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.