Measuring Client Profitability Is a Tether to Reality

It seems like common sense that any law firm would be interested in understanding the profitability of their client relationships. It even makes better sense to reward originators on the basis of this profitability.It has been my experience, however, that many firms do not have an effective system for determining client net income. Part of the struggle in implementing these systems is that there is fear on the part of some that their book of business is not as profitable as believed.

Resistance to implementing client profitability may be especially strong in cases where compensation has been largely subjective or based on a few basic criteria.

Client profitability information has a number of strategic uses including being a resource for determining billing rates. In this post, we will focus on some of the mechanics of calculating client profitability and some items to remember when interpreting the results.

Direct Costs

Direct costs include timekeeper salaries and benefits (loaded payroll). The hourly cost is usually calculated by dividing a timekeeper's loaded payroll by his or her billable hours for the period.At times, it makes sense to standardize the billable hour divisor or the payroll amount. For example, in situations where time for terminated timekeepers from prior periods is being billed currently, without standard costing there is no current period cost to allocate. Additionally, standardizing the cost of a new timekeeper may make sense as it not accurate to assess a client for the entire cost of a start-up timekeeper. In a compensation scenario, this may be approached differently.Direct costs are easy to identify and do not necessarily have to stop at payroll, but timekeeper payroll and benefits are the most common.

Overhead Application

There is not a single formula that fits all firm situations. There are elements that are common to most systems, especially in the area of direct costs (labor, benefits and secretarial allocations), but when it comes to the application of indirect overhead, the process becomes much tougher. Overhead, as I refer to it, includes any expense other than timekeeper salaries and benefits. Items of overhead include salary and benefits costs for secretarial, file clerk and administrative personnel, facility costs, equipment and practice aids, practice development and general and administrative costs. Some firms also segregate some overhead expenses by lawyer, and these could be factored in as a specific rather than allocated cost.

Overhead costs are normally applied to each timekeeper in accordance with a firm's overhead allocation policy. I typically recommend that equity partners absorb the highest allocation of overhead with paralegals absorbing the least. More specifically, a firm may choose to apportion a full share of overhead to an Equity Partner with Income Partners receiving a .75 share, Associates receiving a .50 share and Paralegals receiving a .25 share. There is some flexibility in applying overhead, and the result need not be perfect, but it must be materially correct.

I recommend a graduated level of overhead absorption for the following reasons:

• To allow a young lawyer the time it takes to build value resulting in higher billing and realization rates;
• Remove any disincentives to use associates with high overhead allocations and lower billing and realization rates;
• Avoid creating a perception that an associate is unprofitable due to an unrealistic overhead allocation;
• To reflect the reality that paralegals and associates simply do not need or use as much overhead as a partner; and
• Recognize that a portion of a firm's overhead does not contribute to the ability to produce client work.

Billable Hours versus Billed Hours for overhead application

Another item to consider when computing client profitability is the timing and application of overhead. As mentioned earlier, I normally use billable hours to compute costs per hour for payroll and overhead.A problem may arise when a firm is slow to bill files and has a large inventory of unbilled hours. In these instances, an adjustment for the timing difference may be required. In my experience, most law firms bill monthly and the timing differences are less of a problem. Even if a firm bills quarterly, these differences are not unmanageable. I also recommend computing client profitability on a billed basis. To account for any uncollectible amounts or the risk of uncollectible accounts, I set up an allowance/write-off and recoveries component of the system.

Gross Margin

Gross margin is the amount remaining after accounting for direct costs. Another way of looking at gross margin is to view it as a contribution to overhead and profit. Timekeepers that do not generate enough revenue to cover their direct costs have a negative gross margin. A firm may be satisfied with a partial contribution to overhead and no contribution to profit. For example, new lawyers typically don't have enough of a workload initially to cover all of their allocated overhead. In these instances, all amounts realized over direct costs reduces the amount of overhead for the reminder of the timekeepers.

Other instances may include a start-up branch office or expansion into a new practice area. From a client perspective, a firm may be willing to accept a lower margin given similar strategic considerations.At times, a firm needs to maintain a certain capability or a certain size to attract work from certain clients. It also may be very difficult grow with everyone fully employed and profitable. Clearly, all timekeepers need to cover direct costs and overhead and contribute to profits, but it is important think strategically when considering a timekeeper's contribution.

Net Profit

Timekeepers that are able cover all of their direct costs and overhead contribute to net profit. Acceptable profit margins differ by firm, but I recommend that firms consider all of the factors when reviewing net profit. The average law firm with multiple practice areas will have a number of different profit ranges.Ranking clients in a number of different ways including percent profit, actual profit dollars contributed, gross fees generated and overhead absorbed all provide insight into the value of a relationship.

A quality client net income analysis will provide a firm with the information needed to make meaningful improvement where needed. For example, squeezing a little more from a highly profitable but lower volume account may not have any real impact on firm profits and may even cause a client to consider alternatives. Instead, a firm may want to analyze a high-volume but underperforming account to determine if the staffing mix is efficient and if the firm's overhead structure is competitive. Being able to perform efficiently in highly competitive markets may not be attractive to some, but for many it will produce meaningful results.

Billing rate increases are always a tool for law firms to increase profits, assuming clients are willing participants in this strategy. Law firms are reporting mixed results with billing rate increases, and there is a plethora of market data supporting these reports. What I am recommending is that client profitability data, rates, staffing mix, costs per hour and overhead structure be used to expand the options a firm has for improving profits.By thoughtfully considering all of the elements of profitability, law firms have a better chance at operating in step with the market. Relying heavily on of a single strategy of raising rates or cost cutting will produce limited results and may even hurt profitability.

Compensation

Client profitability as a factor in some or all of a partner's compensation helps to ensure that the firm will operate competitively in the market. Creating an environment where overhead is in check and where partners can reap the benefits of the profitability of their practice is the best antidote against defections and poor performance. Law firms tend to move slowly, and an environment that empowers and encourages partners to act profitably helps to overcome this disadvantage.

One of the concerns that partners have about using client profitability as a sole or large driver in compensation is that it may produce large swings in compensation from one year to the next. Other concerns include splitting origination credit, incentives for working with other partners and adjusting points of ownership.A solid design process will address all of these concerns. Linking client profitability to compensation can best be described as a process that takes time to mature.Partners must first learn to understand the various drivers of profitability, and they need time consider the possible changes to their pricing, staffing and management approach that may be necessary.

Once implemented, however, the system will mature and produce measurable results. More importantly, it will act as a tether to reality.