Economics of Law Practice:
Where Does the Money Go?

by Gary L. Birnbaum and P. Bruce Converse

In an era characterized by increasing competition, stabilized billing rates (after adjustment for inflation), new technology expenses and mounting operating costs, increasing or even maintaining historic law firm profit levels has become a matter of concern for administrators and law firm managers throughout the United States. Certainly, the Arizona market is no exception. Law firm economics and management seminars that previously focused upon managing growth and the benefits of leverage now often focus upon maintaining profitability margins, adjusting personnel ratios and dealing with the absence of leverage.

One of the tools most useful to managers striving to maximize law firm profits is comparative financial analysis: the careful comparison of a firm’s actual financial performance with data from other similarly situated firms. The availability of such data is of particular importance to law firms as, in most firms, the management structure is not typical of other types of business: there is rarely a "management trainee" program, and the number of lawyers who move from a managing position in one firm to a managing position in another is relatively limited. Thus, the ability to use survey data to gain from other firms’ management experiences is critical.

Altman, Weil, Pensa Publications, Inc., is one of a relatively small number of firms that have emerged to fill the need for survey data in the legal profession. Altman, Weil conducts an annual survey of law firm economics, requesting detailed financial information from firms throughout the United States. Response to the survey —which is of course entirely voluntary —has grown each year, and the universe of respondents is now of sufficient size that valuable guidance may be derived from even a cursory review of the survey data. This article employs the most recent Altman, Weil survey results to illustrate the manner in which such data can be used by law firm managers and administrators, and to present some broad (though simplistic) conclusions about the proper focus of managerial efforts.

When a law firm faces a fiscal crisis, common wisdom suggests that the cause is often rooted in uncontrolled expenses and lack of fiscal discipline. While managing attorneys at such "floundering" firms often pay lip service to the need to actively market the firm, adjust historically stagnant billing rates, and improve overall realization figures, the expense side of the ledger is more often the focus of initial, dramatic action. Whether it is because law firm managers feel that they can have little immediate impact upon the firm’s income structure, or because they sincerely believe that the firm has historically and unnecessarily engaged in profligate spending, once a fiscal crisis is acknowledged, draconian spending reductions inevitably follow.

There is little doubt that virtually every private practice law firm can reduce its expenditures to some degree without impacting the quality of its professional practice or the efficiency of its staff. Secretarial overtime, out-of-state continuing education seminars, temporary office personnel, and non-chargeable disbursements provide particularly fertile areas for immediate expense reduction.

What happens, however, after the initial spending cuts and staff adjustments? Where do law firms spend the income they derive from the work of their shareholders, associates, and paraprofessionals?

The following survey may surprise many legal administrators and managing attorneys. Expenditures in certain areas — e.g., marketing and promotion, library and reference materials, and payments to former partners — are so small, as a percentage of gross law firm income, that even a relatively large decrease in expenditures in one or more categories is likely to have little effect upon the overall profitability of the firm. Moreover, by reducing expenditures in areas such as promotion and marketing, a truly Phyrric victory may be achieved: Expenditures may be reduced in absolute terms, but overall income may fall as a consequence, thus decreasing operating profits.

The Law Firm Analytical Model

The best method for focusing upon the relative significance or insignificance of any expense category is to examine each item of expense as a percentage of gross firm income. To permit this analysis, a "hypothetical" or "model" firm, with income and expenses, can be created as a standard.

Income

In the case of a model law firm, "gross revenues" or "gross income" per lawyer is neither a difficult concept to understand nor a difficult number to predict: The mean number of hours worked per attorney, multiplied by the mean hourly rate, with the product then multiplied by a realization rate (to take into account both pre-billing write-downs and post-billing collection losses), yields average gross income per lawyer. Without referring to any empirical data, and without imposing any geographic, firm size, practice area or other limitation, we suspect that most Arizona attorneys would guess that the "average" attorney bills approximately 1,700 hours per year, at an average billing rate of approximately $170 per hour, and a realization rate (after pre-billing write-downs and post-billing collection losses) of approximately 90 percent. This hypothetical lawyer generates approximately $260,000 per year in gross revenue.

Available data suggests that this simplistic model is remarkably accurate. The 1996 Survey of Law Firm Economics published by Altman, Weil indicates that the average gross receipts per attorney for all surveyed firms (377 offices) was $261,967, or $269,679 in the Western Region (which excludes California). 1 Moreover, while gross receipts per attorney do seem to vary in proportion to the size of the firm (number of attorneys), the variance is probably less than might be anticipated.

Table No. 1 Average Gross Receipts by Firm Size

©Altman, Weil, Pensa Publications, Inc., 1996. Reprinted with permission.

