How is Law Firm Profitability Measured?
PART III - Implementation
Once the cost allocation methodology is implemented (as described in Part II) profitability metrics can be calculated. In order for profitability information to be actionable and useful to partners and management, it needs to be implemented so profitability can be seen at any level in the law firm, including down to an individual matter level.
Why is Cost per Hour Needed?
The benefit of calculating cost on an hourly basis is that it enables profitability metrics to also be calculated on an hourly basis. Simply take the revenue generated for that hour and subtract the cost for the hour and the result is the profit (or loss) generated by that hour’s work. Since profitability is calculated at the lowest level, on an hourly basis, these individual hours can be aggregated into matters, clients, office, practice area etc. This enables profitability to be rolled up and seen at both a high-level (e.g. firm-wide) but also provides the ability to drill down to see problems at an individual matter or timekeeper level.
How is Cost per Hour (CPH) Calculated?
The simple answer of how to calculate cost per hour is to total up the allocated costs for any given timekeeper and divide by their billable hours.
Cost Per Hour = Allocated Costs / Billable Hours
However, a major decision in arriving at a cost per hour is what amount to use in the divisor.
- Billable Hours is the obvious answer, but it leaves the question of what happens with hours spent on firm requested, court appointed, or pro bono activities. A timekeeper with many hours in these categories will have a much higher cost per hour than a timekeeper that works the same number of hours but all on billable matters.
- Hours Worked is another option, but if you include all hours in the divisor, you then have costs allocated to nonbillable matters and you must include those in your reporting at the office, practice area, or firm levels in order for the profitability metrics to remain predictive of firm performance.
- Target Hours is a third choice. This assumes all timekeepers work their target billable hours. While this eliminates the variations that arise by using the first two (which may be accompanied by poor decision making), the results here will not be able to be rolled up to show actual firm profitability. This method is best used for pricing and alongside one of the other metrics for practice management.
Example: Assume the Jr. Partner we described in Part II has a 1,900 billable hour goal. She works 2,100 hours, with 1,700 of those being billable, and 400 as firm requested, court appointed, and pro bono. Her allocated costs are $500,000 and her rate is $275.
If we only look at billable hours, Jr. Partner would be unprofitable at a rate of $275 per hour because her $500,000 of allocated costs is spread only over her 1,700 billable hours. A partner with the same number of total hours (i.e. 2,100) but all of them being billable would be profitable at the same rate because their $500,000 in allocated costs would be spread over more hours. This method encourages partners to avoid firm requested, pro bono, and court appointed in order to keep their cost per hour low and their profit per hour higher.
However, if we include all hours worked as the divisor, we now have costs allocated to those non-billable hours and it encourages timekeepers to increase their hours in these no-billable categories. Billable matters will look more profitable overall but the costs associated with these other activities will need to be included to arrive at overall firm profitability. In other words, a profit margin of 0% on billable matters would not be sufficient to cover costs because there would be costs associated with pro bono, court appointed and firm requested activities that were not offset by any profit.
Finally, if we use target hours as the divisor, the variations between individual timekeepers based on actual hours worked is eliminated and so is the incentives to either work more or less on non-billable activities, but the results cannot be aggregated to arrive at actual firm profitability.
There is no single right answer to which method is best and each firm’s answer to it will depend on their culture and the degree to which their lawyers understand and are engaged in discussions of profitability. It is often easier to start with billable hours only and then progress to more sophisticated approaches as the firm’s lawyers buy into the methodology.
Productivity - Why Using Actual Hours is Challenging
As noted above, there are challenges in using billable hours as the divisor when constructing cost per hour. Target hours may be a good companion metric to show next to one of the other methods to provide a benchmark for what profitability “should” look like if target hours were met with the comparison of the two numbers providing additional insight.
As shown in the above example, when a lawyer’s billable hours are below average (or expectation), their cost per hour will increase. When a lawyer’s billable hours are above average (or expectation), their cost per hour will decrease. This can create a perverse incentive to send work to already busy lawyers and make the challenge of finding work more acute for those that need it most. This is known as the productivity problem in cost allocation. Basing cost per hour on actual billable hours bakes productivity issues into your profitability metrics.
