It’s a given that law firms would like to be more profitable.
But how do we become more profitable?
In the following series of articles, I shall point you to the key issues that you need to address to make your firm more profitable.
What are our options?
Luckily the basic business dynamics of law firms can be broken down into three key blocks and by managing those blocks properly, you can achieve your profitability objectives.
Law firms – basically – buy time from sufficiently qualified and skilled individuals, so that the firm can resell their time and experience to clients. The price they charge must cover the cost of employing those people and the firm’s overheads and provide a profit for the owners.
A simplified Profit and Loss account is set out below. From this you can see that there are very few big numbers – the ones that make a difference – that you can alter. We alter them by pulling levers, such that change happens. Making sure you pull the right levers to alter the figures correctly is the trick.
In this small/medium-sized firm, we have 85 fee-earning staff, generating £5m of income. That’s only £59k each. On average those staff cost us £35k each. At this stage, I am not saying what is acceptable: let’s just take it as it is.
Overheads are split, to show the larger categories separately. Those identified separately also tend to be the ones that you cannot change.
There are three basic options, (levers), that we have to increase profit.
- Increase fee earner numbers – just do more work
- Increase profitability per fee earner – increase the income generated per fee earner
- Reduce overheads – cut the cost base
Some of these are better than others and one is – in truth – a fool’s errand.
Let’s look at them.
Option 1 Increase fee-earning staff numbers
Let’s go for growth and increase our fee earning complement by a quarter! That will result in Income increasing by a quarter, fee-earning staff costs increasing by a quarter and Gross Profit increasing by a quarter. So far, so good.
However, extra staff will mean extra costs. You might have sufficient capacity to absorb much of the increase in people but there will, almost certainly, be some extra costs. I have assumed an increase in 10% in this example.
Let’s see how that works through:
We have, as expected, increased our income by a quarter, our staff costs by the same amount and therefore, our Gross Profit by the same proportion, from £2M to £2.5M. Our Gross Profit percentage remains at 40%.
Our overheads have increased by 10% from £1.4M to £1.54M. So, although our Gross Profit increased by £500k, we only increased our Net Profit by £360k.
This is not a disaster – far from it – but our Net Profit percentage has only increased from 12% to 15%.
Now it is time to make some assertions about what profit margins are acceptable. Our Gross Profit should be at, or in excess of, 50% and our Net Profit should be nearer 30%. Higher margins provide a buffer against unexpected downturns in performance and are therefore highly desirable. We have some way to go because adding fee earners also adds to overhead costs, so we are being dragged back, financially.
Increasing Fee Earner numbers
The big problem with increasing fee-earner numbers, is that they don’t start generating cash immediately they start work for your firm. So, you must fund their salary, recruitment cost and new kit, for a few months until they are cash-positive on a monthly basis.
How much you will have to fund new fee earners joining the firm will depend upon the speed at which they start billing and the speed at which the firm collects the cash from those bills. Obviously, we must continue paying salaries throughout the year but month-on-month, until the time that the fee earners generate more cash per month than their salary cost, we will have an increasing funding requirement.
If we assume that with a 25% increase in staff numbers, the firm:
- Takes 6 months to get the fee earners billing at 100% of capacity
- Takes 2 month to invoice the work after the fee earner has done the work
- Takes 3 months to receive the cash after billing the work and
- Pays a 15% recruitment fee, then
The firm will suffer an increased cash demand of about £500k to recruit those fee earners, as set out in the cashflow model below.
The salary cost, in the top line, is £63k p.m. and there is a recruitment fee of £94k – in this example.
The blue line shows the cash coming in, based upon the assumptions above.
The shaded pink and white areas show the monthly cash movement and the cumulative impact of those cash movements.
After month 8, which is the peak funding demand, the extra fee earners start paying their way and the funding pressure starts to ease. However, it takes 21 months, (table not extended that far), to recoup all the funds borrowed.
- There is no increase in the Gross Profit margin and
- There is a large funding requirement to add extra fee earners,
adding extra fee earners may not be the most attractive way to increase profitability.
It is fair to say that firms can speed up the rate at which fee earners get up to full billing capacity and bill and collect their work. This will reduce the demands on law firms: but that is the subject of another article on Financial Management in law firms and I don’t want to confuse the issue here!
In the next instalment, we shall look at another option, which is to increase fee earner productivity.