Profits are a better way to measure a law firm’s financial health. This article explores why so many firms are preoccupied with revenues instead of profit and what you can do about it.
If you double your revenues and your margins remain constant, you will double your gross profit. If the number of partners doubles in the same period, you are standing still (well, less the cost of champagne).
Why are so many firms preoccupied with revenues instead of profit? Here are the most common reasons firm leaders focus on the wrong numbers:
- Various publications rank firms by revenues. Firm leaders are therefore motivated to try to achieve as high a ranking as they can, for both wholesome and unwholesome reasons–wholesome including
positioningto obtain marketing advantages, and unwholesome being basically ego.
- The partners themselves understand the simplistic measure
percentage increase,and it is appealing if you don’t know any better.
Percentage increaseincluded inflation, without highlighting it, so even if there are margin squeezes, revenue enhanement still sounds good.
- Revenue is simpler to calculate than profit, at least firmwide.
The Visibility Test
When it comes to measuring the performance of individuals, many firms still focus on recorded billable hours. Recorded hours are perceived to have value, so if we know the billable hours of two lawyers, A and B, and B’s are 120 percent of A’s, we can safely assume that B is producing more for the firm than A. Or can we?
Some slightly more sophisticated firms measure billings, and even more sophisticated ones measure cash receipts. These measurements fail to disclose the true profitability of the practice, which is ascertainable only by going beyond hours or billings or receipts to include costs allocated to the revenue source.
For example, knowing that a lawyer recorded million worth of time is a beginning. Knowing that 0,000 was billed is better, and knowing that 0,000 was received is better yet. But we cannot really assess the value of the practice until we know that the costs associated with that revenue generation were 0,000–producing a net contribution of 0,000.
Allocating Costs (The Dark Side)
Why are so many firms reluctant to allocate costs? Here are some of the reasons:
- It is not simple to allocate costs. What do you count and what don’t you count? It may be easy to allocate staff if there is a 100 percent allocation to a group or team, but in the real world it usually gets a lot messier than that. And then there are issues like this: Is the new office in Timbuktu, which specializes in Practice Area X, a cost of that practice area, or is it the beginning of a presence that benefits and adds international credibility to the entire firm and therefore a cost of all practice areas? Having discretion as to allocation creates dilemmas. And we hate dilemmas.
- The computer systems may not allow the flexibility to do the combinations and permutations of calculations, or the people who operate those systems may be ill-equipped or just plain reluctant to handle the changes.
- Change means some uncertainty, and therefore discomfort. It won’t be done the way we have always done it so successfully. It’s not broken, is it?
- Politics. Individuals with significant personal power are not about to allow any new measurement process that they have not already analyzed to the nth power to determine exactly how it might affect them personally. Partners are as sensitive about cost allocation as they are about compensation.
- The ramifications of doing the analysis may be dangerous. If practitioners in Practice Group A were to learn how much more profitable they really are compared with Practice Group B, they may begin putting tremendous pressure on decision-makers as to compensation and other important issues. There might even be a drive to expel Practice Group B from the firm. Worse, the entire Practice Group A may shop for another host firm where they will be more appreciated, or break away to become a boutique. Either way, the firm’s fabric is torn.
If you are truly managing, you need the data to determine profitability. How you share the data is a different matter.
Profit is typically deduced by subtracting expenses from revenues, usually firmwide. Instead, financials ought to calculate profit from many more perspectives: by lawyer, practice group, industry served, client, geographical location, and by any other useful dimension within the firm.
I am not saying you should publish this information; I am saying you need to ascertain it.
If your systems won’t give you the data (or worse, if the data are not being captured), priority one is to create systems that will. You may have to make reasonable compromises, but sit down with your data processing people (internal and external) and determine what is possible. Talk to your counterparts in firms using the same software and find out how far they are going in this direction. Compare notes.
Next, begin to analyze–even if you have to guess–what is going on. Begin to formulate your views (or educated suspicions) as to where profitability is being enhanced and where it is under attack.
Third, manage accordingly. What does that mean? Well, individual situations are far too unique to generalize here, but you may find this list of questions helpful. Whether you are analyzing individuals, groups, or locations, thinking about these issues might get you started:
- Are we placing excessive emphasis on hours?
- Are we placing insufficient emphasis on rates?
- How can we get rates up, if not today, then over time?
- Are we honestly assessing the quality of the client list?
- Are we accurately assessing the contribution each client makes to our firm?
- Should we fire some of the clients at the bottom of the list?
- Do our marketing efforts bring us sufficiently high-quality new clients?
- Are we measuring individual performance accurately (as opposed to simplistically believing billable hours or cash receipts in the absence of data on related costs)?
- Are we still recruiting based on linear thinking like the quality of the schools and class ranking, or are we beginning to think about other attributes, such as collateral experience (summer jobs), other degrees, and how that nonlegal experience and education may fulfill future firm needs (even several years from now)?
- Are we tolerating people who are hurting us?
In the long term, it may be sensible to tolerate and even foster less-profitable practices if they complement more profitable practices and the people in them are part of the
glue that holds the firm together (leaders, founders, facilitators, and mentors of value).
On the other hand, it may be imperative to stop tolerating less-profitable practices if they include people who are difficult, unresponsive, or adversarial to management, harsh with junior professionals or support staff (or peers), or who consume a lot of time and energy (high maintenance).
Practice Group Leaders
When the firm doesn’t know how to properly measure your group’s performance, ignore the Neanderthal measurements and focus on making your group powerful and successful. The suggestions above can be applied to your group as if it were a firm. Your success will give you options. Be patient, but over time if you cannot persuade your firm to measure the group’s real profit contribution rather than merely revenues, maybe your group would be better off in a more enlightened environment.
If you are managing the top line without regard to the bottom one, you are on a perilous journey–a slippery slope to oblivion. There are as many
bottom lines in a professional firm as there are ways to examine a multifaceted gemstone. Firm leaders who begin to explore true profitability (even secretly, so the billable-hours-and-revenue freaks don’t find out) will enhance the real performance of their firms.
It’s like having a new indicator on your car’s instrument panel showing fuel efficiency by miles per dollar. After all, this is what partners are really seeking: maximum return on their financial interest in the firm.
© 2001 NLP IP Company. All rights reserved. This article is reprinted with permision from Legal Times (1-800-933-4317 or [email protected]).