Calculating internal hourly rates
March 22nd, 2011 by Jim Cotterman
Law firms have an increased interest in understanding internal rates as AFAs (alternative fee arrangements) take hold with clients. Understanding costs at a firm level is easy once you sort through the differences between cash and accrual accounting. The hard part is allocating costs to various sub-groups within the firm — such as individuals, classes or groups of individuals, matters, clients, offices and practice groups.
For those of you who are precision minded it is possible to devise a cost accounting system so detailed as to take any activity and assign it to multiple cost centers — each of the aforementioned sub-groups. The account numbering schematic for such a system would be quite complex as would the coding and verification tasks. We will forgo the obvious political challenges involved in selling such a system. So while such precision is a possibility, it is largely not a practical approach.
Simplification is preferable, although not altogether without its potential political challenges. And there are some, probably acceptable, higher risks for analysis error. But let’s use simplification at its best for this posting and reserve a more in-depth discussion for an upcoming article. We will use the following assumptions:
1. A single office law firm partnership with a collection of practices that are reasonably similar in their economic models.
2. Partners and associates use/share resources (offices, secretaries, technology and the like) without any significant distinction from group to group. This means that office sizes are very similar, secretarial sharing is equal across groups and that all timekeepers use a similar technology package.
3. Paralegal use/sharing of resources is about one-half that of lawyers. Thus each lawyer will be counted as one fee-earner and each paralegal will be counted as a one-half fee-earner. This convention is commonly found in most economic surveys of the profession.
4. Expenses include the net affect of cost advances and recoveries on the behalf of clients.
5. Compensation deductions from total expenses for determining firm overhead define compensation as salary, bonus, benefits and associated payroll taxes.
Accordingly we can take the total expenses of the law firm and subtract the compensation costs of the associates and paralegals. The remaining expenses represent the overhead of the firm. .Divide this remainder by the total full-time-equivalent (FTE) fee-earners to determine the overhead per fee-earner.
Once overhead is sorted out, we can turn to compensation. Here there are three assumptions for our posting.
1. We are looking for internal hourly rates for each group of individuals — partners, associates and paralegals — so average compensation for each group is used.
2. Compensation for development of internal hourly rates includes only salary, benefits and the associated payroll taxes. Including bonuses (with their associated benefit and payroll tax costs) is an option depending on your firm’s particular philosophy on bonuses.
3. A partner’s compensation consists of a fair exchange for his/her labor (the portion we need) and the profits earned on the work done by others. There may also be a return on capital component depending on whether interest is paid on partner capital or not. Again, for simplification, we will use the partners’ draw as a proxy for the fair exchange portion we are interested in for our purposes. There are other proxies that could be substituted, such as extending the lock-step associate pay scale into the partner ranks or using an outside reference point such as a senior in-house lawyer.
So we now have the total average cost of the group to include allocated overhead and compensation before bonuses. Divide the total average cost by the expected billable hours to obtain a preliminary internal hourly rate. Divide that rate by the expected realization factor for the group to obtain a required internal hourly rate. Attached is a sample calculation.
