Are Law Firms like Manufacturing Companies?
All firms want to become more profitable. The difficult question is: What can we do differently to become more profitable?
From a big picture perspective, I visualize a law firm as being similar to a manufacturing company. If you consider a law firm has gross revenue less direct costs equals gross profit, less overhead, equals net income, you get the picture. Some people may ask “What are direct costs, we do not have inventory”, but in fact there is inventory, namely work in process, and your direct labor for attorneys are your direct costs. For benchmarks, in a mature law firm, I look for one-third of your costs being for associates, one-third to overhead, and the final third as compensation to owners. These are rough industry benchmarks, but give you something to compare to. Here is an example of this format:
Revenues
Increasing revenues is the most obvious driver of profitability. If you can add more clients, perform more billable hours, increase your rates, or find creative ways to bill more than what you could at standard hourly rates, i.e. contingent fee work, or fixed fee work, you will become more profitable. Increasing realizations are an area where you can have impact. If you improve your realization 2% on $10,000,000 revenue, $200,000 more profit will fall to the bottom line. Increasing rates can have similar impact, if you raise rates 5%, but your realization falls 2%, you still have a net 3% addition to revenue. Of course you also need to factor in if there would be any loss in clientele if you raised rates 5%? This is the same analysis a manufacturer would go through in analyzing the impact of price increases on the sale of its products.
Client acceptance is a critical step to helping ensure the firm has quality clients. Each firm should have a formal client acceptance committee or process. Current clients should also be analyzed to see if some of them should be moved on. Clients with low realizations over time may actually be consuming resources rather than adding to profitability.
Firms can also improve revenues by speeding up the billing and collecting cycle. To the extent you can do this, you will have a short term impact on net income, because most firms keep there books on a cash basis, and if you speed up the collection cycle, you will have more gross revenue. To me this is an excellent practice, it is making it more efficient, and when there is a better correlation with the performance of services and billing, the client perceives more value, and is more likely to pay. Anything you can do to decrease the time between the performance of services and billing of work will have a positive impact on the firm.
Direct Costs
Direct costs, or salaries, are the largest expense of law firms, therefore opportunity for savings. There is a fine line between having too many attorneys and not enough. I like to show owners compensation as a distribution in the equity section of the balance sheet, assuming you are a PLLC or LLP, so you can get a feel for how much is being contributed to the bottom line for the owners to split.
If you are not generating enough gross profit, it may be an indication of being overstaffed. If there is a limited pool of work, you would prefer to have 8 associates with 1,800 billable hours than 9 with 1,600. This may seem obvious, but you should look at your average associate billable hours and analyze reasons for under-performers, to see if maybe it is a staffing issue. What would the impact be with less?
Direct costs are a key area where the firm can improve profitability by utilizing leverage. Leverage is having multiple people below the owner level contributing gross profit, which helps cover overhead, allowing the owners to earn more. If you can hire more associates, and keep them billable, that is the best solution to earning more in a professional service environment than at a standard billable hour situation. Partners are limited in the number of hours they can personally perform in a year, and the rate they can charge, but if they can get a volume of associates below them, they have the opportunity to earn substantially more than on their own. The key is the ability to keep the associates busy with billable hours.
General & Adminstrative
Overhead should be mostly a fixed component. The largest cost in this category should be rent, which is not a variable cost. Firms can take steps to reduce overhead, but the impact on the bottom line should not be as significant as the first two categories, as most of these costs should be fixed. It is always worthwhile to review overhead and look for creative ways to reduce it, but in the big scheme, assuming you have managed your overhead well, should not have a material impact on profitability. The biggest impact should come from increasing revenues or decreasing direct costs.
Calculating overhead per attorney is a useful exercise. It allows you to consider how much gross profit is needed to cover their overhead, and add to the overall firm profitability. Keep in mind there are many more variables that impact profitability that go well beyond a production analysis, namely subjective criteria, like leadership, client generation, mentoring, etc.
Allocating overhead to attorneys can be a fine art. I prefer to keep the analysis relatively simple, when it gets too complicated, too many assumptions are made. This could be the topic of a whole article.
Conclusion
Many law firms have detailed income statements. Being able to stand back and see the big picture, and using the format of a manufacturing company, helps me to analyze where there are opportunities for improvement.
