Legal Business

Legal Business

Overheads

The article discusses how to better manage overheads especially in larger partnership firms.

The ‘Sieve’ Culture

Something strange often seems to happen to firms as they grow, especially during the transition from sole principal to partnership: money starts to leak from the firm in the same way water leaks from a sieve.

Sole principals are acutely aware they are spending their own money. If they decide to spend $500 attending a seminar, they know their overheads will be $500 higher and their profits for the month $500 lower — not to mention the loss of fee-earning time. They are very aware of expenditure and are excellent at obtaining value for money. They are not necessarily ‘tight’ with their money; they merely want to spend it wisely.

Attitudes can be very different in partnerships, especially larger ones, where the feel of a direct link between spending money and profits can be lost. A partner once commented that spending money did not really matter as it was not his money that was being spent! It can even seem like a reinforcement of status, to see who has the largest office, newest laptop or best furniture. In particular, as firms get larger they can become weak at obtaining value for money.

It is very easy to lose control and accountability in larger firms. The traditional approach of allocating overheads across departments does not help with this, often making it more difficult to get a true grasp on the firm’s overheads. Firms with well controlled expenditure budgets and clear management accounts, in which figures are easily identified and understandable, have always been able to control overheads better.

Part of the task of effective financial management and control is therefore to reintroduce a sense of accountability and to plug some of the leakage in the sieve.

Process/Investment Related Overheads

Non-salary overheads can be grouped into those areas of expenditure that are:

• Process related — such as rent and rates, stationery, telephone, professional indemnity, accommodation costs, library — they are necessary for the work to be processed; and

• Investment related — such as training, IT and marketing. They are fundamental to the future development of the firm because they help identify new areas of work, improve the way work is processed, and improve the profitability of that work, but are discretionary.

The latter normally accounts for less than 15% of fees, yet is often the first area to be cut in the event of any pressure on profits. Although many firms spend under 2 or 3% of their fees on key areas such as training or marketing, these are often the first areas to be cut:

‘I am not convinced we can easily increase our fees and believe we will have to look at reducing our overheads if we are to increase profits’.

There is a great temptation to cut the wrong areas.

Process related overheads include many items that are relatively fixed, at least in the short-term. Over time, however, it is often possible to obtain better value for money for these items especially if you introduce a culture of seeking value from all suppliers.

Whilst some overheads increase gradually, the larger items — additional office space, a new IT system — tend to increase in significant steps. These steps can have a big impact on profitability and the challenge is to balance the level of a firm’s long-term overheads with the number of fee earners it has and the level of fees they generate.

A sole practitioner working from home and doing his own typing will have very low overheads. Overheads will include stationery, telephone and fax, IT costs, professional indemnity, and so on. As soon as this person decides to rent an office, overheads will increase. As the firm continues to grow, so does its overheads and a large practice can easily have significant overheads per fee earner.

Overheads as a Percentage of Gross Fees and Per Fee Earner

Studies in the UK indicate that most firms manage their overheads at around 30–33% of gross fees, although some of the most profitable 11–25 partner firms are down at around 2%. In the least profitable firms, overheads are running at 35–40% of gross fees. The high percentages in the less profitable firms could reflect high fixed property costs or may be due to the low levels of fees generated.

The more profitable firms are not necessarily spending less on overheads, but the level of their overheads can have a better relationship to the fees generated. The more profitable firms actually spend more per fee earner than the less profitable firms.

This may be due to the type of work being undertaken. It is likely that the more profitable firms will do greater better quality private client or commercial work and will occupy more expensive and prestigious offices than, for example, a small firm. They are likely to be in better premises and may wish to project a certain image and style to their clients.

In a survey conducted in the UK in 2001, approximately 21% of the more profitable firms’ overheads were in respect of accommodation costs, 9% in respect of IT, 5% in respect of marketing, 2.5% in respect of training, with the balance accounted for by all the other overheads of the firm.

Other surveys have indicated that around 35% of a firm’s overheads are attributable to accommodation costs, depreciation and professional indemnity. There is often little that firms can do about this, in particular in the short-term; therefore attention should focus on the balance, starting with the biggest items.

