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A Primer on Analyzing Law Firm Profitability

By Terri Olson

Some years ago, David Maister, working from the Harvard Business school, produced the following scary little formula for computing the net income per partner in a law firm:

Net Income Per Partner = (Leverage +1)(Billing rate)(Utilization)(Realization)(Margin)

This article is for those who’d like to improve profitability in their own firms, but may not know how to proceed when faced with a formula like that. So first things first: what do these terms mean?

If we take a fairly typical small firm, what would this formula say about it? Smith & Associates, practicing somewhere in southwest Georgia, has four attorneys, of whom only one (Smith) is a partner/owner; there is also one paralegal but he does not bill for her time. Mr. Smith is billing his work at $110 an hour; his associates are billing at $90. To find his utilization, he averages out how much he and the associates bill and find it comes to 1425 hours per year. He has to guess at realization — he doesn’t keep those figures — and he guesses deliberately low, at 85 percent. The ratio of income to expenses is provided by his accountant, who tells him that his gross income was $541,500, of which $310,000 was expenses. Plugging those numbers into the formula, we find:

(1+ [3/1])(95)(1425)(85 percent)(43 percent), or a net profitability per partner of $197,918.25.

Those figures look pretty good, but let’s remember that his net profitability is not by any means the same thing as his net income. He’s still got to pay all of his taxes from this amount.

Let’s look at what you would need to do to raise the profitability level of a partner or a practice area in your firm. Obviously, raising any one of these "levers" sky-high would have significant impact. If, for example, Mr. Smith raised the average billing rate in his firm from $95 an hour to $125, his sample profitability figure would go to $260,418.75. Similarly, if he increased "utilization" by figuring that everybody would now bill 1900 hours a year instead of just over 1400, profitability would zoom to $263,891.

One thing that merits mention is the impressive effect of leverage on net profitability. Let’s play with this just a bit. If we gave Mr. Smith a partner (and took away an associate) and the new partner worked the same amount (utilization) as the old associate but billed at the higher rate, and they evenly distributed the income, we’d have:

(1+2/2)(100*)(1425)(85 percent)(56 percent**) = $135660

*average goes up since two, not one, bill at the higher rate

**new net revenue = $541,500 + ($20 * 1425) - ($310,000 - $60,000 [the associate’s salary plus benefits]) = 570,000 - $250,000 = $320,000, for a margin of 56 percent.

So you can see that the more ways the pie must be sliced, the lower the profitability per partner, unless you can simultaneously adjust some of the other "levers" significantly — which is why new partners are usually required to bring in so much business with them (affecting utilization, billing rate and margin).

Of course, there are numerous problems associated with these hypotheticals. The most obvious one is the quality of life issue! While it’s true that upping the billable hours will up profitability (all other things being equal), the result is not likely to be a felicitous one unless your firm’s hours have been substantially below average and you’re now able to bring them up to a more realistic level.

The other problems all center around the effect that raising one lever can have on the others. For example, raising the billing rate may have the effect of lowering utilization if doing so places the average rate substantially higher than the market, because you won’t be able to keep everybody busy billing their 1900 hours a year when clients take their work to other lower-priced firms. Adjusting leverage, that is, lowering the ratio of non-equity to owner personnel, is, on the face of it, an effective means of increasing profitability, but unfortunately, it also generally has the effect of lowering the average billing rate (partners bill higher rates than associates, so if you hire five associates to improve your leverage, you’re lowering your average billing rate). However, associates usually bill more hours and cost the firm less in expenses than partners do, which evens the playing field somewhat.

See how tricky this can be? By this time, you’ve probably figured out that a spreadsheet program is going to be very, very helpful if you want to take your hypotheticals further.

Playing with the other levers is a little safer. Improved realization is a worthy and generally harmless goal, always bearing in mind that true 100 percent realization means not only that all time billed for is collected (possible) but also that all time worked is billed for (not possible or even desirable). Improving the ratio of income to expenses is another laudatory goal, one which often gets buried by its more impressive-sounding brother and sister levers.

Unfortunately, when firms look at decreasing expenses, it’s easy to lose sight of the big picture and focus on very small expense items (price of paper, pencils, etc.) that may not affect the margin significantly yet take a great deal of staff time to control and may lower morale as well. It may be more palatable for staff and other attorneys alike to try to increase revenue while holding firm on expenses, which will also improve the ratio .... For example, could the firm improve efficiency enough that a new secretary would not be needed even if a new associate were hired or more hours put in by the existing ones? Can library costs be held at 1996 levels until the end of 1998?

Going back to our hypothetical four-lawyer firm, our partner after reviewing his figures decides to investigate several options to increase productivity:

Leverage. He doesn’t feel that there is enough legal work in his small town right now to support hiring another associate, even if it would improve his leverage, so he does nothing in that area at present. He makes a mental note that his most senior associate will expect to be considered for partnership in another year or so, something that will affect leverage at that time

Average billing rate. He notices that his average billing rate is below market for his area, and that there’s not very much difference between his billing rate and that of his associates, so he raises his personal billing rates slightly, "grandfathering" in most of his existing clients

Utilization. He notices that the hardest working associate bills substantially more than the others do. Instead of raising everyone’s utilization, he more realistically decides to establish a billing floor that will hopefully bring the other two associates in line

Realization. He has never really looked at realization before, so he buys a billing program and after several months sees that his realization is down around 80 percent, not the 85 percent he had guessed, and concludes this figure is unacceptable. He meets with his paralegal and puts her in charge of a collections program and also resolves to increase the size of his retainer and to be more careful about the quotes he gives to clients, so he won’t feel he has to "write off" so much.

Margin. He has likewise never paid too much attention to categorizing office expenses, although his accountant gives him the basic ratio of expense to revenue. He begins to use an accounting program in-house to give him those figures, calls the Law Practice Management Program to find out what percentages are for other firms, and decides to target the particular expense item that seems to be the most out of line. He does this by establishing an incentive program for his staff to reduce that expense.

So you can see that as complicated as all of this may sound, it boils down to the two common-sense principles about making money that everybody knows. To make more money, you can:

Bring more in. (Adjust average billing rate, utilization, and realization.)

Take less out. (Adjust leverage and margin.)

Terri Olson is the former Director of the Law Practice Management Program.

This article was originally published in the Georgia Bar Journal, October 1996, Vol. 2, No. 2, p. 54 

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