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In the past I have talked about how law firms have become profit-margin businesses versus their old cost-plus model. And I have alluded to the fact that associates and other non-partners are the source of margins and therefore profit. So I thought I would take a crack at modeling a single associate to see what margins they might produce and then talk about threats to these margins and opportunities to regain them. I suppose I have avoided peeling things back to this layer so not to scare associates too much. I may have waited too long.
We’ll start with the basic profit equals revenue minus cost equation. For a single associate, their hours billed and paid will be the revenue. Their costs are broken down into two types: overhead and compensation.
Firms find some perverse enjoyment in arguing about overhead costs. The basic concept here is that the overhead cost for the firm is determined and then divided by the number of time keepers. This gives a cost to support each timekeeper. Overhead includes space, administrative staff (marketing, accounting, etc.), malpractice insurance and any other general expense. Lawyers love to argue about which aspects of overhead should not be applied to them. Putting those arguments aside, we’ll assume some reasonable allocation of overhead to an associate on a per year basis.
This one is easier. Take comp plus additional benefits costs, usually in the neighborhood of 30% of comp.
The Revenue Challenge
In the good ole days, an associate could easily bill 1900 hours or more per year. However, the past few years have seen the average hours billed per year per associate dropping. Add to that drop, the increasing levels of rate discounts and the general drop in realization against standard rates and you begin to see the problem. I call this the double-whammy problem.
We’ll be generous and estimate that in 2006 a fourth year associate had a 50% margin. For the moment we will hold costs constant and determine the impact of fewer hours and lower rates. If effective realized rates (standard rates minus discounts, write downs and write-offs) equal 85% of standard rates (a current industry number) and an associate’s annual hours are down 10%, then their margin has dropped from 50% to around 25%. This means their contribution to partner income has been cut in half.
If commenters feel so compelled, they can contest my assumptions about rates and hours in the market. But the bottom-line in this analysis, is that the margins on non-partners are dropping because of discounts and under-utilization of time keepers. The actual amount will vary per time keeper. For first and second year associates, these challenges are even more daunting, as they were already negative back in 2006. For seventh and eighth year associates, they may be less challenged, but they are also knocking on the partnership door, about to move to the other side of the profit table.
What Does This Mean for Associates and Firms?
The Market is setting prices. Therefore firms should focus on managing costs under these prices. Firms probably think they were doing this by laying off staff and some lawyers back in 2009/2010 and by cutting back on technology and other purchases. And for a short period of time, that approach worked. The overhead costs were reduced to maintain the margin on our hypothetical fourth year. Some of that savings was permanent; other portions were simply delayed purchases or projects. Current market stats show costs are now rising for firms at about 6%, which reflects the ‘playing catch-up’ efforts now going on with technology and other administrative needs. The real point here is that firms could maintain short-term margins by cost cutting, but they cannot cut their way to growth in the long-term.
Back to our Associate
Firms invest in people and knowledge. When an investment fails to generate returns, you need to reevaluate that investment. For most firms today the issue is our associate … multiplied. Dropping utilization of timekeepers means you have over invested in productive resources. So you either bring in more business or reduce productive capacity. Bringing in more business is problematic in a flat market. So instead of 10 associates utilized at 80%, you will want 8 associates at 100%. And firms need to stretch this thinking across all timekeepers. At least they do if they continue to think like they did in 2006
Clients are asking for efficiencies from their law firms. This, on its face, would seem to indicate utilizing fewer time keeper hours, not more. I fondly refer to this as the Better – Faster – Cheaper (BFC) Challenge. For a firm this means they want to better manage the costs around this associate while maximizing the revenue they produce.
I suggest firms need to shift their thinking on investment. They do invest in people, but it should no longer be an investment focused on their time. So instead of hiring more associates with the dream it will produce the respective revenue and profit streams, firms need to invest in new approaches. Ideally, looking at our original revenue equation above, a firm will want to invest in driving up the revenue side of it. Imagine an associate who ‘bills’ 1700 hours but generates revenue at a 2500 hour level. How can this happen? That is the investment challenge for firms today, clearly in line with our BFC challenge and the cries of our clients. Firms need to invest in new delivery models and technology that empowers our associate to deliver that higher level of value to the clients.
In this world we may want to come up with a better term than “overhead.” Think of a fighter pilot flying an F-16 jet in to action. I doubt he or she considers the design team and ground crew as “overhead.” Law firms would do well to view money spent on technology, marketing, etc as another type of investment in their businesses. Just because something is not a ‘direct revenue generating time keeper,’ does not mean it is not vital in generating profit for the business.
Associates – I apologize for not bringing this to your attention sooner.
Law firms – The answer to your challenge is clear. Redefine how you invest in your business. Focus on what your clients want. Embrace new (and improved) ways of meeting your clients’ needs. Profits will follow.