If we operated a legal practice with 100% variable costs then we could maximise profits no matter what level of revenue we achieved.
For example, if revenue increased, we could add more lawyers, support staff and office space. If revenue decreased we could wind back our use of people and reduce occupancy costs.
100% variable costs in a legal practice and almost every other type of business is not only difficult, it is almost impossible to achieve.
While 100% may be an ideal, we know that a certain percentage of our expenses should be variable. If they were not, then any downturn in fee revenue would automatically wipe out the earnings of the owners of the practice.
The starting point for determining the mix between variable costs and fixed costs is to consider the variability of revenue.
Let’s consider at an example:
Let’s assume that a reasonable possibility is that revenue could decline from $600K to $500K. If expenses were not reduced then owner’s earnings would immediately fall by $100K being the same amount that revenue declined.
Percentages highlight the impact
Revenue declined by 100K/600K = 16.67%, yet earnings declined by 100K/200K = 50%.
What percentage of expenses need to be variable in order to maintain owner’s earnings at $200K?
Expenses would need to be reduced by $100K to $300K to maintain earnings at $200K. In the example below, labour costs and other expenses are each reduced by $50K.
Therefore (100K/400K) 25% of expenses need to be variable in order to protect earnings against a (100K/600K) 16.67% decline in revenue.
That may seem to be a surprising result.
A relatively small percentage change in revenue requires a much higher percentage reduction in expenses for earnings to be maintained.
What can a legal practice owner or manager do to maximise variable expenses and minimise fixed overheads? Here are some ideas:
1. Labour: Increase the use of part timers, casuals and contractors.
2. Occupancy costs: Subletting, shorter leases, use of serviced offices and meeting room hire services.
3. Technology: The use of software that you pay for only when you use.
An example is FilePro software which is charged on a per new-matter-opened basis. The fee is added to the matter. This gives firms the option to charge the fee to the client as a reimbursable disbursement.
While 100% variable expenses might be an unrealistic ideal, the percentage of expenses that should be variable may be higher than you think before doing the calculations.