Cost accounting can help firms determine just how profitable they really are.
However, the firm might not be as prosperous as partners and legal managers believe. Without peeking behind the curtain and looking at the numbers, firms can never be quite certain that they are meeting their goals and exceeding their expectations.
“Law firms have historically been viewed as professional organizations providing valued services for the benefit of their clients while working together in a respectful professional manner,” says Michael Leddin, Executive Director of law firm Segal McCambridge Singer & Mahoney. “This may well remain to be true, but at their core, law firms are businesses with owners and the goal [is] to generate revenues and profits.“
If law firms haven’t already, they need to start using cost accounting to truly know if they are profitable. When they utilize cost accounting, they can see if they are on the right track and taking all of their expenses into consideration.
“Whether you are an attorney who is working on an hourly rate or flat fee, you must determine if the pricing model covers the costs of staff time and case expenses,” says Thomas J. Williams, EA, a tax accountant who operates Your Small Biz Accountant, LLC. “Attorneys juggle many tasks at one time and often put their business on the back burner.”
Even if attorneys are busy with a million other projects, they need to look at their financial paperwork to stay afloat. “More financial information is always better than less,” says Joseph S. Leventhal, Office Managing Partner at Dinsmore and a member of the Board of Directors at the Federal Bar Association. “It’s important to know the profitability of an attorney, a practice group, an office or any other measurable group. The firm may accept that certain offices, practice groups, or attorneys are not profitable. But that should be a conscious decision made with the expectation that the firm is making an investment in that group (or attorney) for a particular longer-term reason.”
If firms want to avoid politics in the office and causing conflict, they can choose to defer to either their in-house accountants or hire outside companies to help.
Cost accounting involves looking at all the costs associated with the law firm. When firms utilize cost accounting, they will take into account every cost they have for their attorneys, associates and paralegals, according to Samuel J. Catanese, CPA, Leading Partner at Catanese Group. The cost will include things like salaries, payroll taxes, legal dues and fees, a profit-sharing plan and malpractice insurance.
Then, firms will see how much attorneys, associates and paralegals are charging clients per hour and whether those charges exceed their bill rates, says Catanese.
For example, one partner may bill a client at $150 an hour, but it is costing $180 an hour just to employ that partner. Every time he or she works on a project, the firm is losing $30 an hour. Firms need to switch the equation and ensure they are profitable every time.
Firms have to figure out what they can do to either cut costs or increase their billing rates. “You need to determine how much it costs to generate each dollar of revenue to determine where resources should be allocated to realize the greatest profitability,” says Leddin. “[Also], identify what modifications should be made — for example, staffing, leverage, rates, etc. — to improve the return on underperforming business units or locations.”
Along with comparing hourly billing rates to costs and taking all the expenses into account, firms should run some tests to see where they stand. They must administer case studies by choosing two to three files and tracking all the activities, from the initial consultation to phone calls, meetings and everything in between, says Williams. “The analysis should be conducted at least on a semiannual basis. Staying profitable requires an attorney to gather data, analyze it and draw conclusions that help the practice stay ahead of the curve.”
The first year one firm implemented a cost accounting strategy, they saw a 350 percent increase in profits. Other firms can experience the same if they use cost accounting.
Often, law firms will keep doing what they have always done because they are used to routine, but an analysis helps them break out of it.
“Law firms often fall into to the habit of focusing on ‘the work we've always done for the clientele we’ve always served at our standard rate, which we raise when we feel we need to,’” says Matt Burkinshaw, a former law firm partner who is now a business consultant for firms at Performance Growth Advisors. “Measuring the profitability of an area of practice, which includes the nonattorney staff and resources necessary to serve that market, can expose inefficiencies that need to be addressed. This analysis can also highlight profitable practice areas that are under-represented in the firm and drive decisions to invest in building those areas.”
Once firms run their studies, they will know their costs and how they compare to billing rates. Then, they can come up with a plan of action or profit plan. Unlike a budget, which is focused on expenses, a profit plan is meant to drive revenue.
According to Catanese, this plan involves implementing the cost accounting system; coming up with the cost per hour for each product; identifying the profitability of each client, producer, division and office; and establishing a profit plan for the firm.
Cost accounting doesn’t come without its own challenges. “It's a situation that may be politically dangerous. Some partners think they are very profitable and when they see their cost, they are not,” notes Catanese. “You may have one partner bringing in $1 million, and then when we do the cost analysis, his cost may be $1.2 million. Partners don't like to think they are not profitable."
When handling cost accounting, if firms want to avoid politics in the office and causing conflict, they can choose to defer to either their in-house accountants or hire outside companies to help.
Even if attorneys are busy with a million other projects, they need to look at their financial paperwork to stay afloat.
Catanese, who assists law firms with cost accounting, says that very few are doing this but that it is absolutely necessary. It is up to the law firm administrator to put a plan into place.
Typically, the Catanese Group will go in, do a cost accounting analysis, and then in the second year, let the firm perform it on their own. The cost accounting plan needs to be updated at least once a year. According to Catanese, in the first year one firm implemented a cost accounting strategy, they saw a 350 percent increase in profits. Other firms can experience the same if they use cost accounting.
“By working closely with a law firm accountant, you can develop an actionable plan with milestones that hold you accountable,” says Williams. “No matter the tools or expertise that are available at your disposal, only you can set the success of your business.”