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Associate salaries have been escalating higher than you ever could have imagined. Contrary to the local news reports, your expenses for labor, energy, technology and other staples have risen far more than the Consumer Price Index. Some of your long-time clients have discovered RFPs, and rate increases have met strong resistance. Keep reading; it’s not all depressing. Law firms today increasingly face competitive pressures from both internal and external sources. Clients are demanding lower costs, faster turnaround and higher quality. The competitive environment has taken its toll on firms that were unable to adjust to the requirements. Because the economy has been robust for the past few years, there seems to be more work, less staff and higher expectations. Everywhere we turn the challenge is to improve productivity and make sure the right decisions are being made. Most law firms, unlike their corporate counterparts, have no measurement tools to determine client or attorney profitability. In most firms, the only measure of profitability is the income statement. It, however, doesn’t show clients, matters, and attorneys. Firms will evaluate clients, matters and attorneys by only looking at realization reports, either on billing or cash receipts. The problem is that profitability assumes costs both direct and indirect, whereas realization is only a measure on the income side, the ability to get each hour first billed then collected. This is the equivalent of a manufacturer determining that, on average, 95 percent of all types of widgets made it through manufacturing and quality control and were sold. Unfortunately some types of widgets that were 95 percent “realized” sold for $100 but cost $120 to produce. Realization was impressive, but the business was in serious trouble. So why don’t law firms measure profitability? They just don’t have the tools and a working model for analysis. The analogy of the widget fits here; law firm “widgets” are hours. Some “revenue dollars” cost more than others. Let’s examine the cost issues in this formula: � Revenue – Direct Costs = Gross Profits � Gross Profits – Overhead Costs = Net Profit To put this into law firm terms, revenue is cash collections. Most firms show revenue on a cash basis. Direct costs are the actual salary values and fringe benefits of the attorneys actually working on the case where the hours were billed and collected. This may be easily calculated by taking actual hours worked and dividing that into the salary/fringe cost for each attorney, Software can easily track monthly salary costs and fringe-benefit ratios. Secondly, hard disbursements are often overlooked direct costs. The revenue side includes revenue for both hard and soft disbursements. For this example, we will only back-out hard disbursements at “cost,” while handling recapture of soft costs as part of firm overhead. The accounting system can track the actual cost of hard disbursements paid to vendors, such as filing fees. It’s important to get these at “costs” in case mark-up/downs were taken. We now have gross profits. The overhead portion of the formula is the most difficult. Here we have two categories: administrative salary with fringes and shared office overhead. This is where the equation will fail if there is not an agreed-upon model being used. One method, not at all recommended, is to come up with a complex formula by attorney to allocate every type of cost in the firm. It goes like this: my office is smaller and costs less of the rent; my computer costs more; I get a bigger portion of the amortization, more light bulbs … well, you get the idea. To think that every bill would be analyzed and apportioned out accordingly is probably unrealistic. This level of detail isn’t worth the effort. What the firm needs is a “model” of costs that is consistent. My CPA friends continually remind me that taking a little “liberty” may be all right if it’s done consistently. The model being referred to is calculating a firm’s actual recorded billable hours each month and dividing them into certain expenses flagged in the general ledger. For firms with branch offices, the model should allow flagging expenses that are directly related to that branch vs. general overhead expenses shared by the entire firm. Here is where we can also factor in the influence of non-billable hours, not to be confused with hours that were written off. Non-billable hours should be firm-approved activities such as continuing education, pro bono work, business development and firm administrative. These should be factored in as general overhead expenses for the attorneys who recorded them at an hourly rate of their salary plus benefits. Voila, we now have a “burdened” cost per billable hour for our formula. There can be some other calculations included, but we’ll stop here for a basic model. In today’s law firm, accounting systems of this type are a requirement. What’s the benefit to the firm? A consistent method of determining real profitability by billing attorney or by client or, even better, by matter. Firms today are looking to expand, acquire other firms or be a specialized boutique or general practice. Without these types of numbers how can these decisions be made intelligently? Remember the old saying, “You can’t manage it if you can’t measure it.” In today’s competitive marketplace, the measurement of client, matter, attorney and area of law profitability has evolved into a bare necessity for effective law firm management. Law firms are realizing that to be competitive, they must run their businesses like their corporate counterparts. This means measuring profitability in as many ways as possible. Jim Hammond, executive vice president for ASA Legal Systems has almost 20 years of law firm accounting experience. He may be reached at [email protected]

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