Law Firm Profitability Analysis: Making it Work
Published for Thomson Reuters Legal Executive Institute on August 25, 2015
As I wrote last week, law firms are increasingly adopting profitability measures, a positive development for the firms, their people, and their clients. In this post I will address five issues that are critical to making the most of profitability analysis:
Management Team Buy-in
Communication to Partners
Methodology
Application
Learning
Management Team Buy-in
The first step to successful implementation of profitability tools is genuine buy-in by the firm’s management team. Ultimately, they are the ones who will make the strategic, compensation, and other decisions that will be influenced by the profitability data. It is essential that they understand, internalize, and approve the program and its objectives.
Many issues relating to methodology and implementation involve judgment calls with which reasonable people can (and will) differ. It is important to air these issues with the management team so that they feel heard on them, especially as to decisions that are decided differently than what they would have done. This will enable them to defend the program more effectively against the resistance that surely will come.
Communication to Partners
It is also essential to communicate fully and clearly to the partners how and why the firm is adopting new profitability tools. The firm will be asking the partners to accept the profitability feedback and change the way they serve clients in response. They need to feel included in the process and to understand why they are being asked to change.
In informing partners of the objectives and mechanics of the assessment, two points are particularly important. First, they need to understand that the overall goal is to help them be more successful. The firm seeks a more complete picture of its financial reality, to help find the best way for each partner to flourish in a changing marketplace.
Second, the new tools are analytical, not judgmental. The tools will be used to understand the firm’s economics, not to grade the partners as satisfactory or unsatisfactory.
Methodology
The core of the profitability model is assigning revenue and expense to the undertaking to be assessed. This can be done any number of ways, each of which will have pluses and minuses. Whatever methodology the firm chooses, it should strive to make it as comprehensible and workable as possible. Partners must be able to understand it, explain it to others, and use it.
Most firms build their profitability model on timekeeper hours. Each timekeeper is assigned a direct cost per hour based on his/her compensation and an indirect cost per hour based on an allocation of overhead. There are some important judgments to be made in designing these hourly costs, but they are readily manageable.
Importantly, this model is not synonymous with billing by the hour. It is simply a way to calculate cost by keeping track of the portion of human resources deployed to generate the revenue.
Application
Perhaps the most sensitive issue is what undertakings the firm will assess. By what segments of the firm’s practice will it measure profit? Will it be by partner, by client, by practice group, by office, or by another grouping? These questions likely will generate the greatest focus on the dangers of unintended consequences of profitability analysis.
The answers will turn on what the firm is trying to accomplish and what units are most likely to yield valuable information to improve the firm’s success. Generally, the larger the unit being assessed, the more valid the conclusions to be derived.
Learning
Finally, the firm needs to establish a structure and procedures to capture and act on the learning generated by profitability analysis. The accounting group can run the numbers, but the partners and practice managers must digest them and distill the practical lessons for improved client service.
This last point takes us back to the importance of communication at the outset. For profitability analysis to make a difference, the firm will need buy-in from its partners and its leadership. They must endorse it and must be ready to do their part in converting the analysis to action.
As I wrote last week, law firms are increasingly adopting profitability measures, a positive development for the firms, their people, and their clients. In this post I will address five issues that are critical to making the most of profitability analysis:
Management Team Buy-in
Communication to Partners
Methodology
Application
Learning
Management Team Buy-in
The first step to successful implementation of profitability tools is genuine buy-in by the firm’s management team. Ultimately, they are the ones who will make the strategic, compensation, and other decisions that will be influenced by the profitability data. It is essential that they understand, internalize, and approve the program and its objectives.
Many issues relating to methodology and implementation involve judgment calls with which reasonable people can (and will) differ. It is important to air these issues with the management team so that they feel heard on them, especially as to decisions that are decided differently than what they would have done. This will enable them to defend the program more effectively against the resistance that surely will come.
Communication to Partners
It is also essential to communicate fully and clearly to the partners how and why the firm is adopting new profitability tools. The firm will be asking the partners to accept the profitability feedback and change the way they serve clients in response. They need to feel included in the process and to understand why they are being asked to change.
In informing partners of the objectives and mechanics of the assessment, two points are particularly important. First, they need to understand that the overall goal is to help them be more successful. The firm seeks a more complete picture of its financial reality, to help find the best way for each partner to flourish in a changing marketplace.
Second, the new tools are analytical, not judgmental. The tools will be used to understand the firm’s economics, not to grade the partners as satisfactory or unsatisfactory.
Methodology
The core of the profitability model is assigning revenue and expense to the undertaking to be assessed. This can be done any number of ways, each of which will have pluses and minuses. Whatever methodology the firm chooses, it should strive to make it as comprehensible and workable as possible. Partners must be able to understand it, explain it to others, and use it.
Most firms build their profitability model on timekeeper hours. Each timekeeper is assigned a direct cost per hour based on his/her compensation and an indirect cost per hour based on an allocation of overhead. There are some important judgments to be made in designing these hourly costs, but they are readily manageable.
Importantly, this model is not synonymous with billing by the hour. It is simply a way to calculate cost by keeping track of the portion of human resources deployed to generate the revenue.
Application
Perhaps the most sensitive issue is what undertakings the firm will assess. By what segments of the firm’s practice will it measure profit? Will it be by partner, by client, by practice group, by office, or by another grouping? These questions likely will generate the greatest focus on the dangers of unintended consequences of profitability analysis.
The answers will turn on what the firm is trying to accomplish and what units are most likely to yield valuable information to improve the firm’s success. Generally, the larger the unit being assessed, the more valid the conclusions to be derived.
Learning
Finally, the firm needs to establish a structure and procedures to capture and act on the learning generated by profitability analysis. The accounting group can run the numbers, but the partners and practice managers must digest them and distill the practical lessons for improved client service.
This last point takes us back to the importance of communication at the outset. For profitability analysis to make a difference, the firm will need buy-in from its partners and its leadership. They must endorse it and must be ready to do their part in converting the analysis to action.