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Should we measure profitability? Let us count the ways – Part 2

Posted by Jack Bostelman on Nov 11, 2012 | 0 Comments

Part 1 discussed 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 discussed how to allocate some types of expenses at the matter level. This Part 2 discusses 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.

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General expenses. General expenses, also known as indirect expenses or overhead, will be allocated to matters, offices and lawyers on a more arbitrary basis. Examples of general expenses include book and electronic library subscriptions, technology infrastructure costs, compensation and benefits for most administrative staff and occupancy costs for administrative staff.

One allocation method for these general expenses is to allocate them to a matter in proportion to the share of firm revenues of the matter. A somewhat more accurate method would be to allocate general expenses to a matter in proportion to the matter's share of direct margin. Direct margin is revenues minus the specifically allocated expenses discussed in the previous section, such as timekeeper compensation and occupancy expense.

The greater the expense category as a percentage of firm expenses, the greater the importance of the allocation method. For relatively smaller expense categories, it is not worthwhile expending lots of effort on the allocation method. Treating the category as a general expense may suffice.

Expenses that are actually tracked to matters (because they may be billed as disbursements) should, of course, be allocated specifically to those matters. For example, if the firm tracks subscription usage by matter (whether or not billed to clients), that usage as a percentage of total firm usage for the subscription service could be the basis for a specific allocation to the matter.

Profitability by client, practice area, type of work, type of fee arrangement, billing partner and supervising partner

Once profitability by matter can be calculated, profitability for many other sub-units – such as by client, practice area, type of work, type of fee arrangement, billing partner and supervising partner – can be calculated simply by aggregating profits for the matters comprising the relevant sub-unit.

Profit per equity partner for the sub-unit equals its profit divided by the notional number of equity partners attributable to the sub-unit. That notional number of equity partners equals equity partner work (hours times standard billing rates) for the sub-unit as a percentage of total equity partner work for the firm, times the total number of equity partners in the firm.

Sub-unit data issues

A problematic area in these profitability calculations, though, is the accuracy of some of the sub-unit data. The calculations require associating matters with sub-units. For example, matters can be associated with a practice area, type of work, type of fee arrangement, client, billing partner or supervising partner.

Practice area and type of work. Some sub-unit data, such as practice area and type of work designations and client definitions, may be unreliable. In this discussion, practice area means the lawyer group that manages itself around a particular subject matter, such as mergers and acquisitions, capital markets or intellectual property litigation. Type of work means a sub-class of matters undertaken within the practice area and used for tracking purposes, such as hostile takeovers within the mergers and acquisitions practice area, initial public offerings within the capital markets practice area or trademark infringement within the intellectual property practice area.

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For example, is practice area and type of work information typically completed by a partner's assistant during the new matter intake process, without review by the partner because the information isn't used for anything the partner directly cares about? In that case, practice area and type of work information should be considered suspect. Similar issues may exist for other sub-units, such as a fee arrangement designation for a matter. In each case, the reliability of the data should be investigated before using it as a basis for profitability calculations. In some cases, it may be worthwhile to embark on a separate project to improve the integrity of that data, at least prospectively. Knowing the information will be used to calculate profitability is one way partners can be induced to improve data accuracy.

As another example, do practice area definitions correspond to the way internal practice groups are managed, or do they correspond to the designations used for external marketing purposes, which are typically more numerous? This is not an issue of data reliability but rather an issue of data relevance. If only external practice areas are tracked, then even if the data is reliable the designations won't be useful for profitability calculations, which need to relate to the way lawyers are managed. If the external areas can be mapped to internal practice areas, then profitability by internal practice area could still be calculated.

Billing partner. Billing partner data for a matter is likely highly accurate, but is it meaningful? This is another question of data relevance. If billing partner corresponds to rainmaking activity, profitability by billing partner will be a meaningful metric. If billing partner status does not correlate with rainmaking, and there isn't other hard data that tracks rainmaking to specific matters, then profitability by billing partner should not be used. Instead, rainmaking should be among the important intangible factors considered after the hard profitability figures are available.

Client definitions. Yet another example of data reliability may be client definitions. For a variety of reasons, some firms may utilize multiple client numbers to represent work for the same actual client. Does the firm have a rational and accurate basis for determining the client name associated with a matter, such as the client division or type of work involved? Or are there several ad hoc client designations for the same actual client, based, for example, on who gets billing credit for that “client”? If the multiple client numbers are rationally based, they provide a basis to calculate profitability by those sub-clients. If not, then the only basis for client profitability calculations is to aggregate the work for all client numbers attributable to the same actual client. If the grouping of client numbers to actual client has not yet been made, it will have to be done before profitability by client can be figured.

Profitability by lawyer and office

Profitability by lawyer and office is calculated similarly to profitability by matter:  revenues and expenses are allocated to offices and lawyers. Similar specific and general allocations that need to be made are discussed below.

Revenues

Revenues for a lawyer are the lawyer's proportion of each matter's collections, based on the lawyer's relative work on the matter at standard rates (hours times billable rate for the matter).

Revenues by office can be calculated as the sum of revenues for each lawyer resident in the office.

Expenses

For purposes of calculating profitability by lawyer, the lawyer's compensation and benefits would be specifically allocated to that lawyer. As discussed in Part 1,  lawyers who work more hours in a year (in other words, have a higher utilization) will show greater profitability than equally compensated lawyers working fewer hours on comparable matters. This is because the attributable expenses of the harder-working lawyers are lower, driven by their greater number of hours. This is a desirable result when calculating profitability of practice areas and offices, because it creates an incentive to utilize underworked lawyers by attracting new work or reducing headcount. It is probably not appropriate, however, when calculating profitability at the individual lawyer level,  because the individual lawyer (at least at the associate level) generally has little ability to control the availability of new work. In calculating profitability by lawyer, the firm's target annual hours per category of timekeeper would be more appropriate than actual hours.

In calculating profits per office, instead of using the two-step method used above for matter profitability – allocating occupancy expense first to lawyers then to the office – occupancy expense could be allocated directly to each office.

Other expenses would be allocated to lawyers or offices using the overhead allocation method discussed above for calculating profitability by matter, such as on the basis of relative direct margin.

In the next post

The next post will describe issues to be considered in taking action based on profitability data. It will also discuss cautions in sharing this sensitive data more widely within the firm.

[Photo credits: © Can Stock Photo Inc. / Kurhan & rbhavana]

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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