How to Calculate Net Profit Margin  for Law Firms

Many law firm managers and owners will argue that it's difficult or impossible to measure net profit margin (NPM) accurately in a law firm.

However, at PROFiX, we’ve been perfecting this over the years. There is so much value in measuring the NPM of your firm, in addition to calculating it by lawyer and practice area. You can see which areas of your business are highly profitable and which ones need to be streamlined.

Why Net Profit Margin Is Unique at Law Firms

Law firms have an exceptionally high net profit margin compared to other industries because of their partnership structure. Payments to partners are not considered a wage expense that would be included in the income statement in any other industry.

However, in a law firm, these wages are actually paid out as draws, shown only on the balance sheet.

This means that when calculating gross profit margin by taking your revenue and deducting your COGS (such as lawyer and paralegal salary expenses), the partners’ compensation — who are often the highest billers in the firm — is not included in the wage expense.

The more partners in the firm, the artificially higher the net profit margin will be.

Calculating Accurate Net Profit Margin for Law Firms

Allocate an appropriate market value salary to the partner when calculating net profit margin. What would that partner's compensation be if he or she was an employee of the firm? Also be sure to include an accrual for bonuses in the monthly NPM calculation so the figure is accurate and includes all compensable amounts.

With this approach, you can get a clearer picture of your net profit margin because you essentially turn each partner’s payments into a wage expense, rather than a draw that is only seen on the balance sheet. As a result, you can get a better idea of the financial health of the firm.

Need a primer on calculating net profit margin? Read our detailed article on Net Profit Margin.

Allocating Overhead Expenses When Calculating Profit by Each Individual Lawyer

It's not the best approach to take a simple overhead expense calculation in law firms. By dividing the number of revenue-generating employees by the total overhead, you won't account for the difference in resources each employee takes.

For example, this type of calculation would make a paralegal seem unprofitable and operating at a loss, and make a senior lawyer seem extremely profitable. The reality is they take up very different amounts of overhead costs. A senior lawyer will be assigned a marketing budget, an expensive laptop, and travel budget. A paralegal will only require a desktop computer to produce revenue.

That’s why you have to look at the real COGS and develop a strategic overhead expenses allocation formula to apply to each individual lawyer in order to get a true understanding of their accurate net profit margin.

Is Your Firm Financially Healthy?

If your net profit margin is always artificially inflated because of the way your partners’ compensation is reflected, it’s likely you don’t really know how well your business is doing.

Get in touch with PROFiX today and our team will walk you through how we can help your firm clarify your financial position.

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