Financial management for profit

There may be several interpretations of the purpose of management accounts, but success boils down to delivering the right information to the right people, quickly and accurately to enable them to properly assess business performance. The key to achieving that is a complex but not insurmountable challenge. By Shaun Gillanders

Financial reporting can be divided into statutory reporting (annual accounts) and management reporting (monthly accounts). Both sets of reports are derived from the same data: the ledgers and chart of accounts. Both are for the most part concerned with money and finance. Both are usually produced by accountants. However, the two sets of information are generated for different purposes and shouldn’t be confused. Statutory reporting is about complying with laws and regulations, tax returns and profit sharing, and reporting externally what profits have been achieved and the financial state of the business. Management accounts should be about managing the business in its wider sense. While there are probably about as many descriptions of the purpose of management accounts as there are accountants, a general specification for management accounts is probably best summarised below:

1. To ensure that the financial targets of the business are met;

2. To enable the effective delegation of the management of the finances;

3. To control business finances;

4. To ensure management understands where value and profit is generated;

5. To ensure that investment or working capital can be appropriately directed.

To successfully provide this service the management accounts need to deliver the right information to the right people, quickly and accurately to enable them to make business decisions. This entails a compromise between accuracy and speed. The audit for annual accounts occurs some time after the year end and requires reviews of invoicing to determine materially correct accruals and prepayments (for example). Usable management accounts should be available within five working days of a month end. The time frame means that a detailed review of work in progress or debtors cannot be achieved. The important output from management accounts is an ability to identify when the business or a business unit is not achieving its financial objects and work out what needs doing to put the business back on track.

Getting the balance between speed and accuracy right is crucial to using the management accounts effectively. Getting the right information to the right person in a law firm is also crucial. While partners have a responsibility for the firm’s finances, they may not be able to effectively influence them. Management accounts need to give business-unit heads sufficient information to enable them to assess whether their part of the business is performing as expected and, if not, identify where the problems are so that they can be dealt with.

What gets measured gets managed
Given a set of targets, an intelligent person will quickly work out the most efficient way for them to deliver those targets. However, this may not be the most beneficial way for the firm. To manage this, targets need to be suitably specific to be objective and need to complement each other to enable them to provide an all-round image that fairly represents the performance of the person, team, division or organisation being measured. So, for example, giving a fee earner a target to charge a specific amount of time may encourage that fee earner to ‘dump’ time on client codes. At best this may be a tendency to round up units or at worst create fictitious client accounts on which time is lost. To counter this, the profitability on each matter needs to be measured and monitored, and adverse performance investigated. Dumping time on codes that then is not billed will result in poor profitability on that client code. One way around this would be to raise invoices for the time dumped but not send them out to clients, building up a large bad-debt balance. What was intended as a measure to improve profitability could result in wholesale profit fraud. Targeting debtors days and bad-debt write offs, as well as the chargeable hours and profit margins, would manage the problem.

This by no means implies that fraud is occurring in law firms, but highlights that what gets measured gets managed. If you target and measure the wrong thing, you will only achieve your goals by luck.

So what do we measure?
At a financial-reporting level we need to ensure that individuals, teams, divisions or branches get measured against things that they can control and influence. We also need to ensure that the targets once measured enable the management team to make predictions about the rest of the financial year.

To achieve this we need to be smart about what we measure and target. Andrew Otterburn in his book, Profitability and Law Firm Management1 discusses the pros and cons of financial reporting and even produces standard templates to use. The general thrust of the book is to focus on income and make department heads responsible for finances that they can manage, rather than financial transactions that they have no control over. This moves teams to focus not on profit but on contribution to overhead recovery and profit. Contribution is the income that the division is responsible for, less the direct costs associated with the division and includes partners’ notional salaries. Contribution equals fees and commission, less direct staff costs and other direct marketing and running costs. This generally results in any infrastructure costs (like rent) being excluded from the contribution statement. The aim is to make the contribution statement free from any cost (or income) allocations that are based on any sharing formulae. The costs in the contribution statement should be only those that the firm’s divisional head could have prevented by stopping someone ordering something.

All the overheads not accounted for in contribution statements must be accounted for in some overhead statement so that a responsible person can manage the cost while maintaining service delivery.

Because the contribution statement contains all the direct costs and a notional partner cost for partners in that department, it can be directly compared against any other department and conclusions drawn about relative benefits of the department. Working capital or investment capital can then be directed to departments based on their relative performance. It allows disparate business units to be compared. The inclusion of partners’ notional salaries also enables departments with heads who are salaried to be directly compared to those where partners run them. Every firm will have a different definition of a partner’s notional salary, but how it is worked out is fairly unimportant. What is crucial, is to think what the partner earns in solving client problems and managing teams, as opposed to what they earn by just being an owner of the business. Identify what this notional salary is for every partner and add it to the contribution statement.

