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Should we measure profitability? Let us count the ways – Part 3

Posted by Jack Bostelman on Nov 25, 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 discusses how to allocate some types of expenses at the matter level. Part 2 discussed allocating general expenses to matters and issues arising in calculating profitability by other sub-units, such as by client, practice area, office and lawyer. This Part 3 describes cautions to be considered in taking action based on profitability data and sharing this sensitive data more widely within the firm.

Cash basis vs. quasi-accrual approach

Because actual cash collections lag, often by a significant amount of time, the performance of the work and incurrence of related expenses, using actual collections as a basis for profitability calculations may be disadvantageous when the calculations are being used to aid management decisions. The profitability information would be significantly delayed in relation to when the work was performed, correspondingly delaying any action management may choose to take.

One way to address this delay involves using forecasted collections (revenues) based on hours worked on a matter. Under this method, the theoretical collectible amount at standard rates would be reduced by historical rates of discounts, write-offs and write-downs. Expenses would be calculated the same way as for the cash collections method of calculating profitability previously discussed. Using forecasted revenues, though, aggregate annual profitability for all matters will not precisely equal the firm's actual profitability for the year, which could be confusing to some.

Is there off-the-shelf software for granular profitability analysis?

Spreadhsheet canstockphoto7574696 300x174

Although conceptually straightforward, the above allocations and profitability calculations involve a tremendous amount of number-crunching. There are also many details that need to be taken into account, such as when a timekeeper changes offices mid-year, billing rates change and matters are re-staffed.

Fortunately, there are some off-the-shelf software tools that can do this work. This is not a software review, but one product worth considering is the Business Intelligence Module of Redwood Analytics (part of Lexis-Nexis). It includes a tool that, once configured with allocation rules, allows the user to create on-the-fly reports on-screen showing profitability by a variety of sub-units, including those discussed in this post. The user can obtain further detail, to examine what's behind the profitability figures, by clicking on the profitability information that's reported. This software tool can tie to all the major billing and accounting systems used by large and mid-size law firms.

Another software tool with very similar capabilities is the Profitability module in the IntelliStat Business Intelligence suite by Data Fusion Technologies. This product originally tied only to Thomson Reuters Elite's billing and accounting system, but I understand will soon be able to work with Aderant's billing system as well.

Customers of Elite 3E (by Thomson Reuters Elite) will likely already have access to its Profitability module, which comes bundled with its Billing and General Ledger software. This product has essentially the same capabilities as the Redwood Analytics and Data Fusion tools, though it works only with Elite 3E.

These software packages don't eliminate the effort previously discussed to devise allocation formulas for revenues and expenses and ensure data integrity for groupings of matters into other sub-units, such as practice areas. They do, however, make granular profitability calculations a practical undertaking and provide user-friendly interfaces and tools for examining the underlying components of the data. They also include security features allowing control over which users have access to the information.

To disclose or not disclose?

Once the firm's chairman has ready access to profitability by client, practice area, type of work, type of fee arrangement, billing partner, supervising partner and lawyer, the chairman must decide what to do with that highly sensitive information.

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Most AmLaw 200 partners don't think about profitability of clients, matters and other sub-parts of the firm's overall profits. The firm's chairman should consider what behaviors he wishes to change by exposing the information to the partners, then expose only the relevant information and accompany that with an education program to ensure the partners understand the information they are being given and the behavior the firm wishes to change. He also needs their buy-in that the information is meaningful. A gradual approach is usually best, in terms of the sub-units for which profitability is shared with partners.

In achieving buy-in regarding the relevance of profitability information, it is worth noting that partners do think about profits per partner. Law firm leaders can perhaps convince their colleagues to care about profitability of clients, matters, practice areas, etc. by pointing out that profits per partner is merely the aggregation of all the profits on all the clients (or matters, etc.), divided by the number of partners. If they can increase profits on individual clients, profits per partner will increase.

Another question is whether profitability for all instances of the sub-unit (say, clients) is shared with all partners, or whether each partner is shown only the profitability metric applicable to him or her, together with the firm average. Different answers may apply to different profitability calculations. For example, profitability of clients might be made available to all partners, while profitability by supervising or billing partner might be made available only to the affected partner.

A further question is whether to include profitability as a factor affecting partner compensation. That could be a strong driver of behavior, but if pushed too hard or too soon runs the risk of creating discord among the partners. Consistent with the theme of moving gradually, it would be best to introduce profitability as an information-only metric for some time before using it as a factor in partner compensation. The goal is to allow each partner sufficient time to understand and accept how the metric is calculated, how it applies to his or her practice area, office, clients and matters (and even to the partner individually) and what actions the partner can take to change profitability. Only after the results of that phase are assessed should the firm consider using a profitability metric to affect compensation.

In the end, many law firm leaders may opt to keep the profitability information to themselves or to share it only with their executive or similar committee. That trades off reduced conflict within the firm for reduced ability to take or motivate action based on the information. When it comes to exposing sensitive profitability information, though, it is better to proceed too slowly than too fast.

Profitability data is not the end of the analysis

Lawyers presented with the prospect of using granular profitability information as a management tool will be quick to point out that it fails to take into account important intangibles. For example, does an unprofitable office bring in important work that's handled by another office? Does a low-profit practice area attract high-profit work for another practice area? Does an important and profitable client condition its use of the firm on the firm's advising in an unprofitable practice area or maintaining a specific unprofitable office?

Also, if a practice area shows low profitability, is that because its work overall is low-profit, or are there a few unprofitable clients dragging down the average? Does a lawyer show low profitability because he or she works too few hours, or because he or she is required to work mostly on low-profit matters? In each instance, the appropriate action to take depends on which explanation applies.

These observations are all correct. It's important to look behind the data. It's also important to look beyond the data. That requires examining the constituent components of the data (made easier with the software tools described above) and speaking to the relevant practitioners about what the data purportedly show before drawing conclusions. This work must be done by partners who really know the firm and its practice. Profitability data is a tool that requires a management time commitment to utilize effectively.

Concerns that partners at large may not consider these issues could lead a law firm leader to err on the side of maintaining profitability data within a small circle of senior management, or exposing it only in the context of a formal presentation that includes the relevant explanations.

Conclusion

Considering granular profitability information can be an important, perhaps compelling, tool for law firm leaders. Today's software can make accessing this information very user-friendly. Law firm leaders will, though, need to invest some time in establishing appropriate allocations for the calculations, making the investigations needed to interpret the results, considering whether and to what extent to expose the information to other partners and developing a program to train those partners in understanding and acting on the information.

[Photo credits: © Can Stock Photo Inc. / lucadp & iDesign]

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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