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Should we measure profitability? Let us count the ways – Part 1

Posted by Jack Bostelman on Oct 28, 2012 | 0 Comments

This post has three parts. Part 1 discusses why it may be a good idea to consider profitability at a more granular level than the firm as a whole, such as by client, matter, practice area or even partner. It also discusses how to allocate some types of expenses at the matter level. Part 2 will discuss allocating general expenses to matters and issues arising in calculating profitability by other sub-units, such as by client, practice area, office and lawyer. Part 3 will describe cautions to be considered in taking action based on profitability data and sharing this sensitive data more widely within the firm.

Should profitability be measured?

Keith Mayfield, Chairman of an AmLaw 100 law firm, is spending another Sunday morning looking at his firm's recent financial reports. He wishes he had more granularity. Today he's focusing on profitability.

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Keith's colleagues seem enamored these days with looking at overall realization rates, which are the amounts actually collected as a percentage of what was worked at standard billing rates. Keith understands that realization rates are important, but believes profitability is the purest measure of financial success. Because it takes into account rates, leverage, margin and utilization, Keith believes profitability should be the starting point. High realization rates on work with low profitability aren't such a great thing. Low realization rates on high-profit work, such as work that utilizes lots of associate leverage, may be an area for improvement but worth the effort to fix. Realization rate is but one of those four key variables that mathematically combine to equal profits, as discussed in an earlier post, “The Economics of Practice Management,” Parts 1 and 2.

“Wouldn't it be great,” thought Keith, “if I could see profitability by client, by practice area, by office and by type of work? Wouldn't it be even greater if I could see it by matter, by type of fee arrangement and even by lawyer and partner?”

Then Keith wonders, “If I could get that kind of granularity, should I share it with my fellow partners? It could be divisive.”

Let's explore first how a profitability metric could be used and how it could be calculated. We will return in Part 3 to the pros and cons of sharing the information.

Why measure profitability?

In corporate America, suggesting that profitability at the divisional or even product level is not a key metric would get you kicked out of the room. Within the AmLaw 200 world, however, you'd probably be in the majority, at least among rank and file partners.

Hopefully law firm leaders don't need a long list of reasons to consider profitability of clients, matters, practice areas and other sub-units. Whether to share that information and how to act on it are a different matter, discussed in Part 3 of this post.

“You can't manage what you don't measure” is an old business adage. Certainly there are important intangibles that also must be managed, but the measurable ones shouldn't be ignored.

What profitability analysis can do

Profitability is a metric that can lead to management decisions. For example, by measuring profitability of clients, the firm could improve overall profitability by eliminating (or at least de-emphasizing) the unprofitable or low-profit margin clients and spending the free time developing new clients. By measuring profitability of practice areas, the firm could consider whether it wishes to grow the more profitable ones and move away from the less profitable ones. If a particular office is less profitable than others, the firm could investigate whether the problem is on the expense side or the revenue side and pursue an appropriate course of action. Improving profitability of any individual sub-unit, such as profitability of a single office or a single client, will improve firm profits dollar-for-dollar.

Year-to-year trends can also be considered. For clients, practice areas or offices for which profitability is improving, the firm could investigate the reasons and seek to apply what is learned to other areas. For those in which profitability is trending down, the firm has the opportunity to learn the cause and intercede before results deteriorate too badly.

Proceed cautiously

The potential business consequences of this profitability analysis are significant. For this reason, whether to undertake the analysis may be controversial within the firm. That goes to the question of whether and with whom to share the results, which will be discussed in Part 3 of this post.

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Any analysis of metrics must also take into account other factors. For example, a practice area with low profitability may nevertheless be an important source of referral work for a more profitable practice area. A client of low profitability may also bring the firm profitable work through referrals. Certain profitable work may come to the firm only because of the existence of a particular office, even though that office is involved only to a small extent in performing the work.

Furthermore, as in all financial analysis, it is important to get behind the numbers before drawing conclusions. A decline in profitability of a practice area might be caused by one or a small number of clients, not the nature of the practice itself. In that case the fix lies in addressing the work for those clients, not a turn-around effort for the practice area.

But first you have to have the numbers.

How do you calculate profitability on a granular basis?

Start with profitability by matter

A convenient starting point can be to calculate profitability by matter. Profits for many other sub-units – such as by client, practice area, type of work, type of fee arrangement, billing partner and supervising partner – will be calculated simply by aggregating profits for the matters comprising the relevant sub-unit. For example, profits of a particular client for a given period are the sum of the profits for all the matters for that client during the period.

Profit by matter

Profit for a matter equals the revenues attributable to the matter minus the expenses attributable to the matter. This is the absolute amount of profit (or loss) the matter contributes to total firm profits. We will discuss later in this post issues arising in attributing revenues and expenses to matters.

The sum of profit (and loss) for all matters equals total profits of the firm. It should be noted that some matters will show losses, however surprising this may be.

