Turnover versus profitability: balancing the scales of success

Profitability is a term easily bandied about by law firms reaping the rewards of economic boom periods. However, as soon as things take a turn for the worse and the competition for profit intensifies, lawyers find themselves in a difficult environment, one in which the success of the business demands a careful balancing act. Michael Simmons, a partner at Finers Stephens Innocent, considers the profitability minefield and what areas lawyers must tackle to enjoy a more prosperous future.

Most solicitors are still financially illiterate. It all goes back to the English educational system based on ‘arts against science’. Most of us come from the arts’ side and probably took the opportunity to give up maths at the earliest possible moment. We suffer because of this lack.

We can understand the principle of turnover. If we gross more fees in a year, we expect to make more money, but sadly we are increasingly disappointed. Many law firms are running faster in order to stand still, if not to move backwards.

By working ever longer hours, we have, at least until recently, still been able to increase turnover, but, as the post 11 September recession deepens, there are increasingly signs that turnover itself is dipping.

The world has realised that the Americans have not eradicated Al-Quaeda and the fear is deepening of another World Trade Center disaster, which will depress financial markets further and blow away completely that fragile commodity, confidence.

Faced with falling turnover, most lawyers panic. The primal desire is to protect our incomes and the threat to our incomes often leads to hasty, and somewhat primitive reactions. In a previous recession, a partner known to me was heard to utter the immortal words: “Cut anything you like, but don't cut my drawings.” Not surprisingly, that immature attitude was reflected in the failure of that particular firm.

Economic cycles, like history, have a habit of repeating themselves, and partners are once again threatened by a drop in earnings. This forces managing partners to look beyond turnover figures, and to consider profits and profitability.

The immediate tendency, based of course on panic, is to get out the pruning shears and cut expenses. This is usually done without appropriate analysis and these cutting exercises result in something akin to the baby being thrown out with the bath water.

The problem is that so many of a law firm's overheads are not susceptible to short-term pruning. Fixed costs such as rent on the premises cannot be reduced overnight. You may regret that decision to move the firm into expensive marble halls, but the property market in a downturn ensures that you cannot pass on the lease and have to grin and bear the burden.

The obvious area for speedy cuts is that of staffing. Going by the book, our managing partner will work on the principle of last in, first out. Is this wise? If you talk to a banker who lends regularly to law firms, you will be assured that the true assets are the staff. Banks lend on the strength of the partners and not on the basis of a law firm’s other, somewhat scanty tangible and intangible assets. Your lawyers comprise your true capital value.

These issues are closely bound up with those of profitability. In fact, when the going gets tough, profitability is the key to the survival or failure of most law firms.

A profitability analysis of most law firms, especially when it has not been done before, is a painful exercise. It is also a fairly simple one based on arithmetical issues, although the market, past, present and future, needs to be considered as well.

Having started with the issue of the firm's personnel, examine carefully the work product of what we call fee earners, and the Americans call time-keepers. We are here talking about billings, chargeable hours recorded, and fee collections. One of these three aspects may be outstanding, and the other two inadequate. What we need to consider is a balance between the three. All should be above average.

Allowances have to be made for those who spend time on management, successful marketing, training, recruitment and other authorised activities for the firm. I recommend that you first carry out the cold, arithmetical analysis and only afterwards factor in as honestly as possible the other issues. The arithmetic may be so shocking that ‘touchy-feely’ issues do not provide sufficient mitigation.

It is not enough to carry out a redundancy exercise based on lawyer profitability alone, but now look at the profitability, or the lack of it, of the various areas of work undertaken by the firm. This means taking the overheads of the practice and dividing them as fairly as possible between the various departments and groups within the firm. Some divisions are easier than others. When it comes to support services, there may be a lot of special pleading, but the division must be made whatever attempts are made to blur the issues by those who feel threatened within the firm.

Once again, this is not a difficult arithmetical exercise, although innumerate lawyers may need help in carrying it out. The results rarely surprise, as they usually serve to reinforce gut reactions, and prejudices.

Some of your firm's activities may be so unprofitable that it shrieks to the heavens that you should cut them out immediately. In a shrinking market, sentiment becomes a superfluous bed-fellow. Many of us have embraced the concept of the full service firm from the largest to the smallest within our profession. The profitability exercise may decide for you that you cannot afford this luxury.

