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4 posts from November 2014

November 26, 2014

Book excerpt: The challenge of measuring law firm profitability (Part 2 of 3)

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.

For starters, you would think it would be easy to measure the revenue associated with a matter, but it’s not. Iezzi’s text notes that:

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. 


November 19, 2014

Book excerpt: The challenge of measuring law firm profitability (Part 1 of 3)

This series was adapted from my new book Client Value and Law Firm Profitability.

Based on our confidential interviews with managing partners and other leaders from 50 AmLaw 200 firms, there can be no question thatclients are demanding more value than ever before, and it is putting pressure on the bottom line.  There is, however, much less agreement about the best way to measure the bottom line.  Earlier in this chapter, we discussed the many problems of relying on profits per equity partner, realization, leverage and other traditional measures.  So it may seem obvious that the way out of all this confusion is to move toward the approach used in almost every other business: applying cost accounting to measure profit. The basic formula looks deceptively simple:

Profit = Revenue – Cost

Cost accounting establishes rules for defining both revenue and costs, but it’s not as simple as non-CPAs might think.

Before we started working with law firms, my company spent almost 20 years developing training programs for financial services clients and for government agencies. Many of the government contracts we worked under were “cost plus,” in which an hour of a person’s time must be billed at its “true cost,”—as defined by many pages of government accounting rules—plus a negotiated fixed fee.  (In our experience, the negotiated fixed fee on government contracts was typically between three and five percent of cost, which seems laughable by the standards of many law firms.)  So you’d think that if anyone could identify the true cost of labor, it would be a government contractor.

But we gradually learned that government contractors have a number of options for calculating both the direct cost of what a person is paid per hour and allocating the indirect costs of benefits, rent, general and administrative overhead, and so on, to different groups within the company. So there was no single number for the “true cost” of a particular hour of labor, despite all the rules and regulations. The answer depended on a number of assumptions and interpretations.

Still, many law firms see cost accounting measurement of profit as the Holy Grail, with potential benefits to both themselves and their clients. As ACC Value Co-Chair Michael Roster has summed it up:

Once a firm or practice group shifts to a true profitability set of measurements, the firm finally has incentives to:

  • Keep reducing its cost of production—meaning moving matters to those with appropriate expertise while lowering leverage and hourly rates, where hourly rates are now used to monitor the cost of production, not how to maximize what can be billed
  • Measure and deliver better outcomes and be rewarded for that
  • Learn how to fix the cost of any given type of work
  • Along the way, improve profitability

However, in one leading text on law firm accounting, CPA John Iezzi explained that in working with law firms, he learned that this is much, much harder than it sounds:

My first article [on law firm profitability was]… written in 1975… after I had recently left public accounting, convinced that one could apply the same cost-accounting techniques to the service profession as one did to any other industry. [However], this was not the case, as I later determined once I began attempting to apply various cost-accounting practices to the legal profession.

The result for many firms is that, as one managing partner admitted:

We struggle with a standard profitability model, and we don’t really have one right now.

Another managing partner pointed out the underlying problem:

There’s really more art than science as to what you count as revenue, and similarly what the cost allocations are going to be. Lawyers will debate all day long about those things. So it’s important to have uniform or reasonably well-accepted best practices for profitability analysis. I don’t think our practice is there yet.

As far as we can tell, neither is anyone else. When I talked to several members of our Research Advisory Board about this, Don Ware, chair of Foley Hoag’s Intellectual Property Department, said:

I’ve never heard of a law firm that has a good way to measure matter profitability. Many say they do, but when you push on the details it becomes clear that they really don’t.

This is not for lack of trying. A growing number of software programs are available to handle the calculations. The two long-time leaders in the field—Intellistat Analytics from Data Fusion and Redwood Analytics from Aderant—have been providing sophisticated tools to quantify law firm profitability for several decades. But to use these tools, one must make a series of assumptions, and that’s where the trouble starts.

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

November 12, 2014

What clients want: New results from Altman Weil’s 2014 CLO survey

Question:  What is the single most important topic for law firms to focus on in today’s increasingly challenging environment?

Answer:  Whatever clients want.

