This series was adapted from my new book Client Value and Law Firm Profitability.
The questions about assumptions raised in Part 2 of this series go on and on, and they raise the kind of awkward issues that sow resentments and dissension. As one partner interviewed for and article by Michael Roster noted:
Many of us have long believed that the non-attorney costs of the various practice groups are wildly different. At most firms, no one wants to hear that, probably because it might open Pandora’s Box.
Some experts believe that this box should be opened, and when it is it will reveal that different practice groups can afford to charge different rates. One expert we consulted, who preferred to remain anonymous, put it this way:
Cost accounting should be kept very simple lest the lawyers argue about it forever more. That said, it should not be the same for the higher cost of production groups that need a lot of work rooms, support services, etc. (such as litigation) versus the very low cost of production groups that can work in a cubicle and only occasionally might need a conference room (such as trusts and estates). GM charges a lot less for a Chevrolet than for a Cadillac, and yet the overall Chevrolet division may be far more profitable that the overall Cadillac division.
Others disagree and feel that analyses that compare relative costs will become divisive by focusing lawyers on their short-term individual interests rather than the long-term benefits of working together. The labor and employment group may come to question the wisdom of belonging to the same firm as the M&A group that needs more expensive space. Lawyers from the Cincinnati office may begin to ask whether it is really worth having a New York office with much higher overhead.
To explore the real-world solutions that law firms are using most often, we interviewed two of the leading consultants in the field: Russ Haskin, director of consulting services at Aderant Redwood Analytics and Jeff Suhr, vice president of products at Data Fusion Technologies/Intellistat.
According to Haskin:
If a firm has hired a pricing director but does not look carefully at profitability in a sophisticated way, it is doomed to fail.
Haskin said that very few large firms do more than pay lip service to the concept of profit margin—and those that do are far ahead of the game. Among other things, they are ready to respond to AFA proposals in a way that will be profitable for them. A firm that looks at profitability in the “old” way by examining gross revenue rather than profit margin as seen at the client or engagement level is simply not equipped to respond intelligently to an AFA request.
Both consultants agreed that the key to success is to simplify assumptions, and one way to do that is to look at gross margin (revenue minus direct costs). Suhr argued that at the matter level, gross margin is a better measure than any that includes overhead because issues like office space can’t be controlled at the matter level.
Haskin suggested that to simplify the cost analysis, the firm should allocate a standard cost rate to each lawyer or group of lawyers, for all clients, like the senior partner we interviewed who said:
We have a model that takes into account cost not based upon actual draws or salary, but it takes into account junior associate, mid-level associate, senior associate, junior partner, partner, and senior partner typical costs.
At the end of the day, there is a reason why Data Fusion’s 91 clients use 91 somewhat different methods to measure profitability. Companies like Data Fusion and Aderant Redwood work with each client to come up with a consistent approach that has grass-roots support within each firm.
As John Iezzi summed it up at the end of a chapter on cost accounting:
The subject of profitability at [the matter] level is one that is very difficult to grasp for those not fully versed in cost-accounting concepts. Whatever methodology is used, it should be agreed to by a consensus of the partners so that the results are accepted once the methodology is applied.… Make certain that everyone buys into how the process is going to be done, and more importantly, why it is being done and what decisions will be made from the information once the analysis is completed.
Jeff Suhr made a similar point more succinctly:
The right way to measure profitability is one that is accepted in your firm. The art is to measure it in a way that keeps everybody happy.
And as one managing partner in this study summed it up:
You can argue all day about what the right profitability metrics are or what you’d include. We argue about it a lot.
Many participants, like this senior executive, think that the cure is worse than the disease and that firms should stick to more traditional measures:
We’ve used realization as a surrogate for profitability to this point. True profitability has been reserved for senior management analysis. We haven’t wanted lawyers arguing about indirect allocations and whether they only use 10% of a legal administrative assistant’s time versus 33%.
The profession may never find the perfect solution that some lawyers seem to want, but less than perfect estimates are absolutely essential in helping firms adapt to a rapidly changing world.
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.