The principles underlying effective control of overheads are:

• to ensure you obtain value for money in all your purchases;

• to challenge all expenditure — why are we buying it?;

• to challenge existing working practices and custom — why do we need so much floor space? Could we work open plan?; and

• to fix budgets in advance and allocate responsibility for the various expenditure headings so as to increase accountability.

One firm summed up its policy in the following way:

• never sacrifice quality for price;

• never accept the first price quoted; and

• always get at least three competitive quotes for any major purchase.

The Issue of Allocation

Overheads are usually either specific to a department or are more general and relate to the whole firm. Examples of the former would include specific marketing, training or library costs. Examples of the latter would include the cost of the annual accounts, accommodation costs, depreciation and insurance.

It is good practice when preparing a budget to identify those items that are specific to a department and to allocate responsibility for them to the department head. They would in effect be given a budget for that item and would not need approval from anyone else for expenditure unless the budget was going to be exceeded.

Problems arise when attempts are made to allocate the firm-wide overheads across the various departments. At the end of the day, all the expenditure of a firm relates to the legal departments and it is relatively easy to argue that all costs should be allocated to the departments concerned. All that has to be done is to agree to a formula for the allocation that is fair.

Most firms allocate overheads in their management accounts across their various departments. They would base the allocation on a variety of methods, with the most common being on a per capita basis or pro rata to fees.

The advantage of this approach is that partners and fee earners are constantly reminded of the total overheads of the firm, but there are two main drawbacks. The first is that accountability is often reduced because overheads can be lost amongst the other costs of the departments. If overheads are spread across a number of departments it can be difficult to work out easily what the total is and even more difficult to work out the amount on individual overhead items.

The second drawback is that the usefulness of the department’s management accounts, as a tool to help departmental management, is very much reduced. Any real discussion about the performance of the department or team is confused by the inclusion of items outside the control of the department head.

Overheads are better managed centrally and should not normally be arbitrarily allocated across departments. It is relatively easy to set a target amount of profit for each department that would cover its share of the firm’s overheads and also its contribution to the firm’s profits.

It can also be useful to remind fee earners of the total expenditure of the firm by calculating the salary and overhead costs each fee earner has to recover before they actually begin to contribute to the firm’s profits. This is something any firm should be able to work out quickly.

It is often useful to undertake this calculation on a departmental basis, and it should include averages appropriate for the department. Instead of a two- or three-year qualified solicitor, if the department mainly employs legal executives or paralegals, you should use a salary appropriate to them. Notional salaries should be included in respect of the cost of partners as fee earners.

Also, your fee earners might not have their own secretary; often a secretary can support three or four fee earners, in which case you should include the appropriate proportion of the cost of a secretary.

It is easy to calculate the overheads per fee earner for your firm, and this amount would normally be applied across the departments. It could be argued that some departments make more use of the firm’s central resources than others, but there is a danger of over-complicating the calculation for little benefit.

The calculation also includes an allowance of interest on partner capital. Partner capital is an alternative to external funding from a bank and should therefore be included as a cost of financing the firm.

Some firms apply a multiple to a fee earner’s salary in order to calculate the minimum fees they are to bill. A multiple of three or four times’ salary has often been used.

In Conclusion

1 Beware of a ‘sieve’ culture concerning expenditure and try to instil an attitude of accountability and responsibility.

2 Be aware of the distinction between overheads that are process related and those that are investment related. Be careful about unnecessarily cutting back on the latter.

3 Be determined to obtain value for money from all your suppliers.

4 Try to avoid allocating expenditure across the departments of the firm unless it is specific to that department.

Stanley Jeremiah

Goodwins Law Corporation

E-mail: stanley_jeremiah@goodwinslaw.com

respect of IT, 5% in respect of marketing, 2.5% in respect of training, with the balance accounted for by all the other overheads of the firm.

The principles underlying effective control of overheads are:

· to ensure you obtain value for money in all your purchases;

· to challenge all expenditure — why are we buying it?;

· to challenge existing working practices and custom — why do we need so much floor space? Could we work open plan?; and

· to fix budgets in advance and allocate responsibility for the various expenditure headings so as to increase accountability.