An Overview of “Profitability Accounting Methodology for Law Firms”
By Jay Erdman
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.
At SurePoint, we believe that law firms should measure profitability utilizing a different and better measurement derived from the traditional “cost accounting” methodology used by the accounting function in the manufacturing world.
In this approach, the cost accountant produces standard “cost models” by allocating the direct labor and overhead costs absorbed to determine the standard cost of producing a product. Based on this analysis, a company can price their products appropriately so that a proper gross margin is realized to meet their overall financial goals.
In the service business, the production of “products” is not so clearly defined and requires a different approach. In a law firm, the “profitability accounting analysis” is a costing methodology that determines the cost of a revenue stream. The analysis computes the series of direct and indirect rates per hour of the timekeeper and allocates those costs to their revenue to measure their gross and net contribution to the firm’s profits.
What is the process?
To conduct a profitability analysis, you need to consider the following elements.
First, you must identify the revenue method you are measuring:
- Full Accrual is where the revenue is recognized when the time is worked.
- Modified Accrual is where the revenue is recognized when the time is billed.
- Cash Basis is where the revenue is recognized when the time is collected.
Each method has pros and cons. Full Accrual and Modified Accrual may never turn into cash due to write-offs or non-payment. However, the client might look profitable under those methods when, in fact, the client has not paid their bills. The management committee will quickly lose faith in the profitability analysis as a useful tool if this occurs. We recommend the Cash Basis revenue method. Under this method, the cash has been received and the profitability measurement answers, “What did it cost us to create that revenue stream?”.
Second, you must identify the profit you are measuring. For example, is the firm’s profit to be measured:
- Zero, and all the equity partner’s compensation is considered part of their direct cost? 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? The equity partners will have no compensation cost and will look very profitable.
- The amount distributed over the base monthly draws? This is a generally acceptable approach, as the monthly draw is deemed to be the equity partner’s 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. However, for equity partners, whose compensation includes both their ‘salary’ and share of the firm’s profits, there is no industry standard for identifying their ‘direct’ 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. These are costs that come and go with the timekeeper. This calculation should also include the timekeeper’s proportional share of costs attributed to their administrative support (also with their respective direct costs calculated in the same manner).
Fourth, you must calculate the indirect costs for each timekeeper. For this calculation, you simply take the total revenue, subtract the net profit to be measured, subtract the allocated direct costs, and the remainder is the indirect costs.
Generally, the pool of indirect costs 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 receive a 100% weighting factor
- Associates receive a 50% to 75% weighting factor
- Paralegals receive a 0% to 33% weighting factor
Each timekeeper is then 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 result is the direct rate per timekeeper per hour and the indirect rate per timekeeper per hour.
The steps identified above, and the assumptions made for each must gain acceptance by the user of the analysis (e.g., Management of Finance committee) so that the profitability process and reporting is considered fair and objective.
Presentation of Profitability Data Points
Depending on the system, your financial management solution should be able to generate a 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 to provide statistics by
- Originating Attorney
- Billing Attorney
- Responsible Attorney
- Working Attorney
- Area of Law
- Practice Group
This information enables you to analyze the firm’s profitability from several perspectives.
Unlock Higher Performance and Greater Efficiency
Every law firm needs to have a solid understanding of its profitability components:
- Products: The practice areas that are most profitable and which ones need to be re-evaluated.
- Clients: The entities who buy the products.
- Attorneys: Those who sell, manage, and create the products.
Conducting a profitability analysis is an educational process for law firms. Empowered with the information above, your firm can improve its profitability by gaining a better understanding of its revenue streams, cost structures, pricing points, relevant volumes, and profitability logistics. In doing so, you can uncover opportunities to drive growth, efficiencies and more value for your clients.
About the Author
Jay Erdman, CPA, is an Executive Advisor with SurePoint Technologies. He consults with law firms across the country on a range of topics including partner development and financial management issues. He is a frequent speaker at local, regional and national ALA events.
Jay earned his degree in Accounting and Management from the University of Cincinnati and has over forty years of accounting experience and law firm specialization.
SurePoint Technologies is a pioneer in developing the “Profitability Accounting Methodology for Law Firms”. Jay has conducted more than 100 profitability studies.