Professional Service Firms Articles
Measuring Profitability - How to allocate expenses fairly and consistently

Target Audience: Legal Professionals, Professional Service Firms, Law Firm Accountants

Any discussion of partner compensation will include an “aside” on how best to determine an individual partner’s contribution to profitability. It stands to reason that the higher the contribution to overall profitability, the higher that individual’s compensation. This means measuring not just billing, or even realization, but also expenses.  Unfortunately, determining the costs incurred by individual attorneys can be a slippery slope. Dividing total expenses by the number of attorneys won’t provide an accurate answer. Conversely, tracking every expense associated with each individual attorney would be cost prohibitive.

The compromise is to design a system that can easily capture and allocate the majority of costs that are directly attributable to an individual attorney and then devise a methodology that fairly allocates the remaining costs.

Are they direct or indirect costs?
Direct costs can be traced to an attorney relatively easily and with a high degree of accuracy. Typical costs that would fall into the direct expense category include:

• Associate and paralegal salaries,
• Employee benefits,
• Life insurance premiums (excluding key person
• coverage where the firm is the beneficiary),
• Payroll taxes,
• Memberships in professional associations and clubs,
• Professional journals, magazines and newspaper
• subscriptions,
• Auto allowances and travel costs,
• Communication device expenses,
• Administrative support (secretarial support
• allocated to specific attorneys),
• Entertainment expenses,
• Continuing professional education,
• Home office expenses, and
• Personal postage and office supply expenses.

Any remaining expenses will be either indirect or overhead expenses.

Let the games begin
Historically, law firms have tried to allocate firm indirect costs, collectively referred to as overhead, to partners in a manner that distributes profits fairly. But such allocation methods usually result in partners arguing that their allocation of the overhead was too much.  That’s why it’s critical, when calculating profit contribution per partner, to specifically identify as many expenses as possible.The fewer expenses lumped into overhead, the better.

What typically makes up overhead? It includes any expenses that would be difficult to track and allocate to a specific attorney, such as occupancy costs, equipment leases, software licenses and outside support, administrative and support staff, marketing materials, public relations, professional liability insurance, staff functions such as office parties, and outside consulting fees.

The variances of overhead consumption
The easiest method of allocating indirect costs would be to divide the total by the total attorneys in the firm — easy but wrong.

The fact is that different attorneys can use vastly different amounts of resources depending upon their annual client billings, type of practice, management duties, and time and status in the firm. For instance, a senior partner who serves on the executive committee, heads up the litigation practice, and has two personal secretaries and a corner office will most likely consume more resources than a second-year associate would.

Weighing in on overhead allocations
The most common approach to solving this inequity is to use a weighting method. Attorneys are grouped (using annual client billings or billable hours, or a combination of the two) into categories and assigned a weighting factor.  A typical weighting may look something like:

Category                            Weighting factor
Senior partner                      1.75
Partner                                1.50
Junior partner                       1.25
Associate                            1.00

Once the weighting is assigned, the total weightings are added together, and the total overhead costs are divided by the total weightings to determine a per-unit cost of overhead.  This per-unit cost is then multiplied by each attorney’s individually assigned weighting factor to determine his or her overhead allocation.

For example, if there were only four attorneys, one from each category, the combined weighting would be (1.75 + 1.50 + 1.25 + 1.00) = 5.50. If overhead expenses totaled $600,000, a unit of overhead cost would equal ($600,000/5.5) = $109,091. A senior partner would receive an overhead allocation of 1.75 x $109,091, or $190,909.

Profit-per-partner scorecard
Once the overhead allocation has been made, you’ll have all the necessary pieces to compute profit contribution on a partner-by-partner basis. (See “Profit-per-partner scorecard example” above.) While this overhead method isn’t perfect, by directly allocating as many costs as possible to individual attorneys and using a well-considered weighting system, you should be able to keep the allocation debates to a minimum during compensation review time.

PROFIT-PER-PARTNER SCORECARD EXAMPLE
Using the senior partner from the weighting example, here’s how you would determine this partner’s profitability:

Personal billable time: 1,000 hours @ $400 per hour  $400,000
Book of business credit: 50% x $1,000,000 (will vary by firm)  500,000
Gross revenues for the senior partner  900,000
Firm realization factor at 95%
(5% deduction for unbilled and/or uncollected fees) (45,000)
Net revenue for senior partner $855,000
Less direct costs assigned (300,000)
Less overhead allocation of 1.75 x $109,091 (190,909)
Profit contributed by senior partner    $ 364,091

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