It may be possible to hive off these activities by negotiating with the partners concerned to leave with their particular clients and staff. Let them worry about their own future profitability. You have had enough.

If this cannot be achieved, then these activities need to be terminated along with the staff concerned, if the latter cannot be redeployed elsewhere within the firm on more profitable work. In order not to leave those clients high and dry, try and enter into sub-contracting arrangements with other firms, who continue in those markets and provide an adequate service. In an ideal world, you can claim commission for your introductions, but this should be secondary to the need to hive off the unprofitable work, while at the same time providing continuity of service to the clients concerned. It is a strange fact of life, that one firm's unprofitable business is another firm’s staff of life. This may well be down to lower overheads, better concentration, or superior management.

You are now two-thirds of the way there, but it is still necessary to turn the searchlight on your clients in terms of the profitability analysis. If the 80/20 rule does not apply easily, you are still likely to try and impose it. The myth, or perhaps, the reality, is that 20 per cent of your clients provide 80 per cent of your profit, while at the same time another 20 per cent causes 80 per cent of your problems. Sadly, most of us cannot exist by working solely for the top 20 per cent. While a diet of cake alone is delightful, most of us have to subsist on a considerable amount of bread and butter as well.

Your aim must be to jettison the bottom 20 per cent of your clients, who take up far too much of fee earner time as against the amount that you can bill and collect from them. Once again, with a reasonable time recording system in place, it is not difficult to work out who goes and who stays.

You may wish, once again, to enter into arrangements with other firms to take on these under-performing clients, if indeed you can readily effect the transfer to them. At least your conscience will be clear that you are not merely ditching those clients and you may wish to dispose of the lawyers who service those clients simultaneously. By looking at the profitability of lawyers, areas of work, and specific clients as a whole, the exercise becomes much simpler. Beware becoming too focused on the figures alone. In terms of all three elements, lawyers, areas of work and clients, you need also to look at trends before making your final decisions. All three mirror the economy, and can rise, stay static or decline.

Thus, you need also to look at the potential of your lawyers. The rising stars may not currently be performing satisfactorily, but, if they fit into that category, perhaps the fault is that of management, and more can be done to get the best out of them. They should not be on the list for redundancy.

Work types need to be put under a similar microscope. Certain areas of work may not yet be profitable, but, if they are in the pioneering stage, and you have invested in them, perhaps you should persist with them. Others may currently be earning reasonable profits, but perhaps you can see the writing on the wall. These are areas that are about to fall steeply into decline. There may well be other work types that are already not for you in that they are classified as mere commodity areas of practice, where fees have sunk to a derisory level and the creation of a computerised

production line alone can make them economically viable for a practice. You may well not be interested in factory farming for your law firm.

Clients are susceptible to the same scrutiny as the industries in which they work. Emerging clients in pioneering industries may not be able to pay your current level of fees, and hence may fail in the profitability stakes. However, if you treat these clients and industries as an investment, perhaps they should not be axed, but kept as an investment for the future. The choice is yours, and there may well be some delicate balancing acts required. Conversely, clients in mature industries, who pay your going rates and provide a good profit cause no problems and are obvious candidates for retention. However, especially in a speedily declining market, watch carefully that they do not in their turn become loss leaders.

Those clients whose businesses have already declined, or who find themselves in rapidly contracting industries with the result that they can no longer pay your proper fees, must sadly be candidates for the chop. This can be particularly difficult, when you are dealing with old clients, where personal links have been established over the years. Perhaps you will allow sentiment, even in the short term, to triumph over economics. The choice is yours.

The firm that concentrates on profitability issues will survive and ultimately prosper. The arithmetical facts must be made available, so that the correct decisions can be made. However, I advise strongly that no firm should rely on arithmetic alone. Market trends must also be brought into the equation, and I suspect that no firm will fail also to consider issues of sentiment. The balancing act between the three will always be an interesting one. Who said that you could maintain profitability without making hard decisions?

Michael Simmons is a partner at Finers Stephens Innocent and a consultant on professional practice problems. He can be contacted at msimmons@fsilaw.co.uk.