Challenge #5 The problem with leverage
As Toby Brown and Vincent Cordo explain in the book Law Firm Pricing: Strategies, Roles, and Responsibilities (p. 18):
[Leverage can be defined] as the percentage of partner time worked per matter or per client.… The basic economic concept of leverage is that the more [non-equity] workers work, the more owners (partners) benefit. Workers generate the profits that pay partners. Therefore, the more work is pushed down to them, the better leverage you have and the more profit is generated.
Software programs that are designed to help lawyers bid in a way that maximizes profitability often do so by encouraging partners to push more work down to associates.
This concept is tied to the “old normal” pyramid model of profit, in which it was assumed that clients would have all their work performed on an hourly basis and would generally pay all their bills. But the legal world has changed to a “new normal” in which these assumptions are often incorrect.
For example, in a fixed price environment, efficiency is king and leverage can lead to higher costs and more unbilled time. Suppose a $1,000-per-hour senior partner can solve a problem in one hour, but a $300-per-hour associate will require 10 hours to come to the same solution. If the firm is paid the same fixed fee regardless of who does the work, it is obvious that solving the problem at the unleveraged partner “cost” of $1,000 is more profitable than at the leveraged associate cost of $3,000. (Of course, billable rates are a very approximate indicator of cost, but they are used here to keep this example simple.)
Experienced lawyers can clearly do a task more efficiently than untrained rookies. So, why not choose a model based on low turnover, where only a very few high potential lawyers were well trained and mentored in order to dramatically increase experience levels? Our philosophy has turned the typical law firm structure upside down. Most large firms have few true partners and a large number of inexperienced associates. A typical ratio is 3.5 associates to each partner. Our experience metric is dramatically different: instead of the usual 3.5 associates/partner, we have 3.5 partners for each associate. This reversal of the typical large firm partner/associate ratio gives us a major competitive advantage in experience.
The result has been an award winning and highly profitable organization that Bartlit describes in the same article as:
The only firm in the world that does billion dollar litigation for Fortune 100 firms and is never compensated based on the hours expended.
One member of our Research Advisory Board summed up this view:
Leverage is a goofy concept sold by management and consultants. Ultimately, except maybe for some of the elite New York firms, high leverage will fail. There’s a reason Bartlit Beck operates with 3.5 partners per associate and Munger Tolles operates with slightly more partners than associates. Leverage and turnover have always been a disaster, except for the “golden era” (1980 to 2005) when clients weren’t paying attention, and thus it looked like a great business model for law firms to be inefficient, with high leverage and high turnover.
At this moment in time, the role of leverage in profitability depends on the client and the fee arrangement. For clients on a fixed fee basis or for hourly clients who refuse to pay portions of their bills due to inefficiency, greater leverage may decrease profit. If you have hourly clients who don’t question their bills and pay in full, greater leverage will still produce more profit. But it seems reasonable to ask how long this will continue.
Challenge #6 Problems applying cost accounting
The obvious 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. (Note: 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.
Many law firms see cost accounting as the Holy Grail, with potential benefits to both themselves and their clients. As ACC Value Co-Chair Michael Roster summed it up in an article entitled “Facing Up to the Challenge: Law Firm Metrics”:
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 the widely quoted text Results-Oriented Financial Management: A Step-by-Step Guide to Law Firm Profitability, 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 in my research 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.
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.
In the final part of this series, we will describe what firms doing to get closer to this goal.
This series is an excerpt from my book Client Value and Law Firm Profitability . An edited and abridged version of this series appeared in the March 2015 issue of MP magazine. The MP article can be downloaded from our web page.