Managing law firm profitability: effective strategies for a competitive market

Managing profitability is a major strategic challenge facing law firms today with many recognising that they must improve profitability if they are to remain competitive. Identifying the areas in which profitability could be improved and what would need to change is one thing: executing it is quite another. David Temporal, a partner at Temporal Consulting, explores some perspectives on this issue and assesses what law firms need to consider if they are to be successful in the long term.

Most firms have seen both income and profits as well in the last couple of years. In many cases this has been as a consequence of good management, a focused strategy and a highly effective and efficient organisation. In a number of cases, however, the financial results have flattered to deceive – more a product of the ‘bull’ market than decisions taken by the partners. The market in 2001 has not been quite as ‘bullish’ and this year a very different picture is emerging.

The financial reporting season for law firms is now well under way and already we are seeing many firms reporting their ‘third best year ever’, with only a small number managing to achieve improvements both in gross revenue and profit per partner. Whatever the final count, it is clear that profits are now not so easily earned and, short of there being a dramatic upturn in corporate activity and resurgence of the telecommunications and technology sectors, this is likely to be the ‘new reality’ many firms will face in the foreseeable future.

Aligning the firm’s economics with its strategic aspirations and the new competitive requirements of the market will not be easy and for many it will raise significant organisational and cultural issues. Success will require strong leadership, strategic focus and a sustained effort and commitment to change.

The new profit motive

When I began to consult to law firms the issue of profitability tended to be discussed more in the context of “Am I earning enough for my needs”, and/or, “Am I earning more than I did last year”. For partners of most major law firms the answers to these two questions was likely to be “yes”. But absolute partner compensation is really not the end of the issue. Firms compete in an open market for people and as partners have become more mobile, the importance of the firm's economic performance relative to others has become a far more important issue.

This relative economic performance becomes essential, for example, in the recruitment and retention of staff. A successful firm is reliant on the quality of its employees, but one of the important factors in attracting and retaining high-quality people is the financial rewards offered before and throughout their employment. It is a factor that will also demonstrate to the outside world the competitiveness of your firm.

Inevitably, in this kind of scenario, the firms that can and do generate higher profits are at a distinct advantage. Furthermore, they have greater ability to fund investments to ensure that the firm continues to be competitive in the future. Hence a firm's relative,

not its absolute level of profit is what really matters in a competitive market.

Understanding the profit levers

An important prerequisite to managing profitability is to understand how profit is generated in the business. In any business, there is always a limited number of key ratios that help one understand how profit is being made (or lost) in that business. In the retail industry, sales per square foot and the gross margin are two key indicators of business health; and in the hotel sector, it is occupancy and average room rate. Similarly, in law firms there are a number of key ratios that help one to understand the basis of profitability and how it might be improved. We will call these ‘profit levers’ as they are what can be ‘pulled’ in an effort to achieve an improvement in profit.

Law firm profit levers:

Utilisation – the percentage of the total available capacity, say 2,000 hours per fee-earner, that is utilised as chargeable;
Leverage – the number of fee earners to equity partners;
Average Hourly Rate – fees earned divided by number of hours charged (the real ‘blended’ rate for the practice);
Realisation – the percentage of chargeable time value that is billed (i.e., not written-off);
Cost Multiple – the multiple of fees earned over the fee-earner salary costs (including a notional salary for the equity partner). The gross margin is another way of defining this;
Overhead (all other non-fee-earner costs) as a percentage of fees.

Different strokes for different folks

These terms are fairly commonplace and well understood by many of those who are involved in law firm management. This notwithstanding, however, there is still a tendency among firms to focus on one of the profit ‘levers’ to the exclusion of others, e.g., utilisation (activity levels) when perhaps the issue on which to focus is the structure of the group. The trick is to understand how the various levers interact to generate profit – and this will inevitably differ from group to group.

For example, in many litigation practices there is often sensitivity to rates, but despite this it can be a fabulously lucrative business if the leverage and utilisation are significantly higher than the average; a similar case for real estate practices whose focus is on more ‘routine’ work of a lower perceived value to the client.

However, other areas tend to require a higher level of knowledge and expertise brought to bear to the specific problem at hand (tax is one such area, structured finance and complex commercial agreements are others) and these types of practices tend to be more concerned with achieving a rate that reflects the level of expertise and seniority. Understandably, they would be less concerned about leverage as the work is unlikely to lend itself to being undertaken by junior people, and we may find that due to the higher personal investment in time required to build and maintain a high personal reputation and expertise, they often operate on a lower utilisation.

The important issue to be recognised in managing profitability is that it is very difficult to prescribe centrally what should be the single and universally applied economic model, as the needs of each business will differ. The route for some businesses will be rate and utilisation, for others it may be an issue of premium pricing. Either would be capable of delivering the expected level of results to the firm.