When the component elements of gross income are analyzed, the logic of the "simplistic" model remains unscathed. The median partner/shareholder billing rate is $175 per hour, while the corresponding associate billing rate is $120. In the Western Region, the figures are virtually identical ($170 per hour for partners/shareholders; $120 per hour for associates). The mean billing rate for partners/shareholders nationally is $184 and the associate rate is $127 per hour. Again, the Western Region figures are similar ($179/$122).

In terms of billable hours, the uneducated assumptions of the "simplistic" model again withstand empirical scrutiny. For partner/shareholders, the national average is 1,722 hours (median 1,707). For associates, the national average is 1,805 and the median is 1,823. Western Region data is, again, generally consistent. Indeed, a recent study conducted in the Phoenix metropolitan area suggests that the average billable hour requirement is approximately 1,900 per year.

Thus, in reviewing average income per lawyer, we may utilize the mean figures from the Altman, Weil survey and assume that our "average" lawyer is generating approximately $262,000 per year in gross receipts. We may then direct our attention to law firm expenses and the relationship of each component expense to the gross income per attorney at our hypothetical "average" firm.

Expenses

According to Altman, Weil, the average total expenses for a lawyer (or law firm) range from approximately 40 percent of gross receipts to approximately 49 percent of gross receipts. Almost incredibly, this is true for all regions, for all urban and semi-urban areas, for all firm sizes, and for all practice areas! Nationally, average total expenses are 44.7 percent of gross receipts or $116,971 per lawyer in a model firm which generates $261,967 in gross income per lawyer. Table No. 2 illustrates that there is little distinction based upon firm size.

Detailed Analyisis of Law Firm Expenses

Acknowledging that only 44.7 percent of gross receipts are allocated to firm expenses does not necessarily suggest that this is an infertile area for management’s cleaver. A closer look at the specific categories of expenses, however, reveals that there are few areas in which major expense reductions are possible.

Promotion Expenses

A cynical observer of the lunchtime crowd at the Phoenix Country Club might suspect that promotion expenses remain one of the few uncontrolled (and uncontrollable) prerogatives of the private practice attorney and that limiting promotion and entertainment expenses to a reasonable level is a task similar to the cleansing of the Augean stable. Empirical data, however, simply does not support this conclusion.

According to Altman, Weil, the average attorney spends 1.5 percent ($3,848) of his gross income per year for promotion. Remarkably, this includes client promotions, entertainment and marketing expenses, social/sports club dues, distribution of firm brochures and announcements, newsletters, client seminars, directory listings, advertisements, client gifts, marketing consultant fees, and presentations to prospective clients. Moreover, actual expenses per attorney vary less than 10 percent from the mean, regardless of firm size. Indeed, promotion expenses appear to be the greatest (both in terms of actual dollars and percentage of gross income) in the smallest firms.

It is sufficient for present purposes to note that an expense category which involves only approximately 1.5 percent of gross income and less than $4,000 per year per lawyer does not represent a particularly attractive target for an ax wielding administrator. Taking the firm credit card away from the firm’s attorneys, while it may have an emotionally beneficial effect, is not likely to resolve a pending or threatened fiscal crisis.

Reference Materials

Cancelling professional subscriptions or reducing the size of the firm’s library is even less likely to have a dramatic impact upon the bottom line. According to Altman, Weil, the average firm spends 1.4 percent of its gross income or $3,691 per lawyer on "reference materials," a category which generally includes books, periodicals, newspapers, subscriptions, CD-ROMs used for reference, and online services (net of client reimbursements). Here, again, the variation by firm size is not significant.

In no case does the "average" firm, regardless of size, spend more than 1.7 percent of its gross income for "reference" materials and related activities.

Equipment Expenses

Certainly, one would assume, equipment expenses — including reproduction equipment, word processors, computers, telecommunication equipment, and all other office machines, as well as supplies, maintenance and repairs for such equipment — must represent a larger portion of our hypothetical firm’s expense dollar. This assumption is correct. However, we suspect that the actual level of expense is far less than anticipated.

According to Altman, Weil, the average firm spends approximately 3.0 percent of its gross income, or $7,770 per attorney per year for "equipment expenses." The level of expense does appear to be dependent upon the size of the firm. Stated simply, larger firms are likely to spend more money per attorney on equipment-related items than smaller firms. The level of expenditure, however, is simply not sufficient to present an appealing target for the budget-cutting administrator. While a firm that has a printer at each secretarial station might well consider whether this level of equipment is necessary, most firms purchase equipment on an as-needed basis and we suspect that it is rare that an equipment budget can be reduced substantially without impacting practice efficiency.

