Gauging Department Profitability
by Barbara Lewis MBA and Dan Otto MBA

If you’ve 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 firm’s profit margin is less, you should find out why. Let’s 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. Don’t fix the things that aren’t 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 around…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 department’s 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 firm’s overall profitability, calculating department’s 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 happenstance.