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Why Understanding Law Firm Economics is So Important

Posted by Daniel Pasquarelli on Wed, Aug 02, 2017

Why Understanding Law Firm Economics is So Important

by Daniel Pasquarelli / August 2, 2017

Law-Firm-EconimicsFor most businesses, profit is simply revenue minus expenses. In the law profession where the commodity being sold is time and knowledge and not actual products, economics gets somewhat trickier. It is also something rarely, if ever, taught in law school. However, for your law firm to succeed, you must have a good understanding of the rules that govern law firm economics.

Being able to justify an attorney’s rate in conjunction with the service being provided is a huge factor in understanding the economic impact that billable rates have on the firm’s bottom line.

Mistakes to Avoid When Managing Law Firm Economics

In industry, businesses can compare the cost of producing a single widget (raw materials, labor, marketing, etc.) to the revenue generated by selling that widget. It’s simple to slice and dice profitability by store location, product, quantity sold by sales teams, etc., giving finance departments clear visibility into the economic health of the business. Not so, in the legal profession. When your biggest expense is your personnel, the economic equation can become confusing without the right tools in place.

Here are some economic challenges common to law firms:

Incorrect Billing Rate. Due to its complexity, lawyers historically have equated profitability with revenue generation. In other words, if you make enough revenue, you should be profitable. Similarly, if you are paid your full billable rate without discounting, you should be profitable. Neither of these philosophies accurately measures profitability as seen in more traditional environments which is revenue minus expenses, taxes, depreciation, and interest.  Billable rate must include the total overall direct expense allocation to a particular attorney in order to not lose money on the case. That means the billing rate must accurately compensate for benefits, taxes and share of administrative support staff in addition to salary.

Not Interpreting the Data. Law firms possess a large amount of information about how their business operates—hours worked, hours billed, top clients, revenue and profit attributable to different representations—to name a few. Failing to use this this data to help improve business operations in areas such as predictive pricing and staffing, is a common mistake that has a direct impact on the law firm’s financial health.

Reviewing BI on a consistent basis delivers a view into the firm’s strengths and weaknesses, both indicators of the firm’s health. Using BI to slice and dice metrics surrounding utilization, leverage and profitability within any area of the law firm, can provide insights into trends and new opportunities.

Cautious of New Opportunities. Law firms have the propensity to concentrate on one practice area or industry rather than expanding into new arenas. Using BI data to determine which services within the firm are potential openings for cross-servicing can be a huge opportunity for future services, expansion and the growth of the firm.

How Can BI Help Law Firms Better Understand Their Economics and Economic Drivers?

In today’s world clients want focus and value from their law firm. To address these needs and prevent clients from going elsewhere for legal services, firms must understand their data, monitor their billable hours and ask the right questions of their BI metrics.

If you want to be competitive in a competitive market, turn to your BI for answers to questions like:

Are billing hours increasing or decreasing? Are they low or high? Law firms’ billing needs are unlike any other service industry. Almost all law firms make their money by billing their clients by the hour. Whether or not an attorney is profitable to the firm, comes down to billable hours. Attorneys must make enough money from billable hours not only to cover their salary and share of the overhead, but also to generate revenue for the firm. It’s not an overly complex equation – the more hours an attorney bills, the more revenue for the firm. Keeping track of billable hours indicates which attorneys are good for the firm and which ones aren’t.

What is the realization for billing and collections? The billing and collecting process of every law firm is fundamental to the firm’s financial success. One way to measure success in this area is to review the balance of unbilled time (or work-in-progress) in the firm. The greater the balance of unbilled time, the less efficient the firm is at billing and collections.  The longer it takes for a firm to send out client billing, the slower the flow of cash.

How profitable is a case? How much will it cost to prepare the case? Keep in mind that while having a $5 million case in the works may sound good, it’s not if you’re spending $6 million in expenses.  Keeping track of which cases are unprofitable and why, prevents attorneys from repeating the same mistake.

Staffing and Personnel Ratios. The largest single overhead expense for law firms relates to personnel. A law firm should strive to keep the support staff/attorneys ratio as low as possible while still producing quality work in a reasonable amount of time.  By monitoring and adjusting this ration, you can help boost the firm’s profitability. Even small reductions in this ratio can have a meaningful impact on a firm’s profitability.

At the end of the day, understanding the law firm economic model is vital to interpreting the health of the firm.  Those firms that understand their economics are better poised to address pricing issues, work more efficiently, adapt to evolving client demands and succeed in today’s highly competitive legal market.

To learn how Business Intelligence can help your law firms get a better understanding of your economics, download our free Viewpoint Document The Keys to Successful BI for Law Firms!

 

BigSquare is the leading provider of Business Intelligence for law firms and professional service organizations.  We focus exclusively on law firm reporting, law firm BI, law firm profitability and law firm analytics.

The Keys to Successful BI for Law Firms 

Tags: Law Firm Economics Economics Business Intelligence Law Firm Profitibility Legal BI

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