Occupancy Expense

There are certainly firms (some in Phoenix, we suspect) that have decorated their offices beyond the requirements of their clients or who have timed their entry into the commercial lease market with a bit less precision than a Michael Jordan jam. Nevertheless, we also suspect that these firms are few and far between.

A law practice management "rule of thumb" suggests that if occupancy expenses exceed 10 percent of gross income there may be a cause for concern. At that level an analysis should be undertaken to determine whether the unusual level of expense is attributable to bad market timing, the unusual needs of a specific firm, or the "Taj Mahal syndrome."

Nationally, the Altman, Weil survey data indicates that the average firm spends eight percent of its gross income (or approximately $21,000 per attorney per year) for occupancy-related expenses, including rent, utilities, real estate taxes, insurance and operating expense pass-throughs. In this area, a true distinction based upon firm size can be demonstrated. Occupancy expenses in firms employing 75 or more attorneys are nearly 30 percent above the mean and more than 40 percent above the occupancy expenses of the average "mid-size" firm.

Nevertheless, despite this size-based distinction, occupancy expenses of seven to 10 percent of gross income are by no means unreasonable, and it is possible that a substantial reduction in this expense category, if achievable, could impact the firm’s reputation in the community or the success of the firm’s recruiting and promotion efforts. Although occupancy expenses must be reviewed periodically (and many firms spend far too little time negotiating their own leases or auditing their own occupancy expenses), unless your firm is a victim of substantial overleasing (in terms of physical space) or a dramatic reduction in size resulting in many empty offices (and high occupancy expense for each remaining attorney), reduction in this expense item is not likely to be a financial salve.

Paralegal Expense

Although most surveys suggest that paralegals bill fewer hours than one might anticipate (the average appears to be between 1,300 and 1,400 hours per year), our "average" firm has approximately one paralegal for every four attorneys and the paralegal expense category represents only approximately 3.9 percent of gross income, or $10,168 per attorney per year. Interestingly, paralegal utilization is highest in smaller firms, perhaps because plaintiff-personal injury work and domestic relations work is focused in the smaller private practices.

Although it’s not a substantial expense item, studies have indicated that prudent use of paralegal resources does contribute to an increase in net income. Indeed, unless your firm is uniquely overstaffed in terms of paralegals and other billed professionals, (e.g., investigators), it is likely that a significant reduction in paralegal expense will decrease your firm’s profitability.

Professional Expenses

Continuing legal education (including travel and living expenses), bar dues, firm retreats and other firm meetings also offer little opportunity to the budget cutter. Nationwide, such expenses average 1.2 percent of income, or $3,035 per attorney per year.

Recruiting Expenses

Although large firms spend significantly more than smaller firms on recruiting (in terms of absolute dollars, as a percentage of income, and on a per lawyer per year basis), the total amount spent in this area is so small that it is difficult to believe that any reduction in a firm’s recruiting program will materially affect profitability in the long term. The average firm spends approximately $1,035 per lawyer per year on recruiting or 0.4 percent of its gross income.

Even in the largest firms, recruiting expenses are substantially less than $2,000 per lawyer per year and constitute only approximately 0.5 percent of gross income.

Malpractice Insurance

It is difficult to generalize when it comes to professional liability insurance because of regional differences, cost differences based upon underwriting history, and wide variations in coverage (liability limits and self-insured retentions). Broad market data does suggest, however, that this category of expense provides little room for savings even for the "overinsured" law firm. Nationally, firms spend approximately 1.8 percent of gross income, or $4,626 per attorney per year, on malpractice insurance. As with many other categories of expense, expenditures per attorney seem to vary with firm size. Recall, however, that average gross income also varies directly with firm size.

Payments to Former Partners

"Payments to former partners/shareholders" generally refers, for survey purposes, to deductible payments only and does not include return of capital or repurchase of shares in a professional corporation. Although the average firm does have an ongoing payment obligation to certain of its former owners, the expense is, once again, fairly minimal, and even complete elimination of these unfunded retirement or severance liabilities is unlikely to have a material effect upon profitability. In contrast, elimination of such programs could have a detrimental effect upon recruiting and/or current shareholder morale. Nationwide, Altman, Weil reports that payments to former partners average 1.3 percent of gross income, or $3,383 per attorney per year.

In sum, the "other expense" category which includes malpractice insurance, professional expenses, lawyer recruiting, payments to former partners, charitable contributions and all other expenses which are not separately itemized, totals only 11.1 percent of gross income, or $29,187 per attorney per year. 2 While this is a significant sum, the foregoing itemized analysis suggests that there is very little room for cost reduction in most of the sub-component areas.

