Profitability
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 …
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.
First, you must identify the revenue method you are measuring:
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:
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:
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.
Depending on the system, your financial management solution should be able to generate a profitability report with the following elements:
Additionally, this information should be easily sorted to provide statistics by
This information enables you to analyze the firm’s profitability from several perspectives.
Every law firm needs to have a solid understanding of its profitability components:
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.
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
SurePoint Technologies is a leading provider of financial and practice management software to law firms nationwide. For more than 40 years, law firms have relied on SurePoint’s tailored enterprise software to drastically improve workflow and maximize financial performance. With a community of nearly 50,000 members, SurePoint continues to transform the legal industry by enabling law firms to unlock higher performance by freeing lawyers of administrative burdens so they can spend far more time focusing on their clients and their practice. Learn more at surepoint.com.
SCHEDULE YOUR DEMO