The profit driver

The major ‘driver’ of profits in a law firm are its clients, the type of work undertaken for those clients, the relative value and worth clients place on the work, the price charged and finally, the costs to the firm of generating the work. If one examines this, we see that much of what really drives profit is directly within the partner's ability to manage and control, and hence any firm with a profit problem would need to focus on the client and work mix of each of its practice groups and examine critically how the work is undertaken and the level at which it is done.

As the most significant impact on profitability will flow from the work done (and who it is done for), it is essential that firms focus on and monitor profit at this level. Hence, to be managing profitability effectively at the point at which it is made or lost it is necessary to monitor the gross margin (or cost multiple) on the work at a matter or transactional level. Ensuring that partners understand that they are accountable for the gross margin generated, as distinct from simply meeting billing or hours targets is a key part of achieving this. To do so, many firms would need to adapt information reports to emphasis the impact of partner decisions on the margin, rather than simply be overly preoccupied with activity levels.

It is not unusual, however, when faced with a concern about profitability, partners point to what they consider to be profligacy in the firm’s general expenditure or

overheads. This can and often becomes a ‘ground swell’ of opinion only satisfied by prompting management to cut into overheads and hold back on key investments. In our view, seeking to sure up profitability through focusing on the overheads alone is short-sighted and rarely, if ever, boosts the firm’s profits significantly; it is an exercise that offers a ‘one-off’ windfall and often fails to address the real issues contributing to lower profits; and it can also cut away what is required to ensure that the firm can be competitive for the kind of clients and work that would contribute to improved profits.

Changing habits: learning new skills

The people who ultimately influence how much profit is made (or not) by the firm are the partners, and in most cases to achieve a positive move in the firm's profitability will require a change in partner attitudes and behaviour.

The most obvious example relates to building the firm's knowledge and intellectual capital on which others might leverage, enabling work to be done more efficiently and/or by less skilled people. In many firms the major part of lost potential profit lies in the high level of reinvention among professionals. To develop and manage the firm's knowledge base will require leadership from the partners and a willingness to be more open and to share their knowledge and intellectual product. It is important that the firm supports the necessary investment in time and resource to build

and maintain the knowledge base and to train people in its use.

Pulling the various ‘profit levers’ will have significant management implications, in particular on the partner. If the route to improved profits is to increase leverage then partners have to become better at managing a larger team, de-emphasise their fee-earning role and enhance their role as team leader and coach. The ability to delegate effectively becomes a critical skill if this is to work.

Similarly, if the route to improving profit is to generate a higher average rate it is the partners who would need to target work of a higher perceived value to the client (or a client base that will accommodate higher pricing) and have the confidence to price services appropriately, rather than discount too readily. Whatever route to improved profit is the right one for your particular practice area, a shift in the way partners operate is inevitably required.

Overall, if the firm is to grow its profits it is critical that partners both understand and can interpret the economics of their own businesses and are developed in the leadership and management skills necessary to support a shift in the economic model.

Conclusion

We are in a period in which firms must develop the capability to manage profitability more actively. Profits can no longer simply be left as a function of the dramatic growth and high levels of activity across the market.

To achieve this will require a shift in emphasis in many firms away from the traditional focus on target hours or bills towards monitoring the gross profit generated in practice groups, on specific matters or transactions and on clients. If this is being managed effectively, then assuming the overheads are in control, firms will be profitable.

Firms will need to address the issue of the strategic focus and understand the implications of this in terms of economic model and manage towards this. This will require questioning whether the scope of services provided, the clients served and the geographic spread of the firm is appropriate. Hence, to be more profitable, some firms may need to be smaller and more focused or indeed alter the focus.

Perhaps the most difficult implication of managing profitability more actively will be on the role, behaviour and attitudes of the partner. Partners will no longer be able to simply see themselves as economic units of production focused on billing and chargeable hour targets. The partner’s role will inevitably need to broaden to embrace understanding the client's expectations about value, at times working to change this and ensuring that the services delivered meet or exceed this; the partner will need to ensure that the pricing of the services is appropriate; the partner will need to consider the staffing on the job so as to ensure the cost of production allows an appropriate margin to be made; and the partner will need to ensure that the skills required to provide the services are in place. This raises the issues about the partner as a team leader and coach, as well as their willingness and ability to delegate appropriately.

Ensuring a firm continues to be considered as one of the most profitable among its peer group is critical – and this will present a major leadership and management challenge for those firms that have for many years seen only rising profits without having to do too much to achieve them.

David Temporal is a partner at Temporal Consulting. He can be contacted at: dstemporal@temporalconsulting.com.