Staff Expenses

The single largest expense for a law firm of any size relates to salary and benefits for its non-professional staff. Nationally, staff expenses average 15.7 percent of gross income or $41,225 per attorney per year. These expenses do vary with firm size: (see table 9).

They vary with the size of the metropolitan area as well: (see Table 10).

Despite the magnitude of this expense item, it is unlikely that a substantial reduction in staff size is possible, even for the most devout budget-cutter. Nationwide, the ratio of secretarial staff to lawyers is now 0.65. This means 65 secretarial staff members for 100 attorneys. Even more significantly, if paraprofessionals are counted as one-half of a "fee earner," the ratio of secretarial staff to fee earners nationwide is 0.58. However, further reduction in these levels (e.g., to one secretary for every three attorneys or at least for every three timekeepers) is possible, and experimentation with this ratio is beginning in the Phoenix area. Advancements in technology may also permit reductions in staff levels. The authors are divided as to the likelihood of this occurrence.

Adjusting for out-sourcing, it is also unlikely that a reduction in non-secretarial staff will have a major impact upon the net income of your firm. The ratio of non-secretarial staff to fee earners is approximately 0.39 on a national basis. Overall, the ratio of all secretarial and non-secretarial staff to fee earners is approximately 1.0. Stated differently, there is approximately one staff person (secretarial or non-secretarial) for each attorney in our "average" law firm. Although larger firms have somewhat higher staffing ratios, the differences are not material.

Most important, despite increased pricing pressures, and despite the advent and implementation of computer technologies, personnel ratios have not changed materially in the past 15 years.

Summary

In summary, law firm expenses are largely fixed and the categories which permit the greatest discretion (e.g., promotion) are generally characterized by the lowest per-attorney expenditures (see Table 13).

The available survey data suggest the following:

• Law firm managers should review each firm expense category periodically to determine if more rigid controls are necessary;

• Although a firm commitment to expense reduction may have an initial, material impact on profitability, most categories of expense are not susceptible to dramatic reduction without impacting practice efficiency; and

• The best, and possibly the only way to revitalize a floundering firm is to focus upon the income side of the ledger. Generally, increases in gross revenues will not be offset by corresponding increases in expenses.

Can a law firm actually plan to increase its revenues while maintaining or reducing its current expense ratios and then successfully implement such a plan? Fortunately for the authors, that is a subject for another day.

Table No. 2 Total Expenses Per Lawyer

©Altman, Weil, Pensa Publications, Inc., 1996. Reprinted with permission.

Table No. 3 Promotion Expenses

©Altman, Weil, Pensa Publications, Inc., 1996. Reprinted with permission.

Table No. 4 Reference Materials

©Altman, Weil, Pensa Publications, Inc., 1996. Reprinted with permission.

Table No. 5 Equipment Expenses

©Altman, Weil, Pensa Publications, Inc., 1996. Reprinted with permission.

Table No. 6 Occupancy Expense

©Altman, Weil, Pensa Publications, Inc., 1996. Reprinted with permission.

Table No. 7 Paralegal Expense

©Altman, Weil, Pensa Publications, Inc., 1996. Reprinted with permission.

Table No. 8 Recruiting Expenses

©Altman, Weil, Pensa Publications, Inc., 1996. Reprinted with permission.

Table No. 9 Staff Expenses (by Size of Firm)

©Altman, Weil, Pensa Publications, Inc., 1996. Reprinted with permission.

Table No. 10 Staff Expenses (by Area Population)

©Altman, Weil, Pensa Publications, Inc., 1996. Reprinted with permission.

 Gary L. Birnbaum and P. Bruce Converse are are shareholders at Mariscal, Weeks, McIntyre & Friedlander, P.A.

The authors wish to acknowledge the cooperation and assistance of Altman, Weil, Pensa Publications, Inc. ("Altman, Weil") in the preparation of this article. The data presented is derived from The 1996 Survey of Law Firm Economics published by Altman, Weil and is reprinted with the express permission of that company. This article is derived, in part, from information presented at a recent seminar entitled "Making Money: The Economics of Law Practice in Arizona," sponsored by the State Bar of Arizona and the Law Practice Management Section.

ENDNOTES:

1. We do recognize that there are other sources of law firm income (e.g., paralegals). Recognition of this fact does not materially alter the analysis in the text.

2. Even technology expenses (hardware and software and related services) are substantially less (on a per-attorney basis) than one might initially project. Altman, Weil reports that actual spending in 1995 for lawyer "technology" was approximately $4,150 per attorney. Budgeted technology expenditures for 1996 and 1997 were of the same order of magnitude.