whose compensation is more than just their ‘attorney’ salary because it includes their share of the Firm’s profits, there is no industry standard for identifying their ‘attorney’ cost for delivering legal services. Many Firms end up assigning the Equity Partners a (culturally acceptable) ‘salary’ for their direct cost for being an attorney and then use the difference of their total compensation as the profit to be measured.
Third, the direct expenses must be identified for each timekeeper. These typically include salary (see above for equity Partners), bonus, taxes, medical, benefits, parking, etc. – those costs that come and go with the timekeeper. Included in this calculation should be their proportional share of their secretary or administrative assistant (also with their respective direct costs calculated in the same manner)
Fourth, we must calculate the indirect costs. Simply take the total revenue, subtract the net profit to be measured, subtract the allocated direct costs and the rest must then be the indirect amount.
Generally the indirect pool is allocated to each timekeeper based upon a weighting average that properly distributes the cost as it is perceived to be utilized. For example:
Partners a 100% weighting factor
Associates – a 50% to 75% weighting factor
Paralegals – a 0% to 33% weighting factor
Each timekeeper would then be allocated their indirect cost amount.
The direct and indirect costs are then allocated on an hourly basis by dividing each individual’s direct and indirect total costs by their collected hours. The end result is the direct rate per timekeeper per hour and the indirect rate per timekeeper per hour.
Note – all of the steps identified above and the assumption made for each must gain acceptance by the user (for example, the Management of Finance committee) of the analysis, so that the Profitability process and reporting gains acceptance by the user as both fair and objective.
Depending on the system you employ (Excel sheets with a pivot table or a full blown profitability product), you should be able to arrange the Profitability report with the following elements:
- Collected Hours
- Collected Fees
- Direct Cost Partners
- Direct Cost Non-Partners
- Gross Profit
- Gross Profit %
- Indirect Cost Absorbed
- Net Profit $
- Net Profit %
- Non-Partner Leverage %
- Revenue Per Hour
- Cost Per Hour
- Difference Per Hour
Additionally, this information should be easily sorted (or pivoted in Excel) to provide statistics by:
- Originating Attorney
- Billing Attorney
- Responsible Attorney
- Working Attorney
- Area of Law
- Practice Group
This information will then allow you to analyze the Firm’s profitability from a number of perspectives.
Use it to your Firm’s advantage
Performing the Profitability analysis will be an education process for the Firm. With the information above, the Firm can better improve its profits due to a better understanding of its Revenue Streams, Cost Structures, Pricing Points, Relevant Volumes, and Profitability Logistics. Every Firm needs to have a solid understanding of its Profitability components – the Products (Areas of Law), the Clients (those who buy the products), and the Attorneys (those who sell the products, manage the products, and create the products)!
Jay Erdman, CPA, a Principal in Rippe & Kingston, LLC, consults with a large number of Law Firms across the country on a range of topics including Partner development and Financial Management issues. He has spoken at local, regional, and national ALA events.
Jay earned his degree in Accounting and Management from the University of Cincinnati and now has over thirty-five years of accounting experience and Law Firm specialization.
Rippe & Kingston was a pioneer in developing the Profitability Accounting Methodology for Law Firms, which began in 1989. Over the years, R&K has been involved in over 130 Profitability studies.