Gauging Department Profitability
by MBA and MBA
If youve read our past columns, you know that average
profitability for a law firm is 33 percent. After all expenses
and taxes are paid, partners should take home one third of the revenues. Firms whose
profit margins are higher than 33 percent can congratulate themselves. Some
firms with smooth running operations and excellent efficiencies can boast margins of 70
percent or even more. If your firms profit margin is
less, you should find out why. Lets take a closer look at profitability by
department or matter type.
Not all departments are created equal. Some
departments may have high profit margins while others experience much lower margins. This is especially true for insurance defense firms with several types
of clients. The insurance defense may only generate a 10
percent profit or even a loss, whereas the corporate defense litigation may have a 40
percent profit. In this case, the firm should concentrate on
improving the operations of the insurance defense department delegation to
paraprofessionals, economies of scale through standardization, etc. Unfortunately,
insurance companies dictate billing rates, which affects the attorneys salaries.
Oftentimes, this discrepancy in profit margins among departments is a
point of contention with the partners, who want to split profits evenly even though they
are not contributing to the profits equally. Partners whose
departments are generating high profits should be earning more than partners whose
department profits are much less.
Gauging the profitability by department, type of client or matter can
provide the firm with a focus on areas that need improvement. Dont fix the things
that arent broken. Tracking the progress of improved
profitability by departments or type of matters can reveal trends that demonstrate to
partners if that area is operating in the best interest of the firm. Unprofitable
departments can be curtailed or resources shifted to more profitable departments.
So what are the mechanics of determining profitability by department
or matter type? You may have attempted to determine profitability by department, but got
stuck on allocating general and administrative expenses. This is easy to get
forget about them. For comparison purposes we define department profits with
consideration to only those expenses that can be segregated. The top two expenses for most
firms, payroll and rent fall into this category. Department profits are defined for each
department as revenues minus direct expenses minus allocated rent.
Revenues are easily segregated by department. Direct
expenses, which are the expenses only for that specific department, include salaries and
wages, benefits, and client costs. Total rent is allocated by the percentage of department
space. Employee salaries can be split across departments if they are shared.
Salaries for non-departmental employees such as word processors, accounting and
marketing personnel should not be calculated as direct expenses of the department.
Indirect expenses are general and administrative costs that cannot easily be attributed to
any specific department. They include office supplies, insurance, postage, etc.
Theoretically, all expenses can be allocated to a revenue-generating department. That
level complexity will give you a better estimate of department profitability, but is more
time-consuming to calculate.
Now you can compare the departments profitability.
A loss in any departments profit calculation indicates a serious problem
since there is no contribution by that department to pay the indirect expenses of the
firm. Concentrate your improvement efforts on the lowest profitable departments first. If
all department profits appear reasonably profitable, then investigate the remaining
indirect (general and administrative) expenses.
Although you may know your firms overall profitability,
calculating departments profitability will enable you to expand more profitable
areas and contract or improve less profitable areas. In some
cases, firms are willing to forego the profitability of one department because it serves
as a loss leader for other areas of the firm that are more profitable. However, this should be part of your business strategy, rather than