Feature

posted 25 Aug 2010 in Volume 13 Issue 1

Tackling costs

Partner Jon Cartwright of Hazlewoods examines the key issues facing UK law firms in setting their budgets for the next financial year.

Almost everyone who talks about law firm performance refers to profit per equity partner, which is a pre-tax figure. With tax and national insurance rates as they are, of much more real-life importance is post-tax profits per equity partner. This brings a firm’s structure and tax efficiency into play, a very important aspect which is somewhat overlooked.

Ten years ago, there were only two common structure types for law firms. Today there are upwards of 15, with many being combinations of partnerships and limited companies. This can bring with it major tax efficiencies. A saving of 10% on the practice owners’ tax liabilities often equates to adding 4-5% to the overall distributable profit. Many practices have not, to date, given this the attention it deserves. While it is no substitute for improving fee income, there are sizeable gains to be made in times when this is difficult to do and when overheads have already been pared down.

Over the past 12 months, the most common themes which have emerged in law firms’ financial performance are:

· practices with niche offerings are continuing to go from strength to strength;

· for some firms, performance in 2010 has noticeably improved on 2009, generally as a result of prudent cost reductions in 2009 as opposed to income growth;

· for other firms, performance in 2010 has been very similar to 2009, particularly for those which made major pre-recession decisions on things like new property, mergers or acquisitions, have grown their cost base as a result and not been able to easily retrench; and

· for some firms, performance in 2010 has been poorer than in 2009, perhaps as a result of a slower or, with the benefit of hindsight, inadequate reactions to the recessionary effects of 2009.

The Law Society’s 2009 benchmarking survey of nearly 200 law firms, which we produced, showed a median reduction in fee income of 6.5% compared to a reduction in fee-earner numbers of only 2.7%. This is not particularly surprising, given the fact that it takes time to reduce staff numbers.

However, what is surprising is that the median cost per fee-earner across the country rose by 8%, from £45,000 to £49,000. No doubt this was partly as a result of the effect of pre-recession pay reviews, but nevertheless it gave an overall position where a 6.5% decrease in revenue was matched by a 4-5% increase in fee-earner costs. Clearly, this was not the case for lots of practices, but it did mean that practices had a major challenge on their hands in the biggest area of their cost base.

Work has now commenced on the 2010 survey. For a comparison of the headline 2009 survey results with our predictions for 2010, see Figure 1.

Figure 1: Financial Benchmarking of UK Law Firms

2009 2010 (Forecast)

Fee income -6.5% no change

Expenditure as a percentage of fee income:

Fee earners 26.6% 25.0%

Non fee earners 22.4% 21.0%

Redundancy costs 0.6% 0.3%

Accommodation 8.0% 7.0%

Professional indemnity insurance 2.7% 3.2%

Office and other expenses (e.g. postage,

telephone, IT, printing, library) 18.2% 15.4%

Financial costs (e.g. bad debts, bank

interest) 3.2% 4.2%

Total overhead costs 81.7% 76.1%

Total pre-tax profit 18.3% 23.9%

Setting budgets

The following are areas in which law firms are experiencing the most difficulty in setting their financial budgets for the next financial year (apart from forecasting fee income, where prudence almost always prevails).

1. Fee-earner statistics

· The total cost per fee-earner, i.e., the amount they need to earn in fees before they start to make a profit, needs to be accurately worked out. The 2009 survey showed the median cost of a fee-earner to be £103,034, a very sobering reminder of where the breakeven point lies.

· The next figure to work out is fee-earner ‘inputs’, or the number of chargeable hours fee-earners are expected to record, multiplied by their charge-out rates.

· Once you have done this, you can turn your attention to how much of a fee-earner’s total hourly charge rate is expected to be turned into fees, i.e. their recovery rate. Often, 90% is considered an appropriate starting point, but this will not suit all work types.

· The results of all the above can then be compared to the forecast fee income figure to check for any material differences. This should then reveal whether you are likely to be over or understaffed with fee-earners.

· Fixed fee work of course impacts the equation, as does any work carried out at premium rates. Premium rates/value billing for challenging work can make a significant difference to overall revenues, provided they are adopted responsibly and well communicated to clients.

