As a law firm decision maker, you would like to be able to identify your ten most profitable clients. But what is the most accurate method to determine client profitability? For that matter, what is the most accurate method for determining the profitability for any of the “components” in your firm: timekeepers, clients, partners, offices, departments, etc.

Let’s look at the example of client profitability in greater detail. At a high level, the formula for profitability is:

(+)       Total Fees Received

(-)        Timekeeper Payroll Expenses

(-)        Direct timekeeper costs (travel, training, parking, etc.)

(-)        Direct non-billable client costs (entertainment, etc.)

(-)        Firm/Office/Dept Overhead (office space, HR, IT, etc.)

=          Client profitability

In order to calculate client profitability using the above formula, you must know how much of a timekeeper’s costs to apply to each client. The sophistication of your firm’s Time and Billing (T&B) system or data warehouse determines how accurately you can calculate each of these components. Let’s examine the typical calculations for each component in greater detail:

Total Fees Received

All firms can accurately extract this information for each client in their T&B system.

Timekeeper Payroll Expenses

All firms can accurately extract this information from their payroll system. They can then allocate this expense to the clients based on the percentage of billable timekeeper hours for each client.

Direct Timekeeper Costs

Some firms will be able to tie certain direct timekeeper costs to each timekeeper. Other costs may be distributed through an FTE-based or revenue-based allocation. These costs are then allocated to the clients based on billable hours.

Direct Non-Billable Client Costs

Firm/Office/Department Overhead

Most firms would use an FTE-based allocation method to assign these expenses to each timekeeper and then allocate to each client through billable hours.

The problem with the typical methods is that they rely heavily on FTE-based calculations. To determine client profitability you must accurately assign expenses to the timekeepers working on that client. Unfortunately, FTE-based allocations are not a fair or accurate method of tying expenses to a timekeeper. As an example, with FTE-based allocations there is no attempt to accurately assign secretarial expenses to the timekeepers who are actually using the secretaries: all secretarial expenses are simply divided among the timekeepers. In general, any FTE-based allocation may be flawed, because all timekeepers do not have the same office sizes, secretarial services, marketing expenses, training budgets, etc.

To calculate client profitability, we need to accurately assign expenses to timekeepers. Let’s consider an improved method for expense assignment:

~          Divide all expenses into the following categories: compensation expenses, other direct costs, secretarial support costs, and indirect costs.

~          For this exercise, we can assume that the compensation expenses are available and can be tied to the timekeeper.

~          Other Direct Costs: Travel, advertising, entertainment, training, seminars, and other fees for the timekeeper. Again, we can assume that the firm can tie these directly to the timekeeper.

~          Secretarial Compensation Expenses: Determine the percentage assignment of each secretary assigned to the timekeeper. (Example: Timekeeper A uses 50% of Secretary B’s service.)  Allocate to the timekeeper that percentage of the secretary’s compensation expenses.

~          Occupancy Cost (This is a special direct expense). The total occupancy cost for the office is allocated to the timekeeper based on the square footage used by the timekeeper and secretary.

~          Indirect Costs (here’s the tricky part): All expenses listed above are direct and can be tied to a single timekeeper. Everything that is left is an indirect expense; therefore, there is no alternative except to allocate these expenses. However, we are not limited to a simple FTE allocation: A sophisticated system should support at least the following allocations:

Weighted staff level at account level

            ·           Percentage of Dollars/Billings/Revenue

            ·           FTE allocation should still be available for use where appropriate

            ·           Square footage as a percentage of all time

                        keepers’ square footage in the office

~          Furthermore, the system should allow the allocation method to be assigned for each G/L account as appropriate. Examples of how to best allocate expenses:

            ·           Cost Recoveries: Credit back to timekeepers

                        based upon a percentage of revenue

            ·           Carrying Costs: Calculate based upon a per-

                        centage of AR and WIP

            ·           Travel: Weighted allocation based on staff

                        level. (Travel expenses may be weighted more

                        heavily to partners since they tend to travel

                        more often)  

            ·           Copying/Messenger: Allocate based on per-

                        centage of billable dollars.

            ·           (The system must allow any allocation method

                        to be assigned to any G/L account)

~          Ultimately, all expenses need to be allocated to the timekeepers in the firm, ensuring accurate profitability analysis.

~          Smoothing factors can also be incorporated into the calculations. For example, the administrative partner who only works a very small amount of billable time can skew the profitability of the clients he works on. For these exceptional situations, alternate cost rates should be offered based upon several different billing factors.

Using the above methodology, accurate hourly cost rates can be calculated for each timekeeper. These rates can be multiplied by the timekeepers’ hours worked for each client, resulting in an accurate accounting of the expense for each client. By accurately assigning the costs, clients with large amounts of hidden expenses will be exposed; likewise profitable clients will also be accurately identified. The same methods that work for client profitability also apply to office, department, timekeeper, and partner profitability. With a proper data warehouse implementation, accurate component profitability information can be calculated and compiled on demand. Component profitability information gives you the competitive edge that you need to focus your firm’s efforts, resulting in increased profitability.

About our author . . .

Tom Jones is Product Manager for Net ResultsTM, Solution 6’s business analytics solution for professional services organizations. Tom can be reached at (775) 747-2353 or at tom.jones@us.solution6.com.