Seven Steps to understand the cost of a law business (The basics)
Costing is the foundation for pricing
In the current legal environment, there is much debate about the pricing of legal services such as margins, hourly rates, fixed fees and value-based billing and that is before venturing into brand premium.
However the first step is always costing. Lawyers need to understand how much it costs to run their business every working day. Cost calculations are the foundation of pricing and profitability, and guide investment and operations.
When looking at how to cost legal services, and hourly or daily rates, it is important to understand how to calculate the parts that make up those costs. For all businesses, there are effectively two types of costs: Indirect Costs (also called overheads or fixed costs) and Direct Costs (Variable costs). As legal service firms sell expertise, they often have higher labour costs than manufacturing companies, and are usually constrained by Utilisation of time, capabilities and expertise.
Step 1: Calculate Indirect Costs
Start with identifying the Indirect Costs of the law firm business for the year.
Indirect Costs are costs that need to be paid regardless of revenue, for example, rent, advertising, marketing, communications, IT, insurance, utilities, storage and rates. Include depreciation and interest paid too. Add in all labour costs that are not charged out such as administration, IT, HR, marketing, assistant and secretarial staff.
Indirect Costs can be tricky as they change over longer periods with volume, scale, types of work and even business culture. Monitor them.
Step 2: Calculate Direct Costs
Direct Costs are directly attributable to the legal services provided and vary according to time worked.
First calculate the costs of direct labour for the year. For law firms this means owner drawings as well as salaries of “fee-earners”, full and part-time.
Add the costs of direct materials and disbursements: in law firms, a small proportion.
Step 3: Calculate Total Cost
Calculate Total Cost by adding Indirect Costs and Direct Costs.
Step 4: Calculate Utilisation target
Calculate Utilisation baselines for the year. This is the baseline or target for time spent that can be charged out to generate income. In law firms, this is usually the “fee earners” Billable Day or Billable Hours targets. It does not include time spent on marketing, administration, meetings and CPD.
Step 5: Calculate Utilised Day and Hour costs
Calculate Utilised Day and Hour costs for the firm. This is Total Cost divided by Utilisation targets in Days or Hours. In law firms with Billable targets, this is the cost of the time for fee earners.
Step 6: Add contingency
Contingency allows for mistakes, unforeseen events and so on. Many businesses use a 10% contingency. Re-calculate the Billable Day or Hour cost by adding 10%.
Step 7: Do a reality check
So what do you think about your costs?
When costs are based on Utilisation targets, it is vital to compare the outcome with actual time spent carrying out legal services. Check using time sheets, audits or surveys. It is often surprising how different estimates are from reality.
Use the cost calculations to review and improve the firm’s management. Are fee-earners enabled to do their best work? Can the firm be more efficient or cost-effective? Is outsourcing an option?
Only when costs of running the legal services business are understood and managed, can pricing be addressed.