5/20/14

Pricing, Profitability and Compensation - Part 1

In this two part series, we will look at how the legal pricing role has been drawn into the profitability role and is now being pulled towards the compensation side of law firms. From there we will apply the knowledge being gained from pricing and lay out a possible future compensation approach focused on motivating profitable behavior by law firm partners. Throughout this discussion we will look at the pitfalls of making such a change, and not making any change.


Part One

As the pricing role has been pulled into the sphere of law firm profitability, many times that pull continues on over into the compensation arena. As noted in the recently published The Law Firm Pricing Report, pricing is a role that takes center stage for profitability, such that the pricing function many times becomes the voice of profitability in a firm. And once profitability is understood within a partnership’s ranks, questions quickly rise about its potential role in compensation.

Discussed at length in the Report is the broader challenge of law firm profitability. The challenge arises since law firm partners (in the general use of the term) are both owners and workers. Any profit methodology needs to tackle the issue of how you treat partner compensation in relation to profit. Is it treated as all profit, or entirely as a labor cost? Or is it split between the two in some fashion? Whichever approach a firm takes, this first pass highlights the relationship between profit and compensation, which in turn makes it clear how pricing will be drawn into the compensation dialog as it evolves.

And the dialog about profit and compensation will definitely be evolving - and as importantly, ongoing. The underlying goal of most compensation efforts, especially outside of the legal market, is driving value and profitability. Compensation should motivate profit enhancing behaviors and should always be adapting to changing market conditions. Therefore a prerequisite for firms is sending a clear and consistent profitability message to its partnership. Without a clear understanding of profitability, a firm cannot expect any compensation system to properly motivate profitable partner behaviors.

This law firm profit message centers on a shift from the old to the new. The old profit discussion was about hours and revenue, since that was effective at increasing profits. However, the market conditions have changed, as in there is no longer increasing demand and low price sensitivity. Under flat demand and growing price sensitivity, the new discussion needs to be a broader conversation about revenue and profit. Prior to 2008, hours and revenue were enough to drive profits. But since then rate increases are down, realization against those rates has dropped from 94% to 84% and the utilization of law firm lawyers has also dropped (increasing the cost per hour of lawyers to the firm), ‘hours and revenue’ is no longer effective in driving profit.

When developing a “revenue and profit” comp system, one should keep in mind the Law of Unintended Consequences. Comp motivates behavior, which means there is always the problem of unintentionally motivating counterproductive behavior. Whenever a system is created, you immediately create incentives for people to game the system to their individual benefit. Although a scary prospect when changing comp systems, firms should realize this ‘gaming’ is already happening under current comp systems. It’s just that the firms are accustomed to the current gaming efforts and have in place checks and balances for tempering those efforts. New comp systems will need to evolve to develop another set of checks and balances to keep ‘gaming’ efforts under control.

The Legal Twist

In many respects, next generation comp systems will need a component that functions along the lines of traditional sales comp systems. This aspect will need to carefully balance protecting current revenue and profit, alongside encouraging new revenue. For those who have been involved in designing sales comp systems, this is no easy task on its own. But here’s the Twist - law firms have an added a degree of difficulty, due to their owner / worker conundrum. Sales people are rarely also front line workers. They do not build the widgets they sell. In contrast, law firm partners need to be rewarded as both workers and salespeople. Both of these efforts have value for firms, but they have a different kind of value. Comp systems will have to balance how each behavior is rewarded.

Caution

Lawyers, being Type-A personalities, tend to see things in black and white. Profit lends itself to such viewpoints. Under this thinking, profit is seen as an absolute. Practices and clients are either good or bad. As an example, a partner might see all profit below average as bad (or even failing). But profit is a mental construct and can be viewed in many different ways. For instance, costs can be calculated on either a budgeted level or an actual level. Which approach used depends on the circumstances and goals. So firms also need to take into account how they communicate profit in relation to comp. Instead of being a black and white issue, profit should be communicate as having a healthy range and that the goal is increasing profits across that range. In other words, instead of using profit as a stick when it comes to comp, it is better used as a carrot.

Of course firms should fully expect some bumps in the road as they begin to transition to different compensation systems. Effective change management will be a necessity, since changes in comp impact the wallets of those involved. When wallets are involved, firms should expect strong reactions and proactively move to address those. Firms should also be ready to make thoughtful adjustments to comp systems. I say “thoughtful” and not reactionary. Be prepared to adapt to core concerns, but be very careful about reacting to individual partner complaints.

Oh yeah - and one more challenge - some practices still function just fine in the old world (e.g. tax and bankruptcy) so new systems will also need to account for that.

In Part Two of this series, we will explore a possible next-generation law firm compensation methodology. 

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1 comments:

Liz M. C. S. said...

I recently read the 2013 ABA report on the pay gap between men and women for partner compensation: http://www.americanbar.org/content/dam/aba/administrative/women/closing_the_gap.authcheckdam.pdf. The recommendations for firms are great both for closing the gap and for motivating partners, through compensation, to work on the varied activities that contribute to profitability.

 

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