This is the third post in an emerging series on law firm profitability. The first was on AFAs and LPM, and the second was on realization’s role. This one explores the role of leverage in profitability.
Traditionally when lawyers spoke of leverage, they were referring to the good ole pyramid. When I talk about leverage, I am focused on two very different things:
- Pushing tasks to their lowest cost labor source, and
- Improving the profitability of work
Recently I saw a presentation from David Wilkins, a Harvard law professor specializing in law firms. He drew a simple, yet elegant graph that helps illustrate my point:
[Graphing technique borrowed from ThisIsIndexed]
The previous post on realization mentions the "rule of three." When firms measure profitability, they apply a cost rate for each timekeeper. In our rule of three, this cost rate covers the two components of comp and overhead. The graph visually displays this rule – at least for non-partners. And it shows that very ‘young’ associates generally don’t generate enough revenue to create profits. The sweet spot for profit comes from experienced associates or other non-partners, whose revenue to cost ratio is high. Looking closer at this rule shown by the graph, what emerges is the understanding that the rule of 3 only applies to non-partners. This is reasonable, since a portion of partners’ incomes come from that profit. In other words, their revenue to cost ratio is negative especially when you account for their own, base comp. In turn this means firms generally don’t make profits on partner hours billed. As with all rules there are exceptions to this one. Very young partners with relatively low comp and high rates can have profitable hours. Or partners who bill (and collect) extremely high numbers of hours can be exceptions. This happens since cost rates are calculated on a per hour basis, and super high numbers of billable hours drop the cost per hour. A benchmark of billable hours per year for this ‘rule’ might be 2600 per partner. As you might guess, this happens infrequently, so the general rule above on the profitability of partner hours holds pretty well.
The graph makes it abundantly clear that law firms profit from associate hours. And the path to profitability becomes clear: leverage your work. Send as much work as possible to higher margin associates.
Seems simple, doesn’t it?
Yet most firms don’t get this. Primarily because comp systems reward a different behavior. They’re not designed to reward profits - they reward hours and revenue. This is the case since these compensation systems were designed under a different model. This was a cost-plus business model, where profit was built into prices (a.k.a. rates). So partners have not focused on the metric of profitability in this fashion.
Once partners understand this, then it becomes quite natural to shift work to its lowest cost, effective labor source. Ron Baker will likely appreciate this statement: Tasks should be performed at their cheapest, most effective, level of timekeeper. This behavior will lead to improved profitability for law firms. But more importantly, this same behavior will lead to lower costs of service for clients. On a simple, illustrative level this means partners should not be performing tasks associates or paralegals can perform sufficiently well. Doing so undermines profits and raises costs for clients.
So why is this not already happening? Why are firms and clients not behaving like economists would expect? IMHO – because they don’t get it. They don’t yet understand how things have shifted at this basic economic level. This underscores the real transition facing law firms right now. They have lived in the cost-plus world for 50 years and now have to figure out the profit margin model.
Oddly, many clients are actually demanding partners perform most of their tasks. They see this as a “hire the lawyer, not the firm” decision. They want the high expertise of the partner and think an associate is less efficient. This approach assumes all or a majority of tasks are best performed by partners, which is not accurate.
When clients figure this out, and they will, law firms have the much bigger task of living in a profit margin world. This will be the subject of the next post in this series.
Conclusions: Leverage is the key factor in law firm profitability. Although realization has an influence, leverage has a much greater impact. In modeling various fee deals, small changes in leverage have measurable impacts on profitability. I always enjoy quoting Karl Marx when lawyers push me on this issue, “You get rich off of the sweat of another’s brow and not your own.” Which is to say, you make money leveraging the work of others. Both law firms and clients alike will do well to understand this. As they come to an awareness of these dynamics, I predict significant shifts in market behavior.