2. Non fee-earner costs

· How many secretarial staff should there be? The first rule when looking at this properly is to forget what you have already, and look at it with a fresh pair of eyes. The days of one secretary per fee-earner are long gone. A ratio of 0.6 to one is a better overall benchmark now. Digital dictation is becoming commonplace – it can pay back very quickly and removes or at least reduces any previous reliance on temporary staff.

· How should you staff other expensive (and key) areas such as IT, marketing, HR and accounts? Comparative data for similar firms is absolutely invaluable in helping you make key decisions here.

· The library is an area in which many practices have historically spent large sums of money, and variances between comparable firms are significant. Many firms are currently having a rethink here. Three tips here are:

1) conduct an audit of your fee-earners to find out how often they use either books or the electronic library – you might be surprised at how little use there is in some areas;

2) revisit the number of licences you actually need; and

3) if you do not do so already, consider joining up with other firms or with solicitors’ networks to improve your buying power.

3. Indemnity insurance

Professional indemnity insurance is a very significant overhead cost these days, but one where more could often be done to help reduce premiums. Here are some key pointers:

· meet your principal underwriter(s), not just the brokers;

· make sure you have an orderly system in place for risk management, complying with code of conduct rules and so on;

· have a review policy in place before new clients are taken on, which extends further than basic money laundering checks;

· for smaller practices, try to increase the number of responsible individuals in the firm to move it into the next banding range – this is easier if the firm is a limited company rather than a partnership, which could well make tax and operational sense anyway if structured correctly; and

· fill in the proposal forms with total dedication to completeness and clarity.

4. Lockup

How much cash are you going to need to run the practice? This can be genuinely difficult to work out with accuracy. Even with customised software, lots of variables need to be inputted over a twelve-month period to provide an accurate steer.

Old debtor and work in progress balances continue to be a bugbear for many firms, and can vigorously eat up working capital. They can also cause difficulties in complying with bank covenants. Slick and communicative fee-earner performance is more vital than ever.

Consider drawing a line under the current position and introducing a new set of standards and expectations for all new client matters to ensure prompt billing and payment.

5. Funding

Another issue is finding the right balance between partner and third party funding. Tax efficiency comes into play here, particularly for practices which have term loans with the bank – effective tax planning can save up to 20% of the debt balance.

Banks are now very used to limited liability structures in law firms, but some managers still automatically look for some form of personal security for borrowing as opposed to voluntarily considering debentures. Banks are gradually becoming more accepting of the value of work in progress in the debenture equation, not just debtors.

6. Cashflow

For the majority of firms, cashflow is the number one priority, and is likely to remain so. The importance of solid forward planning and reliable forecasting cannot be over emphasised. Many firms place too much reliance on spreadsheets as opposed to using bespoke forecasting software. It is generally not expensive to buy either.

A lot of firms are currently taking advantage of the government’s ‘time to pay’ initiative, which has been available for about 18 months now. It allows nearly all forms of tax liability to be settled by instalments after the natural due date. It has been a lifeline for many, and whilst it is likely to stay with us for some time yet, it is gradually getting more difficult to be accepted by Inland Revenue’s call centre staff, who will ask more searching questions than previously.

If your firm is taking advantage of the initiative, now is a good time to be thinking about alternatives. Fortunately, a number of the specialist alternative funders are gradually opening their doors more widely again.

7. Investment

Many firms are now considering capital investment decisions, particularly involving IT changes or upgrades. Tax relief plays an important part in the overall decision. This can get complicated, with not only lease or buy decisions, but also the consideration of short-term tax relief incentives and tax efficient structures for dealing with the funding itself. Firms may end up with the funding in one entity and the new assets in another in order to maximise tax efficiency.

Looking ahead

Turning to the current 2010/11 year, there will continue to be challenges affecting law firm performance, and not just because of economic conditions. There will be a need to review salaries at some point (particularly with many reviews deferred from spring 2010 to this autumn). There will be further overhead increases as a result of national insurance rates increasing from April 2011, as well as rising professional indemnity premiums.

As a result, either further efficiencies will need to be found (which will be difficult for many), or top-line income will need to grow. Charging rates, many of which have been on hold since autumn 2008, are going to have to increase at some point, which in some work areas will not fit well with the prospect of wider ownership of UK law firms from October 2011.

– jc@hazlewoods.co.uk