All law firms, large and small, have one thing in common: a finite limit to discretionary spending.
Non-discretionary spending are those expenditures that are required by your current organizational structure and by law: for example, payment of debt obligations, utilities and taxes are mandatory.
Most everything else can be considered discretionary spending or overhead. Even rent/lease payments, usually considered fixed overhead, can frequently be adjusted if necessary. All money spent on overhead can, with some creativity, be reduced or altered if necessary—there should be no such thing as a fixed cost. Spending for such items as leases and staffing is important but can be modified (albeit painfully) when necessary. Overhead spending is that which could be reduced or eliminated if it does not serve a business purpose.
Who Controls Overhead?
It is unique to law firms that so many individuals have direct impact on overhead spending. In many firms, individual partners, even lawyers generally, can direct discretionary resource consumption, from purchasing new office furniture to charging the firm with personal meals and travel.
Left alone, some lawyers would realize how much they cost the firm only after the money ceases to come in the door. However, cash flow cessation is usually the last symptom of a downward spiral that started long before with failure to control overhead spending.
How many lawyers can calculate, or even understand their impact on the traditional key measures of law firm performance: realization, utilization, leverage and overhead?
When I was practicing as an associate, I showed the managing partner what percentage my billings were of the firm, what my expense was to the firm was and what my "profit" to the firm was (though I had no clue about the realization rate of my billings by the firm). After getting over the shock that I would attempt to have that information, he asked me why I kept it. I told him that I enjoyed my job, wanted to keep it and knew that the firm could/would not keep me if I were not profitable for them. I didn't need to be profitable every month, but I needed to be profitable for the year. Shortly after that discussion I was invited to become a partner.
How is Overhead Calculated?
All lawyers ought to be able to assess the impact that they have on firm overhead, and thus firm profitability. The information to do that would include:
- Billable hours for the latest month and year to date
- Number of hours the firm billed out for them
- Personal compensation (including bonus and benefits)
- Direct overhead expenses for office space, personnel and technology
- Indirect overhead expenses (the percentage of rent, insurance, utilities, entertainment and education that can be apportioned to each lawyer.
The result should determine an individual net profit value to the firm:
Billings - Compensation + Direct and Indirect Overhead = Net Profit
Each firm is different . Yet the formula works for every analysis.
What Does Office Space Cost?
Not long ago, I received a call from a lawyer wanting to know what percentage of his gross revenue should be allocated to rent. He wanted to know whether his percentage was in line with other law firms. I cited one study that put the average at 9 per cent. My response didn't satisfy him; he went to another consultant and was told the average was 12 per cent.
Such generic numbers totally miss the point on two levels. First, they allow lawyers to become self-satisfied that they are the same as others, and that they need not try to do better than the average. In fact, real estate costs that are lower than average make a statement about how the law firm runs its operation—that it is sensitive to the cost structure for the benefit of not only its equity owners, but also its clients (since lower overhead could well translate into a lower fee structure). In other words, the cost of office space is a statement about the law firm itself.
On a broader level, why does it matter what others pay for rent? Certainly you cannot be too far out of line with your competitors and still stay in business. This, however, relates to the whole of your business/practice, not to any single item. The real issues and questions are far more complex than a simple answer to this one question.
- Is your rent competitive for the geographic area in which you're located?
- Is your current physical location one that you, your clients and prospects are comfortable with?
- Would you like to improve the quality of your professional life by moving to other, better appointed quarters, and can you "afford" it?
- Would your current and prospective clients think more of you if you had better quarters, thereby allowing you to take on better cases and charge more for them?
If the answers to these questions mean that you pay 13 per cent of revenue for rent, then so be it. The most important thing is that you've asked the proper questions and made conscious choices consistent with your firm culture and goals.
What Does Turnover Cost?
The Society for Human Resource Management estimated that it costs $3,500 to replace one $8 per hour employee when all costs (recruiting, interviewing, hiring, training, reduced productivity, etc.) were considered. Another organization estimated that termination costs equal 30 – 50 per cent of the annual salary of entry-level employees; 150 per cent of middle level employees and up to 400 per cent for specialized, high level employees.
Apply the 30 per cent figure to a secretary who earns $40,000 per year and you get $52,000 as the cost to replace one secretary. Apply the 400 per cent premium to the annual salary of perhaps $150,000 for an associate at a large firm, and you have a $600,000 cost to the firm for the lawyer to leave! In our Managing Partners Roundtable, members uniformly have estimated the cost to be at least $200,000 to $400,000.
Most firms are unable to determine the costs of turnover. Either they don't measure them, or they tend to underestimate them, or they think such costs are unavoidable. If firms measured the costs of termination and replacement, particularly where lawyers are concerned, they would find their overhead increased by these measurable metrics:
- Hiring costs (recruiting and interviewing)
- Training costs (orientation and training, plus the cost of compensation, benefits and lost productivity while the new person is trained)
- Client service costs (client dissatisfaction, reduced or lost business due to increased workload, lost productivity, stress and additional workload until a replacement is hired)
- Direct termination costs (exit interviews, severance and other administrative costs).
"Retain and gain" is the motto that makes most sense. One source has suggested that a 10 per cent reduction in turnover is more valuable than a 10 per cent increase in revenue or a 10 per cent increase in efficiency/productivity.
What Does Technology Cost?
New computers, software and database research services are significant overhead costs—so significant, in fact, that larger firms have established a formal budgeting process for their technology purchases.
I conducted a survey of selected large firms and found that 66 per cent of the respondents allocated 2 per cent or less of their gross revenue for hardware purchases, while 75 per cent allocated an additional 2 per cent or less of their gross revenues for software purchases.
These numbers aren't large percentages, but are large numbers of dollars. Plus, two-thirds of the respondents age-out their computers and related technology before the end of a three-year cycle (17 per cent in two years), guaranteeing a continual cycle of expenditures. Thus, the amount of dollars committed to technology purchases can be substantial.
Many small firm lawyers, facing the same pressures and wanting to stay current with technology changes, resist buying or updating technology because they are overwhelmed by the high up-front expense. They may be on a four, five or even six-year upgrade cycle because of these factors.
However, if you don't use current technology effectively in delivering your legal services, whether transaction or litigation, you may be perceived as willfully less competent than your competitors. That's malpractice, and malpractice is really expensive.
What Are You Trying to Control?
These examples all illustrate that, when it comes to overhead, it's important to know what cost you're really trying to control. Lawyers and law firms often don't know their true costs of operation. Thus, the amount billed to clients can be a "by guess, by golly" fee, not one based on a cost benefit analysis of direct and indirect overhead. Your firm cannot aspire to set an accurate fee unless you understand the true measure and importance of your key overhead metrics.
Edward Poll (edpoll@lawbiz.com) is a certified management consultant and coach in Los Angeles who coaches attorneys and law firms on how to deliver their services more profitably. He is the author of Attorney and Law Firm Guide to the Business of Law: Planning and Operating for Survival and Growth, 2nd ed. (ABA, 2002), Collecting Your Fee: Getting Paid from Intake to Invoice (ABA, 2003) and, most recently, Selling Your Law Practice: The Profitable Exit Strategy (LawBiz, 2005).