Another Look at Practice Group Analysis

Many law firms now have sophisticated methodologies for assessing or measuring the profitability of their practice groups, and yet many stumble across one of three typical issues.

1. Many firms do not have a clear definition of their practice and industry groups. The issue is that firms often have too many specialised groups with some overlapping, some small, some historical and even some redundant. Partners and timekeepers can be members of more than one group and their time is sometimes difficult to classify between groups. Even where there is some objective definition of what lawyers and/or work are assigned to each group, revenue-sharing problems can also occur where timekeepers do work on engagements (or create originations) for another group. The least complex (and most popular) response to this issue is to make a clear assignment of all timekeepers to a specific group, but this usually works best in larger firms with highly specialised timekeepers who largely stick within their group. It is also possible to code each time entry for a matter or engagement to an office, practice group or industry group, but this can get very complex quite quickly – its value is only as good as the accuracy of the coding. Some firms also assign specific engagements to a specific practice group and all revenues from the engagement then fall within that group’s profitability analysis. This works fine, but it does require monitoring for the possibility that the engagement may morph into another practice group.
2. Overheads – particularly general support costs – are difficult to apportion between groups. When analysis is carried out to a minute level of granularity, I have seen arguments break out about the fairness of allocation of some of the overheads if a group feels it does not make as much use of certain support services as others. The use of marketing and IT are typical examples. Where timekeepers work across more than one group, there is also the issue of how to apportion their cost – the simplest method is often to distribute the cost of each timekeeper proportionately between groups according to the worked, billed and collected revenues by each timekeeper.
3. There is no coherent allocation of the cost of partner time. There are three typical views here. The first option is to ignore the cost of partners on the basis that partners are paid out of profits. This carries huge problems in that it understates the operating costs of the group, it works to the disadvantage of highly leveraged groups, and it makes comparisons between groups tricky. Furthermore, it does not easily drill down into individual partner profitability. The second approach is to account for the full cost of partner compensation as part of the overhead. The problem with this approach is that it overstates the operating cost of groups, since it reflects benefits of ownership beyond compensation for work (capital at risk, client origination, and management activities) and results in small marginal differences among groups. In my view, the best option is to calculate a notional “salary” for equity partners. This is usually triangulated between (1) levels of monthly drawings, (2) the highest salaries payable to non-equity partners, (3) market salaries (where evidence is available). Even this method has a disadvantage in that the element of nationality can be seen as removing accuracy from the profitability calculation.

Once the firm has resolved and defined all of the above issues, the attached table shows how a typical Contribution Analysis can provide a simpler answer than a full and detailed Practice Group Profitability Analysis. It has the great benefit of being able to compare the profitability of groups on a fair basis

Sharing Your Profitability Numbers: All for One?

Because of client pressure on fees, law firms are scrutinizing their profitability numbers more than ever. If the clients are right, firms are looking for new efficiencies, better project management and innovative staffing. But we see that law firm leaders are looking at profitability as “business lines” as well. Is this area of practice a drag on our overall profits and should we drop it? To the extent that some firms have a culture of “One for all and all for one,” that culture is fraying.

If you are a managing partner or an executive committee member, the way that you share profitability numbers can threaten a unified culture. The flip side is that a shared analysis of profitability signals transparent management. We are not talking about firm-wide monthly or annual profits. Of course, all partners get to see those figures. But who gets to see profitability at a practice-group level or the individual-partner level?

We expect the CFO, managing partner and an executive committee to look at profits at a granular level. It would be irresponsible to ignore flagging practices or partners without counseling them. But beyond that group, these seem to be the choices:

1)  share practice-level monthly profitability figures with the practice-group leader and keep them confidential beyond that;

2)  share practice-level monthly figures with all partners (with the greater risk that bad news will leak beyond the firm);

3)  share both practice-level and individual-partner profitability figures with practice leaders, but individual numbers only with each individual; or

4)  share all profitability figures at each level with all partners.

There is a cultural consequence for each of these options. In firms that have a modified lockstep compensation system, there may have been an “all for one” attitude. Over time, litigation may be up when transactions are down. Real estate practice is booming but government investigations are slow. It was assumed, without transparent analysis over time, that revenues and profitability balanced out across groups.

At the other end of the spectrum, firms that place heavy emphasis on originations are more likely to reveal partner-level revenues to all. Some of those are now sharing profitability figures as well. In that culture, the knowledge of my partner’s profitability may not be a surprise. We know we are a “one for one” firm at heart.

The challenge is for leaders in the middle of the spectrum. Even in thriving firms, the profitability of some practices and partners is down and the lawyers either have to improve profit margins or get out of the practice. Do you go about this in a quiet, managed way, without opening controversy between practices, or do you share profitability numbers with all partners and place public pressure on some?

The response will depend on how leaders assess the impact on their culture. Having a strong understanding of the current culture is as important as knowing your numbers.