Profit per partner for a matter

Profit per equity partner for the matter equals its profit divided by a notional number of partners working on the matter. Profit per equity partner is useful in comparing the relative profitability of different matters. In this post, the term “profitability” of a matter or other sub-unit generally refers to profit per equity partner of the matter or sub-unit. The notional number of equity partners working on a matter equals equity partner work on the matter (hours times standard billing rates) as a percentage of the total equity partner work for the firm, times the total number of equity partners in the firm.

As explained by David Maister in his seminal book (Managing the Professional Service Firm, Free Press Paperbacks, 1993), “it is only by understanding the profit per partner of different practices, services (and even engagements) that the firm can manage its ‘equity investments' (partner time) wisely.” Using the profit per partner metric allows comparing the relative contribution to the firm's profits per equity partner of, for example, a low-margin practice area having high associate leverage and a high-margin, partner-intensive practice area.

Revenues

Because the firm's systems are based on tracking financial information by matter, revenues by matter should readily available. These are equal to the actual collections for the matter, after reflecting discounts, write-downs and write-offs.

Expenses

Most major expenses within a law firm are not specifically tracked by matter. These major expenses include compensation and benefits and occupancy expense. These expenses must be allocated on some basis to the matter for which profitability is being calculated. These allocations may be subjective and are among the most difficult aspects of profitability analysis. Fortunately, there is an entire field of cost accounting dedicated to these kinds of allocations, with which the firm's finance staff should be familiar.

It is important, however, for the users of the profitability metrics to understand how they are calculated, so that relevant inquiries can be made when interpreting the data. This discussion includes several examples of the types of expense allocation decisions that must be made.

Specifically allocated expenses. Some types of expenses bear a relationship to the matter to which they are being allocated. These should be allocated using a method that takes that relationship into account. Two examples are timekeeper compensation and occupancy expenses.

Timekeeper compensation. Because lawyer and paralegal time on a matter is actually tracked, that should be the basis for allocation. Compensation and related benefits for timekeepers other than equity partners should be allocated to a matter in proportion to the hours worked on the matter as a percentage of the timekeeper's annual hours. Non-equity partners, who have fixed compensation (and perhaps a bonus) and not a share of overall profits, are treated like associates in these calculations.

Should the timekeeper's actual annual hours be used in the allocation, or should the firm's annual billable hours target be used instead? In calculating profitability of matters and clients, the target should be used. Otherwise, a timekeeper with low annual billable hours will “cost” more per hour than an equivalent timekeeper with high billable hours. It would be counter-productive to create an incentive for partners to staff matters with the busiest associates in order to show greater profitability. In calculating profitability of practice areas and other units that correspond to how lawyers are managed, however, actual annual hours should be used. Low annual hours for timekeepers in a practice area should adversely affect its profitability, creating an incentive for the practice area to develop more work or reduce its timekeeper headcount.

Equity partner distributions are not an expense, but rather a distribution of profits. Still, it will create a more accurate profitability picture notionally to divide equity partner compensation between a “pay for work” piece and a “sharing profits from the business” piece. Doing so will avoid overstating matter profitability merely because a partner devoted hours to certain work on the matter rather than a non-equity partner or senior associate. It would be misleading for an equity partner-intensive matter to show dramatically greater profitability than a comparable matter staffed more efficiently with non-equity partners and senior associates. The allocation to use between “pay for work” and “sharing profits” is a guesstimate. Most important is that a method be selected that is rational and will be accepted by the lawyers who view the profitability data (to the extent the data will be shared with others besides the firm's chairman).

Occupancy expense. Occupancy expense could be allocated to a matter first by assigning the occupancy expense for an office to lawyers resident in the office in proportion to the lawyers' relative individual office sizes. The per-lawyer expense would then be allocated to the matter by essentially treating it as lawyer compensation – in other words, based on the proportion of the lawyer's overall time devoted to the matter, weighted by billing rate. The portion of occupancy expense for an office relating to administrative (non-time keeper) staff performing functions for the firm as a whole should not be allocated this way, but rather should be allocated in the manner used for general expenses, as will be discussed in Part 2 of this post.

In the next post

The next post will discuss allocating general expenses to matters. It will also discuss issues arising in calculating profitability by other sub-units, such as by client, practice area, office and lawyer

[Photo credits: © Can Stock Photo Inc. / gina_sanders & eddietay2001]

About the Author

Jack Bostelman

Jack Bostelman is the president and principal consultant of KM/JD Consulting LLC. Before founding KM/JD Consulting, Jack practiced law in New York for 30 years as a partner of pre-eminent AmLaw 20 firm Sullivan & Cromwell.

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KM/JD Consulting LLC renders impartial practice management advice to law firms on improving efficiency, increasing profits and reducing risk, emphasizing knowledge strategy.

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Before founding KM/JD Consulting LLC, Jack practiced law in New York for 30 years as a partner of pre-eminent AmLaw 20 firm Sullivan & Cromwell.

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