Figure one shows an imaginary contribution statement for a law firm and clearly shows the comparative performance of the court, conveyancing and property-management teams against the rest. Seeing the lower-contribution margin enables the management to make a decision about the organisational structure of those teams and also allows the department head to identify the need for additional revenue sources if the business is to retain its structure. These three teams need to be targeted on increasing their contribution margin to the firm average of 43.4 per cent. In achieving this they will increase their contribution to £302,000, £410,000 and £95,000 respectively (on the same cost base) and the firm’s profit (after partners’ notional salaries) will increase by £230,000. The box below gives a more detailed example of how contribution analysis can be used to focus management effort.

The single largest problem with implementing this is the need to move away from full-cost accounting at a department level and also to deal with shared staff costs in small branch or general practitioner situations. There is a huge pent-up demand for teams to be given P&L accounts so that they can see what profit the team is making. This results in shared costs being allocated across teams. This results in P&Ls where the team leader can do nothing about most of the costs. Is it really reasonable for the head of agricultural law to be able to argue that the business moves to cheaper locations in order to reduce the shared property costs and thereby improve this department’s profitability? I would argue it isn’t even sensible to discuss such matters.

Contribution statements do not work the minute a cost is shared across two departments, but clearly sometimes economies of scale can be obtained if items that are directly used by multiple divisions are bought in bulk. Stationery costs are a good example. The cost of stationery is a direct team cost. However, unless the stock-control system can accurately identify the user of the stationery and the team they belong to so that the direct cost of stationery is charged to that team, then the stationery bill becomes a central cost that is managed by someone who has no control over the stationery wastage. If a team was bearing its own costs of stationery it could use text-message technology or e-mail to save paper. This is good for the bottom line, but when the stationery costs are being charged to a central pool no incentive exists and profitability suffers. Ultimately, there is no perfect solution and firms will need to decide whether being able to compare contribution margins from different divisions and focus management effort on the poorer performers is better than saving individual costs.

So what about branches where partners and lawyers take on much more generalist roles? Given the increasing specialism of law, this general-practice role carries increased risk. Many organisations have tried to shoehorn all partners and lawyers into specialist teams. The consequences of this could be increased costs and potentially reduced service levels as specialist lawyers need to travel to the branch offices to discuss client problems. This is a bizarre consequence of ensuring that clients get advice from experienced specialists. Often, however, clients see the delay and need to make additional appointments as a disadvantage2.

The alternative is to accept this limitation on client specialism and to set the branches up as a separate general-practice division expected to make a target contribution exactly like any other division but to have a diverse income stream from all disciplinary areas. The branch network can then be considered to be a business unit and compared to say agriculture but also individual branches can be compared against each other and those with higher contribution margins encouraged to help the other branches.

Implementing this at your firm
First, you need to identify whether there is sufficient financial information available in your current practice-management system to calculate contribution margins at a department level.

If not then you need to identify how to change the financial recording of transactions to enable this data to be recorded. This may include redesigning the matter-work types and allocating solicitors to practice areas or departments.

You also need to identify whether you have true departmental structures with department heads willing to take responsibility for the contribution of their department. They must be able to take responsibility and provide the necessary financial expertise necessary. This involves training your heads of department in financial management so that they understand how to read and understand a contribution statement.

You then need to transcribe current budgets into department budgets based on contribution of the department to overhead and profit.

Once you can produce the information from the system and know that the heads of department will understand and act on the numbers and variances, then you need to build resilient reports that can quickly generate the margin reports, detailed transaction reports and the reconciliations necessary.

Finally, begin measuring department heads on achieving target margins on target turnover, or better still, break the business down into measurable operational targets that if achieved will meet the target contribution margins.

All of this will take time, but the result is a system where teams are managed to achieve target revenue and costs. This in turn will enable your business to achieve its financial goals.

References:

1. Law Society Publications ISBN 1853288209

2. An alternative would be to deploy specialist advice to all lawyers via a desktop intranet, which could ensure that branch lawyers steer the client in the right direction prior to an appointment with a specialist lawyer

Shaun Gillanders is a freelance finance director and interim manager, and formerly finance director at a Scottish private-client practice. He can be contacted at shaun@overdalkeithfarm.fsnet.co.uk

Sidebar: Managing the growth of the property-management business
The property-management business is struggling to meet its contribution margin. It needs to increase its margin from 38 per cent to the business average of 44 per cent. Let’s assume that the average rental on a property is £400 a month and the management charge is 12.5 per cent. Assuming also that the cost base remains the same then we can calculate that to hit target contribution, revenue needs to be £222,000, an increase of £22,000 (revenue = cost/(1-target margin) = 124,000/(1-0.44) =£222,00).
To achieve this extra revenue we need to earn 22,000/12 each month or £1,833.33. At 12.5 per cent management charge, this equates to (1833.33/.125) £14,667 of rent collected from new properties, which at an average rental of £400 a month is 37 additional properties.
We therefore can give the head of property management an operational goal. We will assume that the contribution margin cannot be increased this year but can give the manager a year-long goal to increase the number of properties managed by 37 (or three a month for the next 12 months) without increasing the cost base, so that next year the business will be achieving target contribution margins.