I had occasion to be on a panel with several other consultants and some managing partners recently.  One of the consultants said, “As you all know, every law firm loses money on associates during their first three years of practice.”   The panel (me included) smiled and nodded acknowledgment of this commonly accepted belief: all young associates cost more than they produce in revenue.

But it got me thinking…could this be true?  What is the strategic logic of hiring associates who don’t produce profit?  One of the first rules of business states that the easiest way to make money is to stop losing it.  So, if all law firms really lose money on associates during their first three years of practice, why don’t they just fire the lot of them and enjoy a nice increase in profits?

Do We Really Lose Money on Associates?
Unfortunately, this is the point where theoretical accounting and functional accounting collide, producing quite a wacky result.  It makes sense to spread the costs of operating a law firm over the entire staff of attorneys and paralegals and then derive a cost-per-timekeeper (fee earner outside the U.S.).  But if a firm fires an associate, the firm saves the associate’s salary (lets say $100,000 per year for round figures), benefits, taxes (say another $25,000), plus half the cost of a secretary (maybe another $30,000).  Suppose this firm even maintains a magic lease that allows it to add or shed office space at will, precisely matching its lawyer count. That equals another $10,000 in savings.  The sum of this savings adds up to well less than $200,000 total.  Yet, most firms should receive at least $300,000 for the associate’s time, thus producing a negative cash flow of $100,000 if the firm fires the associate.  So, why do firms think they regularly lose money on associates?

As law firms attempt to become more “business-like,” they also attempt to apply industrial cost accounting techniques to the practice of law.  The difference is that law firms are structured with owner operators, which produces a distinctly different result than does an investment owner model.  Cost accounting for law firms simply cannot be figured in the same way as it is for a Buick plant.

The Economics of Ownership
In truth, the overhead costs of running a law firm are the responsibility of the owners.  They make the decisions of what costs are incurred and accept the business risks of maintaining unused office space, obsolete computer systems, etc.  Owners accept this risk because it is justified by the reward of profit sharing.

Unfortunately, many law firms have lost their ownership mindset and gone overboard with leverage models.  Conventional wisdom holds that the reason New York law firms are so profitable is because they have three or four associates for every partner.  In point of fact, the reason New York law firms are so profitable is not simply because they have more associates; they are profitable because their partners are capable of generating so much work that the partners can’t do it all themselves. Therefore, they must hire associates to accomplish all the work to be done.

This is a concrete point.  It is fundamental to a law firm’s profitability.  Suppose that attorneys Moe and Larry leave the practice of law and decide to open a hot dog stand.  They don’t worry about the allocation of overhead because they know the cash they generate by working at the hot dog stand must exceed their costs in order to produce a profit.  When sales increase to such a degree that they cannot handle a single additional customer or sell one more hot dog, they hire an employee.  In hiring the employee (who is, of course, called Curly), Moe and Larry’s hope and expectation is that there will be sufficient demand for hot dogs that the new revenues created by having Curly will exceed Curly’s cost, thus generating additional profits (the law firm leverage model).  At some point, Moe and Larry look each other in the eye and agree they will come up with enough business to keep the new guy busy.

Using Accounting that Makes Sense
The reason I bring this up is that as law firms become more sophisticated in their use of practice groups, they are increasingly tracking revenues and expenses to those groups and making management and compensation decisions based on each group’s profitability.  Managing profitability of a law firm at the practice group level makes complete sense, but only if the means of tracking both revenues and expenditures is completely appropriate for a professional service firm, and not more applicable to a manufacturing company.

Unfortunately, I see many firms that simply divide the total non-timekeeper compensation expenses of the firm by the number of timekeepers, or worse, by the total number of billable hours.  The result is that partners are able to push their overhead costs to the non-owner timekeepers, thereby making themselves look more profitable.

The truth is, a firm must base its system for measuring the success of segments of its organization on more than simplicity of calculation.  This means that, if a law firm is going to measure profitability at any level other than firm-wide, the firm must first consider three basic concepts:

Overhead belongs to the owners.  The costs assigned to the worker bees are costs related to their presence.  The test is, if the attorney leaves the firm, do the costs go away?  If they don’t, it’s overhead.

Everything paid to partners cannot be calculated as a compensation cost in measuring profitability.  Partner compensation is based on three factors: how hard they work, i.e., how much money they bring in as a working attorney; how much business they generate for others to do; and their capital at risk.  The only one of these factors related to the cost of work performed is the portion of compensation based on how hard they work.

This is important because partners, as owners, are paid from profits.  It is a zero sum game — if firms count total compensation as an expense, there will be no profits.  In this case, the measurement would be based not on the profitability of the practice group, but the accuracy of the firm’s compensation system.

Revenues must take into consideration originations by the group, not just work performed.  One of the key roles of a practice group is business generation for themselves and other practice groups.  Basing profitability solely on revenues generated for work performed will inevitably result in the balkanization of the firm into the practice area silos most firms are working to eliminate.

Granted, I appreciate that the above may sound theoretical, but I consistently see firms making strategic decisions on which practice groups to grow and spend money on based on very questionable cost accounting.  Bottom line, look at the numbers – look at them hard – but don’t let them get in the way of common sense and business judgment.