10/25/12

The Economics of Law and the Future of Legal KM - Part 3

In Part 2 of this series we explored the impact of Rates and Realization on law firm profits. In Part 3 we look at the other two drivers: Productivity and Leverage.

The Profit Drivers:

Productivity (a.k.a. Utilization)

Productivity is the number of billed hours per timekeeper  Most firms will have a benchmark productivity of 1800 or 1900 billable hours per year, driving an expectation of a certain baseline level of productivity. For profitability, this comes into play on cost rates.

Each time keeper has a cost per year. There are two components: Compensation and Overhead. These are commonly referred to as Direct (compensation) and Indirect (overhead) costs. The indirect costs are usually a hot-button issue for firms as everyone wants to argue about where various administrative costs should be applied. Side-stepping that issue, firms decide on reasonable numbers based on the level of the time keepers. Partners, for instance, may have higher overhead costs allocations as they use more resources within a firm. Once a firm agrees on these costs, then you divide the overall cost number by the benchmark number of hours to get a cost rate per hour.

The punch line on productivity: When productivity goes down, cost rates go up. If you have a lawyer who costs $500,000 per year working 1900 hours, her cost is $263 per hour. If her productivity drops to 1700 hours, her cost rates increases to $294 per hour.

The impact of cost rate changes on profit is typically half that of realization. Of course that depends on the differential between the cost rate and the realized rate. The closer they are, the bigger the impact and it becomes just like the point-of-no-return seen in realization.

Caveat: Lawyers tend to manage profit by focusing on costs. This is the least effective way to enhance profitability. Most costs are relatively fixed on an annual basis. Salaries, rent, insurance, technology and the like are consistent costs year-to-year. Firms wanting to enhance profitability should focus their energies on the revenue side of the equation.


Tangent: We'll take a small detour here to differentiate between profitability on the client and matter level versus profitability on the practice group or firm level. For example, when looking at the profitability of a matter, productivity should be neutralized. If a firm has under-utilized lawyers, it should not count that factor when evaluating the profits for a matter or a client. Under-utilization or low productivity could be used to show increased cost rates on the client level. The real problem with low productivity though is not in how a specific matter is being staffed, but instead is a firm management problem. Under-utilized lawyers are a symptom of over-capacity (i.e. a firm has more lawyers than work). At the client and matter level, the issue is using the proper level of staffing. If you factor in higher cost rates for underutilized lawyers, you are motivating partners to use busy associates instead of those with capacity. This is not a behavior you want to encourage.

Leverage – The Great Equalizer

The last driver of profit is leverage. This is the amount of non-partner work versus partner work performed. Or from another angle, the percentage of partner time worked per matter or per client.

We took that tangent for an important reason. Leverage is the highest impact profit driver. And firms looking to enhance their profitability will want to encourage the best use of leverage and not let low productivity encourage counter-productive behavior.

The basic economic concept of leverage is that the more workers work, the more owners (partners) benefit. Workers generate the profits that pay partners. Therefore, the more work is push downed to them, the better leverage you have and the more profit is generated.

Of course caveats apply. Partner level work should be done by a partner. The mantra here is: push work down to its lowest cost, appropriate labor source. This sounds obvious and reasonable; however, until recently, firms have profited from pushing work up to the highest rate source, which was a great idea when competition was low.

Further, and taken to a logical extreme, you could make the argument that partners should do no work to maximize profits. Technically you would be correct. If partners spent all of their time getting business in the door and workers provided all the effort, you would maximize profit. However, as mentioned above, partners are also workers. Clients expect the high-expertise of partners on their work and in fact make many purchasing decisions with this in mind.

Another point to consider, partner work also generates revenue. In a situation where 25% of the work is performed by partners, about a third of the revenue comes from their time. The bottom-line is that work should be allocated to the right resources. Firms should make every effort to move the work down and ensure the timekeepers involved are constantly improving their skills so they can continually take on higher levels of work.

And a final important point on leverage: When it improves, the fee to clients goes down. As work is pushed to lower cost resources, the overall fee for a given piece of work should go down. I say “should” since this is dependent on the work being performed at competent lawyer levels. If work is pushed down to timekeepers who take too much time to complete the tasks, the reasonable leverage line has been crossed. Staying on the right side of that line essentially means higher profits for firms and lower fees for clients. Truly the win-win result the market is begging for.


In Part 4 we tie the four drivers into a single picture and talk about the effect of market forces on the group of drivers.

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