This series was adapted from my new book Client Value and Law Firm Profitability.
At the 2014 LMA P3 conference in Chicago, Jeff Suhr, vice president of products at Data Fusion, noted that his company currently has 91 clients actively using their tools, including 10 of the top 35 AmLaw firms. Exactly how do these 91 clients calculate profitability? Ninety-one different ways. The fundamentals are the same, but there are important differences in the details, which can have significant implications for the way profitability is interpreted and used to motivate changes in behavior.
Suhr distinguished between the relatively straightforward science of calculating profitability and the art of determining the exact methods that best fit the needs of each firm. He also discussed the different challenges of “macro strategies” for analyzing profits for a firm, an office, or a practice group, vs. “micro strategies” for analyzing a book of business or a particular matter. These sometimes require different assumptions and different approaches.
There are three different revenue numbers you can use. One is the accrual basis revenue number, which is hours worked multiplied by hourly rate. The second is the bills rendered number. And third is the cash receipts number.
The first two numbers reflect theoretical revenue. After client write-offs and write-downs, a significant amount of this may never be received. So a profitability system based on either accrual or bills rendered rewards lawyers for putting in more hours even if they produce no revenue. This is particularly troublesome with fixed fees and other AFAs, where lawyers with too little to do may pile on the hours “since it costs nothing and could help the client relationship.” Not to mention that in many firms attorneys get paid more if they bill more hours, whether the client ever writes a check for the hours or not.
In the LegalBizDev Survey of Alternative Fees, one AmLaw 100 decision maker told us that:
It often happens that alternative fee matters, particularly large ones, end up being adumping ground for individuals who may not be fully employed because you are reportable to the client for the result, not the cost. When lawyers work unnecessarily on a project your profitability looks bad, so in order to really determine the profitability, we need to deal with that issue.
As one chair in this research put it:
What you’re trying to do internally is change the mindset of the attorney who is used to billing hours. In the past, if you billed 2,000 hours, you were better than somebody who billed 1,200 hours. But with an AFA, you have to be more efficient and more concerned with delivering the value to the client in a way that makes this a productive relationship.
That’s why the best measures of profitability must ultimately be tied to cash received. But there’s no way of knowing that figure until a matter is completed and the bills are paid. In a large firm with tens of thousands of simultaneous matters, each on their own schedule, comparisons between matters must be based on a long list of assumptions about what will happen in the future, or postponed until the end of a case, which could take years to resolve. And this can lead to arguments and gamesmanship.
One senior executive at a firm that bases compensation partly on accrual-based profitability highlighted one such problem:
We use dashboard tools including Redwood Analytics and Intellistat to track key metrics and responsibilities for each attorney as a working, billing, and originating attorney. This information is directly used in each person’s annual review and compensation setting, along with qualitative and subjective elements. They have visibility to this key information every day, and it begets a whole different sense of responsibility and accountability.
Determining cost is even harder. In order to truly determine the cost of delivering services for a particular matter, one must answer two basic questions: what was the cost of the direct labor of performing the work, and what overhead indirect costs (such as rent, clerical staff, etc.) should be allocated to that particular matter?
The problems start with how to estimate the cost of each hour of a partner’s time. If a rainmaker partner was paid $1 million last year, how much of that was her direct cost for working on legal matters vs. origination fees, payment for time spent on management, profit distribution, and other factors? A number of different systems of “notional compensation” are used to split compensation between the amount allocated to billable activity and the amount allocated to everything else. The details of how to do this could easily go on for many pages, but in this context the most important fact is that every single system includes arguable assumptions. And if there is one thing that lawyers do well, it is argue, especially if a calculation affects the way their financial results are perceived. And if matter profitability is tied to compensation and perhaps even to job stability, the debates on how to calculate these figures will rapidly get louder and more passionate.
If you think that since associates are on salary, it would be easier to calculate their direct costs, you’d be right. But even there, important decisions must be made. For example, suppose two mid-level associates earn the same $300,000 salary, but Associate A billed 2,000 hours last year and Associate B billed 1,500 hours. To keep this example relatively simple, we will ignore the cost of their health insurance and other benefits and focus strictly on salary. Some firms say that the direct cost of Associate A is $150 per hour ($300,000 divided by the 2,000 hours she billed) while Associate B is more expensive at $200 per hour ($300,000 divided by her 1,500 billable hours).
Now suppose that relationship partners are rewarded for managing matters more profitably. Of course they will try to assign more work to the busy $150 per hour associate than to the $200 per hour associate who has more time available. In this case, the attempt to measure profitability to develop a more efficient system rewards behavior that is actually likely to reduce efficiency by overworking the busiest associates.
Discussions of other aspects of overhead can also get into heated debates about such details as:
- If one practice group heavily uses the services of the marketing department and another doesn’t, should the first group pay more marketing expenses through higher overhead?
- If one lawyer has office space in a high-cost city like New York, and another has an office in a lower-cost city like Cincinnati, do they have different overhead rates?
- If one lawyer in New York has a 600-square-foot office and another has a 300-square-foot office, should that be reflected in different overhead rates?
- If one lawyer’s assistant makes more than another’s, should that be reflected in their personal overhead?
A slightly edited version of this series was published in the October 2014 issue of Of Counsel: The Legal and Management Report by Aspen publishers. The complete article can be downloaded from our web page.