A recent article by Bruce Stachenfeld over at Above the Law reminded me of my biggest pet peeve regarding law firm financial performance: misleading law firm profit margin figures. Bruce correctly points out that “profit margin is a dangerous statistic to use in comparing law firm profitability” because it “can be completely manipulated by two factors: [t]he titles that a firm gives to its lawyers; and [t]he leverage in the system.” Essentially, for a given number of associates, the more partners a firm has, the higher its profit margin (%) will be. The reason for this is that typically all partner compensation is included as profit. This is a mistake. Keep reading to learn why this is a problem and to learn how to calculate law firm profitability the right way.
I’ll let Bruce MacEwen from Adam Smith, Esq. explain why this is a problem to include all partner compensation as profit:
I realized that the primary reason law firms look so much more profitable is that profits are reported before equity partners are paid. The rationale is that equity partners are entitled to everything that’s left over after other expenses are paid, since they own the firm.
Here’s what’s wrong with that. Equity partners wear two and sometimes three hats at a firm. Yes, they are the owners. Some have management responsibilities of varying degrees. But first and foremost they are workers (or, as an irreverent friend of ours likes to say, “day laborers”): The vast majority of their hours are spent servicing, advising, litigating for clients.
What this means is that law firms are reporting profits before taking into account a huge proportion of their labor costs. Were their work done by equally competent lawyers who were not equity partners, the labor costs would fall into the expense bucket.
Don’t Kid Yourself
If you’re a law firm owner and you’re calculating your firm’s profitability before accounting for your own labor costs, you’re kidding yourself. To remedy this issue and get a true financial picture of your operation, you need to allocate part of your take-home pay as your labor cost of producing firm income.
Pretend an imaginary person owned your law firm and hired you as CEO to run it. You, of course, would want to be a paid a salary commensurate with the services you provide the firm. Likewise, the imaginary owner would like to see some profit after paying you to run the business.
What would that salary be? It depends on the kind of services you provide the firm.
If you’re simply performing legal work (think solo or very small practice), your salary would probably be about one-third of fees earned as a timekeeper. This is what it would cost you to hire another attorney to do your work.
What if you’re more of a rainmaker and let other attorneys handle the legal work? Well, using origination credit as a guide, your salary would probably be somewhere in the range of 10% of all fees you originate.
What about administrative/HR functions? This is tricky because you really don’t need to be a lawyer to discharge these functions. To keep things straightforward, just estimate the hours per month you spend on these duties. Then multiple it by a reasonable hourly rate, say $75/hr.
Now, take your salary and multiple it by 1.2 to 1.3 to cover payroll takes and benefits. Now you have a reasonable estimate of the labor cost of your contributions to your firm.
How to Calculate Law Firm Profitability the Right Way
To see your firm’s true profitability, simply take gross fees earned and subtract all expenses, including the salary calculated above, and then divided by gross fees earned. Many firm owners are going to be surprised by result.
Using the formula above, law firm profit margin should be 20% to 30%. If it’s any less, the firm’s CEO is letting down the firm’s owner(s).