One answer to this is to have two separate cost per hour numbers – actual hours and target hours. Creating a cost per expected hour and implementing it side-by-side with the cost per actual hour enables examining profitability and isolating the impact of productivity. The cost per expected hour is also useful in pricing, since it is unfair to expect clients to pay more if the team of lawyers has productivity challenges. It would also increase the risk of not winning the work if it priced higher than normal based upon productivity. Although slightly more complicated than having just one profitability metric, it will immediately defuse what will become a major point of contention with your partners – particularly those with lower billable hours.
Where to Surface Profitability Metrics?
A natural place to surface profitability metrics would be an interactive dashboard since it allows easy exploration of profitability at all levels. Underlying drivers of revenue and cost should be shown on the same page to facilitate easy understanding of cause and effect. These drivers would include realization, leverage, write-offs (WIP and A/R), and inventory levels. Raw cost dollars and raw margin numbers may be additional metrics that can be surfaced. Depending on firm culture, certain information may need to be restricted to select finance personnel that can use it to answer questions or “troubleshoot” profitability. If the dashboard is updated nightly, cost and profitability can be tracked as frequently as daily, depending on how often the lawyers enter and release their time.
In addition to a financial dashboard, all other client and practice reports are potential places to surface profitability metrics. Pricing models used in business development and alternative fee arrangements are also natural places to display for the profitability and cost information.
How to Rollout Profitability Metrics?
It may be best to first rollout profitability metrics in an isolated environment in order to introduce it to firm management. Buy-in and acceptance from management is crucial. Once management is on board, the next step should be to introduce it individually to your rainmaker partners. Their acceptance is also critical and may sometimes be overlooked. It is inevitable that some high revenue partners will not look good under the new metrics (i.e. their practice may have negative profits) and that will need to be explained. Partners will need to be coached on how they can be successful under the new methodology.
Once management and rainmakers are on board, it can be rolled out to the rest of the partnership. Be sure to explain it at partner meetings, practice area retreats, and individually in one-on-one meetings. Also, don’t forget to explain it to laterals and promoted partners. The need for training and reinforcement will continue for many years, but over time, the culture of the firm will change and partners will embrace it. One milestone in a successful rollout can be defined as when the compensation committee is comfortable enough with the new metrics to begin to use them in compensation decisions. However, it would be best to wait a few years before incorporating these metrics in the compensation decisions in order to allow time for partners to transition to the new methodology and to make any tweaks to the methodology. However, once the compensation committee adopts it, the cultural acceptance will accelerate.
What to Expect Post-rollout
The most immediate (and likely obvious) outcome of rolling out a cost allocation methodology and profitability metrics will be questions from lawyers. Some will have an accounting or finance background and will be passionate about incredibly specific aspects of the methodology. Others will not understand, but feel vaguely insecure or threatened by it and seek understanding. Far more will just turn a blind eye to it until firm management starts using the information. In each case, questions indicate interest and are a very positive outcome. It is worth taking the time to answer questions and document complaints, injustices, and other issues. This will serve as the initial framework for a change management methodology.
The other reality post-rollout is that updates will need to be made to improve the system and to address changes that happen over time within the firm. Be sure to be diligent in documenting each change made to the system – who made the request, when it was completed, what was changed, and why it was requested. Initially, changes may need to be made a few times a year, but it should stabilize out to just a handful of updates each year. As a general rule, it is best to make changes after year-end, but early in the year. Making changes late in the year changes your lawyers’ profitability at a point where it is unlikely that they can take corrective action to accommodate the new rules. It is also important to note that changes to the cost allocation system are mostly zero-sum games. There are winners and losers to each change. It is very important to test and understand the impact of each change so they can be explained to firm management. A change log will go a long way towards having a defendable cost allocation methodology and to avoid undoing and redoing the similar changes over and over as members of firm management change over time.
For Additional Information:
Cotterman, James D. "Calculating Profitability." 2014. Altman Weil. Document. 10 Feb 2017. <http://www.altmanweil.com/dir_docs/resource/62858eb1-14c1-4b32-b748-bbe9c4e70bd7_document.pdf>.