Sometimes I speak to law students about law firm economics. The schools want me to tell students the financial aspects of law firms that young lawyers need to know, in order to be successful there. Law firm managing partners want me to help students understand how long it takes for a new lawyer to be profitable for the firm. Here’s some information about law firm economics for law students and young lawyers that serves the needs of everyone.
Direct Overhead Costs
I remember that as a young associate, I had the misimpression that every dollar I billed in excess of my salary amounted to “gravy” for the partners. I didn’t take into account employment benefits and other costs directly associated with each lawyer. Those include payroll taxes, unemployment taxes, attorney occupation taxes, state and local bar dues, health and disability insurance, malpractice insurance, vacation, sick leave, parking and continuing legal education costs. As an associate I also forgot about the costs of the salary and benefits attributable to the administrative assistant or paralegal assigned to help me, or the cost of the furniture, equipment and software we used.
General Overhead
In addition to those overhead costs that can be attributed directly to a specific lawyer, the firm incurs general overhead costs. Those include lease or building costs, library and legal subscriptions, telephone systems, office supplies and the furniture and equipment for each conference room, file room, mailroom, copy room, reception area, kitchen, and coffee bar. The firm buys insurance for general liability, business interruption and fire and casualty and may pay personal or real property taxes. It expends significant amounts for marketing and client relations, and may have significant costs for talent recruitment and retention. Depending on the size of the firm, it will incur cost for salaries, benefits, furniture, equipment and software for staff that handle various functions such as firm administration, accounting, reception, mailroom, filing, human resources and recruiting.
Recruiting and Training Costs
In addition to the direct and general overhead costs attributed per lawyer, law firms incur additional costs for recruiting new hires to the firm. Those costs include out of pocket costs associated with recruiting, such as travel expenses, lunches, dinners and entertainment, and promotional materials, plus the salary and benefit costs of recruiting department staff. Firms that hire summer associates also incur salary, benefits and overhead costs of those summer associates. Soft costs include the lost billable attorney hours spent traveling, interviewing, entertaining and evaluating candidates and summer associates.
Once the associates get hired, the firm incurs both hard and soft costs to train them. Larger firms have orientation programs in which associates are introduced to firm policies, procedures, software, etc. They also periodically offer in-house continuing legal education and other programs taught by lawyers or staff in the firm or outside consultants. Although the time investment in training often seems paltry and inadequate to associates, it can feel quite significant and even burdensome to the senior associates and partners. They often lose billable time when they devote in-house informal training of junior associates.
Break-Even Point
So what does all that really mean? How much revenue does a law firm need to collect to break even on an associate? My casual and unscientific poll of some Texas law firms indicates that the large firms in Houston and Dallas need to generate around $350,000 in collected revenues per year to break even on an associate. One might expect the figures in New York and San Francisco to be higher and the figures in St. Louis and New Orleans to be lower. Those estimates don’t take into account the recruiting costs mentioned above because they don’t recur annually. The relevant point is that most associates don’t become profitable to large firms until almost their fourth year.
Notice that the break-even point is a collected revenue figure. Don’t confuse your billable hours with collected revenues. Billable hours for associates get written down for a host of reasons, including inefficiency and inexperience, client dissatisfaction, client discounts, and the billing partner’s attempts to bring total legal fees in line with perceived value to the client. More leakage occurs after invoicing, because law firms don’t manage to collect 100% of their invoices. In some cases clients demand reductions, just don’t pay, or become insolvent.
Law firm economics get quite complex, so this just scratches the surface. Hopefully, the information will help new lawyers correct some erroneous assumptions and make informed inquiries, however.