10/23/12

The Economics of Law and the Future of Legal KM - Part 1

For my role in the 2012 Ark-group KM Conference, I am talking about the economics of the practice of law to set the stage for how KM can better align itself with the bottom line. This series is from my materials for that conference. The first part describes the challenge for Legal KM and then moves to the economics - specifically talking about the meaning of profitability for law firms.


The days of just pursuing traditional Legal Knowledge Management (LKM) projects like enterprise search and CRM are numbered. Although these systems have value to a firm, they are not addressing the intense pain points law firms currently feel. Law firm leadership does not spend time debating the merits of these types of systems and rarely even gives them a thought. This is a strong message for LKM leaders. What exactly is your firm leadership focused on? Find out and shift your LKM strategy to answer those needs.

The issues keeping most law firm leaders up at night are centered on economics. It is well known that law firms are now in a highly competitive market. And this competition is driving a keen focus on profitability and a better understanding of the core economic forces in both the market and within each firm. LKM needs to establish a firm connection to this type of economics.

To better connect LKM and law firm economics we need to first have a better understanding of what makes law firms profitable. Such an understanding should light the way to helping LKM stay relevant to law firm leadership.

Beyond the immediate concerns for LKM, law firms will benefit from shifting their conversations from hours and revenue to revenue and profit. Until recently, law firm profits were built in to their pricing model. The billable hour was enough to cover cost and a rising profit margin. No longer. A new model is emerging wherein profits are derived from the margin between revenue and cost. Therefore the factors that drive that difference are now moving front-and-center on the stage of law firm leadership.

Law Firm Profitability

What makes law firms profitable? There are four primary profit drivers for law firms. These drivers apply whether a firm uses billable hours or any other type of fee arrangements. Each driver has a different level of impact on profits and some drivers are losing their influence.

Profitability?

Before we dive in to drivers, we should briefly tackle the term: Profitability. What appears to be a simple concept becomes complex. For law firms the challenge arises since partners serve as both owners and workers. Traditionally their incomes have been treated as purely profits, which tends to skew “true” profit based on the level of compensation of a partner or group of partners performing a given piece of work. Firms are now beginning to embrace new definitions of profit that enable the creation of a more classic profit margin. The basic idea is treating a portion of partner income as ‘wage’ leaving the rest as profit. Firms determine a method for separating those two segments either by setting some common standard or by establishing levels of “wage” for various levels of partners. The resulting profit margin then becomes a means of bench-marking performance over time.

Another profitability method used isolates partner compensation on work to calculate a “Profit Per Partner (PPP) number. In this model a PPP calculation for a given piece of work shows whether the matter is driving PPP up or down. The model assumes a standard level of productivity within a firm. More simply, this model states that if all work at a firm looked like a given example, then the firm’s average PPP would be that number.

As we move through the drivers of profit, we may reference one or the other methods. The two do not move in lock-step fashion since they are different mathematical approaches. However, they generally trend in the same direction when any of the drivers change.


In Part 2 of this series, we will explore the first to profit drivers: Rates and Realization. These two drivers were major forces in the past, but are losing influence in the new normal.

Links to:
Part 1 – the challenge for Legal KM 
Part 2 – profit drivers for firms: Rates and Realization
Part 3 – profit drivers for firms: Productivity and Leverage
Part 4 – the market's impact
Part 5 – how Legal KM can re-focus its efforts


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1 comments:

Tony Chan said...

To derive a close approximation on profit based on the margin between revenue and cost, we need to slice and dice billing realization in the context of law firm economics. This is not the same as collection realization as profit is directly impacted by the actual amount collected.

From the KM perspective, the heart of realization is understanding how work products are generated (as managed projects) in terms of cost and expense ratios.

For instance, a litigation partner might decide to delegate legal research to an associate who might be more apt in this type of tasks. In similar fashion, the associate might ask the paralegal and / or the KM staff (library, marketing) to perform business intelligence research to round out the project. In this scenario, realization would be the actual amount billed to the client minus the sum total of the costs incurred.

In a matter-centric environment, the end result is that a project is divided up, delegated to the most appropriate individuals according to their knowledge and billing rates, and using this information to assess whether a given matter is cost effective and served as a gauge for profitability. This model can also be used as a "profit predictor" for future projects.

For this to work, transparency is crucial as all units in a firm need to have knowledge about each unit's capability and limitations. The role of KM in this context would be to permeate information on feature (individuals/depts) and function (capabilites/limitations) throughout the organization.

Since US firms have not widely adopted alternative fee arrangements, the rates and realization model warrants a closer look by tweaking the mechanics accordingly.

 

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