Whether you currently operate a law firm or just intend to someday, it’s essential that you know how to successfully perform a profitability analysis.
Every business needs to make a profit to survive. A law firm is no exception. Profitability analysis is a two-pronged approach to determining whether the firm is making a profit — and what relationship each activity has its revenue or expenses.
Choosing Between Absolute or Relative Term Profit Analysis
Having a design to determine your firm’s profit can be done in an absolute or relative term. Both designs follow the same calculations, i.e., Total Revenue –Total Cost = (Profit or Loss). To analyze profitability (revenue or loss) against each activity in the firm, a range of key metrics may be jointly or severally employed. These include Utilization vs. Realization, Leverage, Costs, Revenue Models, and other metrics.
However, measuring profit in absolute terms is simply determining whether there was a loss or profit at the end of the year. To determine whether your firm is profiting well enough compared to other similar firms, or to current projections, a relative model can be used. Relative analysis can use the Billable Hours Model or the Profit Per Partner Model.
These models are still relevant in determining whether your firm is making a profit and at what level. These models are also considered traditional because they have been modified or custom-built with a plethora of variations currently available and written into IT solutions of the firm’s choice.
Completing Analysis through Billable Hours
In addition to determining a Firm’s Absolute Profit, “Billable Hours” help:
- To determine a realistic revenue projection and revenue model.
- To determine how much you may charge hourly, flat, or as a contingency fee.
- To enable you to keep monthly, bimonthly, or quarterly track on whether you are meeting revenue goals before the year ends.
The formula for this basic approach is to determine a “projected revenue sum,” either in a Business Plan or one relative to that of a firm with comparative size, investments, and experience. This formula is:
Relative Revenue + Tax + Costs + Fees = “Projected Revenue Sum”
“Projected Revenue” ÷ “Active Days” × “billable hours”
Thus, if your firm, for instance, looks at a similar Law Firm that makes $200,000.00 in a year and has a profit after tax of $120,000.00, the figure to be taken as “Relative Revenue” is the profit after tax. Your firm might not share the same taxes, costs, and fees with the comparative law firm.
Your estimation for costs, tax, and fees may be guided by the figures of your previous year (in the case of an existing law firm) or reasonable estimates (in a new firm). For the purpose of analysis:
- Costs include both fixed and variable costs.
- Taxes include corporate and personal income taxes.
- Fees include subscriptions, bar fees, etc.
So, in our example, we take the “Relative Revenue” of $120,000.00 and add our estimated taxes, costs, and fees to it.
$120,000.00 (Relative Revenue) + $20,000.00 (Estimated Tax) + $10,000.00 (Estimated Costs) + $10,000 (Estimated Fees) = $160,000.00
For us to have the same profit, after-tax, as the comparative firm, we need to gross revenue of >= $160,000.00 and not $200,000.00.
Note: This relative revenue may equally be the revenue projection in your firm’s business plan.
The next calculation is:
PROJECTED REVENUE ÷ ACTIVE DAYS × BILLABLE HOURS
$160,000.00 (Projected Revenue) ÷ 241 (Active Days) x (2.5 hours) Billable Hours = 221,300
Note: Active days as expressed above is 365 days a year less weekends, public holidays, leaves, and so forth. Billable hours are standard working hours (usually eight or nine per day) divided by three, representing split periods for lawyering, marketing, and administration.
Thus, for the firm to hit 160,000.00 in a year, it must be billing 2,213.00 per hour (for a minimum of 3 hours per day) or equivalent of a flat or contingent billing.
Where there is more than one attorney, the hourly fee is shared by them, usually by their seniority level. This represents the basis of the “Profit Per Partner Model” (PPP) of measuring a firm’s profit. The PPP Model might also take the form of dividing the overall revenue of the Firm by the number of partners to get the Net Income per partner (NIPP). The NIPP will then be compared with the NIPP of other law firms (depending on their number of Attorneys) to evaluate your firm’s profitability.
Measuring Activities by Profit or Loss
However, these models do not address the true impact of each firm’s activity upon total revenue or loss. To analyze this, a few metrics discussed below are necessary.
- Client Acquisition Cost: these relate to the amount expended on networking, marketing, ads, etc., vis-à-vis the number of new clients converted in a calendar year. In a typical year, the number of new clients recorded is divided by the total amount spent as Client Acquisition Cost. The result is then compared as a percentage value of the new clients’ total revenue in that calendar year.
- Revenue Model: while hourly, flat rate, or contingent billing may be used to measure whether productivity is profitable, this might not necessarily be so. A lower billing may be a better billing in some instances, depending on whether a customer is a one-off or a repeat customer. The billing of a repeat customer lowered based on discount or other factors may have to be tested for true profitability. This is called accessing the Life Time Value (LTV) of the customer. It assesses the total number of cases done for a retained client within a specified period to determine whether the gain from the repeat levels is lower or higher than a billable hour might recoup.
- Utilization vs. Realization: Utilization relates to the number of hours an attorney served a client within a given period based on shared hourly rates amongst attorneys in your firm for a given period. Realization relates to the hours clients actually paid for overall. While Realization is usually less than Utilization based on discounts, write-offs, etc., any lesser amount registered due to client’s dissatisfaction may be a problem traceable to an attorney or paralegal that might have a connection with it.
- Leverage: relates to the Realization ratio of an Associate compared to that of a partner. Usually, a partner is tasked with a higher hourly rate to generate targeted revenue for the firm based on his/her experience. An associate may, however, work more hours, thereby leveraging up in the Realization ratio. While these ratios help to analyze the input of each Attorney on the overall revenue, higher leverage is generally an indication of more revenue for the firm and vice versa.
- Costs: cost relates to monitoring all forms of costs, whether fixed or variable. The essence is to compare how the figures are performing compared to a profit after tax as well as a way of monitoring leakage, especially concerning variable costs.
These are only a few of the key performance metrics a firm might use to determine its true profitability. A law firm’s financial statement specify the metrics that make the most sense to it and will be able to target its analysis better once the legal practice has been in operation for some time.