In the 20 years that I have been implementing cost accounting systems for professional service firms, I’ve continued to encounter those who think that cost accounting doesn’t apply to them, and that it’s more suited to industries like manufacturing.
While we in service industries do not produce durable goods, we do have measurable production, and so, cost accounting certainly does apply. Our production is based on time spent serving client needs — understanding this is vital in understanding how cost accounting can be applied to service firms.
All law firms should implement a cost accounting system if they want to understand their own business. By implementing a cost accounting system, your firm will be able to determine profitability by producer (attorney or paralegal), division, office location and even client.
While at Harvard Business School, I developed a cost accounting program for service firms. Utilizing my own firm as the pilot, we achieved a 350% increase in profits in less than a year resulting from the new profit-planning and measurement system we put in place. We still use this program today for our firm as well as for our clients.
The biggest challenge for a cost accounting system is how to allocate overhead. The cost accounting program that I developed calculates overhead at a minimum, approximately 10% to 15% [OF WHAT?]. The secret to a good cost accounting system is to have most expenses directly allocated to a producer. By doing this you can actually achieve a cost per hour for each producer.
Most firms establish billing rates by assumption.For example, firms will say Attorney Smith has been here for 15 years and does good work. His billing rate is $250 per hour. Attorney Jones has been here for 12 years but she is really good at what she does and is a specialist. Her billing rate is $300 per hour.
After understanding the costs to Attorney Smith and Attorney Jones, the cost per hour for Attorney Smith may be $150 per hour and the cost for Attorney Jones may be $325 per hour. This would make Attorney Smith very profitable ($100/hr.) to the firm and we would lose money on Attorney Jones (-$25/hr.).
This holds true for every client of the firm, as well. The cost accounting system would tell you if clients are profitable. This also will tell you if divisions within the firm are profitable or not.
Most partners believe that if you have a large client, then they must be profitable. That is not always the case. In fact, an average of 30% to 40% of large clients are not profitable to many law firms; and in some firms, that percentage is even higher.
All firms have low-volume and low-income clients that bring no value or purpose to the firm. Somehow, there’s always a rationalization or excuse as to why they are with the firm, and the partner-in-charge always seems to have a reason to keep them. Those clients, on average, represent 3% to 5% in value yet take 10% to 15% of the firm’s resources.
After understanding your costs, you should establish a profit plan for the firm. A profit plan is different than a budget. While a budget is expense-driven, a profit plan is revenue-driven and establishes revenue goals that the firm works toward each year.
By understanding firm costs, making adjustments to billing rates, controlling write-down amounts, dropping unprofitable clients and managing your billable hours, profit goals can easily be met.
This blog post was written by Samuel J. Catanese, CPA, the leading partner of the Catanese Group, a certified public accounting and business management firm located in Western Pennsylvania. Mr. Catanese has worked with law firms across the country on consulting and profit planning engagements. For more information, call (814) 255-8400 or email him at email@example.com.