Of course, different clients want different things, so lawyers should start by improving the dialog with their own clients.  There are a variety of free resources on the web to help structure these conversations, including a list of questions from the Association of Corporate Counsel and my posts several years ago in this blog entitled Value questions to ask your top clients

For those who want the big picture on client trends, there is no better source than the Chief Legal Officer Survey which Altman Weil has been publishing for the last 15 years.  (Full disclosure: LegalBizDev is a strategic alliance partner of Altman Weil, but I would have written exactly this same post even if we had no relationship with them.) 

When the 2014 survey was released yesterday by author Daniel J. DiLucchio, the first question I turned to was on page 27: “Of the following service improvements and innovations, please select the three that you would most like to see from your outside counsel.”  The answers from 186 CLOs were greater cost reduction (58%), more efficient project management (57%) and improved budget forecasting (57%). 

Since better legal project management (LPM) leads to cost reductions and to improved budget forecasting, you could say that the top three client requests were LPM, LPM, and more LPM.  Interestingly, these same three issues were at the top of the list in Altman Weil’s CLO survey last year although this year the percentages were a few points higher.

The main conclusion of this year’s report was that “corporate law departments are wielding their buying power to drive down expenditures on outside counsel” (page i.)

The survey included a number of questions related to cost reduction, starting with the fact that 91% of the law departments in this survey received price reductions from outside counsel in the last12 months.  The median discount – or halfway point -- remained in the 6% to 10% range, just where it was in the 2013 survey.  But for those above the median, the percent of law departments that got discounts over 10% increased substantially in the last year (from 28% to 36%).

The summary also noted that “The survey asked about preferences for outside counsel pricing on work other than ‘bet the company’ matters. Thirty-seven percent of CLOs said they prefer transparent pricing in which they understand how and why the price is set and have the opportunity to discuss changes. Twenty-seven percent chose guaranteed pricing, and 26% opted for value-based pricing, defined as a variable price based on the CLO’s assessment of value received. Only 10% of respondents said they wanted the lowest price available.  Initially it may seem that law departments just want to pay less for outside counsel. But these results show it’s more complicated.” (page ii)

I respectfully disagree with this interpretation.  I don’t think it’s that complicated at all.

Cost is certainly not the only element in value, but it is by far the biggest one.  In our recent research on Client Value and Law Firm Profitability, when we asked, “When your clients ask for more value, roughly what percent of the time are they simply asking for a lower price,” the average response was 63%. In other words, nearly two-thirds of the time, “value” is nothing more than a request to pay less and all other interpretations pale by comparison. 

In our experience, all of the pricing approaches mentioned in the Altman Weil survey – transparent, guaranteed, and value-based – are not alternatives to lower prices, they are usually part of a larger negotiation to reduce price.  Soon after clients ask for transparent pricing, the next thing that happens is that they point to line by line examples of ways to cut the price.  When they want a guaranteed price, it may come as a result of a reverse auction in which all bidders are required to guarantee a price, and the lowest price wins.  And when clients look for “value pricing,” somehow that almost always seems to mean “give us more for less.” 

Meanwhile, the demand for outside counsel is going down (26% plan to decrease the use of outside counsel while only 14% plan to increase it), placing still more downward pressure on prices.

What are firms doing in this increasingly cutthroat environment?  Some are burying their heads in the sand in the hope that the good old days will return.  Some are giving bigger and bigger hourly discounts in the kind of “suicide pricing” that Bruce MacEwen has described as unsustainable in his book Growth is Dead. And some are getting serious about increasing efficiency and cost-effectiveness through LPM, so they can deliver the same quality at a lower cost in hours and dollars.

Which approach makes sense to you?

November 05, 2014

Tip of the month: Embrace experimentation aimed at quick wins and developing champions, one practice group or one lawyer at a time

Lawyers love precedent, and many law firm committees are postponing action until they see evidence proving the value of a “one size fits all” perfect solution that will fit their entire firm.  But there is no silver bullet, and firms that continue to look for it could go out of business while they wait. The key to success is, as Stuart J.T. Dodds put it in his book Smarter Pricing, Smarter Profit, to “think big and start small.” 

The first Wednesday of every month is devoted to a short and simple tip to help lawyers increase efficiency, provide greater value to their clients and/or develop new business. This month’s tip is explained in detail in Chapter 7 of my new book Client Value and Law Firm Profitability.