What is Our Efficiency Ratio?
Efficiency ratio is a term used to measure your expenses relative to your revenue. The term came up when I was discussing law firms with some bankers. I told them the interesting thing I noticed when looking at overhead per attorney was that while controlling expenses is a good thing, the more profitable firms tended to have higher overhead per attorney, in my experience. Why would that be?
I view law firms as manufacturers. On the balance sheet you have inventory, which is your unbilled time, or work in progress. The income statement format has revenue less direct costs equal to gross profit. Direct costs are timekeeper salaries, payroll taxes and benefits. From here, you subtract your overhead from gross profit to reach net income. When discussing the efficiency ratio, I am looking at overhead relative to income. So if you took your overhead and divided it by your revenue, you would have your efficiency ratio. As a broad guideline, a law firm would have direct costs equal to 33% of revenue, overhead would be another 33%, and the net income would make up the balance.
When you look at law firm statistics, larger firms have higher overhead per attorney. This makes intuitive sense, because larger size would indicate higher expenses, but why on a per attorney basis would it increase? I would argue larger firms have more systems in place to support the attorneys to be productive.
The objective in managing a law firm is to find the perfect balance between efficiency for generating revenue and overhead cost. Obviously you could go too far with increasing overhead. Most overhead costs are fixed, but there are variable components, like administrative staff. Administrative staff should make the attorneys more productive. An obvious example would be a billing clerk. If a billing clerk saves each partner 4 hours of time per month, you have 20 partners who have billing responsibility, and the average billing rate is $250, this would translate to $240,000 of increased productivity. It is pretty easy to justify having this position.
Other positions might be more difficult to justify, but I would argue many firms are short-sighted on administrative positions. The above example demonstrates a pretty large dollar increase in productivity for a standard position. A marketing person or department can save the attorney’s significant time in branding, setting appointments, and organizing events. Interestingly, marketing is generally measured against what new revenue was brought in, but again, what about the opportunity cost of increased productivity? If a marketing person could save each attorney 2 hours per month, and you have 30 attorneys, average rate $200, this translates into $144,000 of increased productivity.
The point of the efficiency ratio is that it measures expenses relative to income. By hiring these two positions, let's assume the fully loaded cost of these, including salary, benefits and an overhead allocation for space to be $80,000 each, you have gained $384,000 in revenue, and cost of $160,000, so a net contribution to net income of $224,000. Your overhead per attorney increased, but your revenue per attorney increased by a wider margin, making the firm more profitable.
How do you measure yourself? I suggest benchmarking, get some industry statistics, and see how you compare to other firms. You can also look at the recent history of your firm, and look for trends in your overhead costs.
Having the lowest overhead per attorney may not be the most profitable position.
