What's a Good Profit Margin for Your Small Law Firm?

Sarah showed a huge smile when I asked her how she's feeling out her numbers as we prepared to talk about her firm's financial reports. After ten years of running her small family law practice, she still wasn't sure if she was making enough profit. To be honest, I will admit there's never an upper limit to making too much. And, I'm sure you will agree that making too little should be a crime.

Her firm brought in $900,000 last year, but was she dividing that money wisely? That was the real question. She decided to follow the "Rule of 1/3" her and I had talked about in a prior meeting: allocating one-third for employee salaries ($300,000), one-third for overhead expenses ($300,000), and keeping one-third as owner's total compensation & profit ($300,000). After setting aside money for taxes from that final third, Sarah finally felt confident she finally had a sustainable law firm.

By tracking her numbers monthly, she discovered that her most profitable months came from handling complex divorces rather than simple wills. Within six months of shifting her practice focus and maintaining this disciplined financial split, her revenue grew to $1.2 million while keeping the same balanced distribution. This meant she could finally hire that talented associate she'd been eyeing and invest in new case management software – all while maintaining a healthy profit and tax reserve.

The Rule of 1/3: A Simple Formula for Success

Most companies will talk about their profit margin. Profit margin, specifically the net profit margin, for a specific period of time, typically up to one year, is your net profit divided by your gross/top line revenue. It measures how much profit you are keeping of your total revenue.

But, I've found a more practical way to think about your law firm's money is to follow what I call the Rule of 1/3. This straightforward approach suggests dividing your revenue into three equal portions:

1. One-third for employee costs (including staff salaries, benefits, and payroll taxes)

2. One-third for overhead (including rent, utilities, technology, marketing, and other operating expenses)

3. One-third for owner's compensation & profit (remembering that you'll need to set aside a portion of this for personal income taxes)

For example, if your firm earns $600,000 annually, you should aim to spend no more than $200,000 on employee costs and $200,000 on overhead, leaving $200,000 as profit before taxes. Remember that depending on your tax jurisdiction and business structure, you might need to reserve 30-40% of that last third for taxes, leaving you with roughly $120,000-$140,000 in actual take-home pay.

The Magic Number

For most small law firms I work with, I see a healthy split for that last bucket of owner's compensation and profit falls between 35% and 45%. A lot of different factors create this. To be clear, what does this number represent? This means that for every $100 your firm earns in top line revenue, you should keep $35 to $45 as compensation and profit after paying all your expenses.

How Does This Compare

The most financially successful small law firms carefully manage how they use their money with strategic focus. When a firm can maintain around 33/33/33 splits for the use of their money, this provides a stable foundation for growth. Firms that struggle to reach 20-25% for that last bucket often face challenges that need immediate attention to ensure long-term sustainability.

Why These Numbers Matter

Think of your law firm like a car. Just as a car needs gas to run, your firm needs profit to thrive. A healthy profit ensures you can grow your business organically and handle unexpected costs when they arise. It allows you to invest in new technology that keeps you competitive and reward your hardworking staff with competitive salaries and bonuses. Perhaps most importantly, it provides a cushion for those inevitable slower months that every law firm faces.

What Affects Your Rule of 1/3 Balance?

Things That Help

Maintaining careful control over staffing costs helps ensure you stay within your first third allocation. Using technology effectively can help reduce the number of employees needed while maintaining high service levels. Being strategic about office space and other overhead expenses helps keep the second third in check. Implementing efficient billing practices ensures strong cash flow to maintain these proportions. Following this disciplined approach to financial management means your final third can reliably generate the profit you need to grow and prosper.

Things That Hurt

Overstaffing can quickly consume more than your first third allocation. Choosing premium office space or investing in unnecessary amenities can push your overhead beyond its third. Failing to set aside enough money for taxes from your owner's compensation & profit third can create serious cash flow problems during tax season. Taking on cases that require additional staff or resources without corresponding revenue increases can disrupt your careful balance.

Quick Tips to Best Use Your Revenue

First, improve your time tracking practices. Modern time-tracking apps can help you capture all billable hours accurately. Make it a habit to send bills promptly, and follow up consistently on unpaid invoices. This alone can significantly improve your cash flow and profit.

Second, take a hard look at your costs. Consider whether you really need that large office space, or if some team members could work remotely. Look for opportunities to conduct virtual meetings when appropriate, saving time and travel expenses. Consider sharing resources with other firms to reduce overhead costs.

Third, be strategic about the cases you accept. Choose matters that align well with your expertise where you can work efficiently and add real value. Don't be afraid to decline work that doesn't fit your firm's strengths. Focus on building relationships with clients and referral sources who can provide a steady stream of profitable work.

The Bottom Line

While the Rule of 1/3 provides an excellent target for managing your firm's finances, remember that every firm is different. New firms might see different proportions at first. The key is to track your numbers and work toward this balanced distribution over time.

If you're not hitting these proportions, don't panic! Use this as motivation to make changes. Look carefully at each third of your spending and identify areas where you can adjust. Remember to always set aside money for taxes from your owner's compensation & profit portion – this is not optional and should be done with every deposit.

Remember: Following the Rule of 1/3 doesn't just mean organized finances – it means you can confidently grow your firm, knowing exactly how much you can spend on staff, overhead, and how much profit you'll have after taxes. This clarity allows you to make better business decisions and build a stronger firm for the future.