Image [cc] evan p. cordes

One of the biggest question marks in the legal industry is around driving change in law firms. We all know change is needed, but it tends to come very slowly for law firms [insert shocked exclamation here, soaked in sarcasm]. There are a number of classic law firm change methods in use, but none tend to increase the rate of change at a level consistent with change in the real world. I suggest fear as a strong motivator and fear around money as the penultimate motivator.

And this is where profitability comes in.

We’ve covered the subject of profitability in the past about what it is, but here I want to suggest it as a tool for change. More specifically, law firms should create cultures of profitability in order to drive change.

The Profit Methodology

The first step in creating a profit culture is deciding on a profit methodology. This first step can be the one that brings the entire effort to a grinding halt. Partners can easily see that any profit method will eventually impact them, so they spend hours arguing about what it should or shouldn’t be, trying to tilt the model in their favor. This is of course understandable. However, given the proclivity for and skill in arguing lawyers possess, having all of them engage on this at once is what usually kills the plan. In actuality, a given model favoring one partner over another is so minuscule, the arguments are not worth making. But remember our guiding light about fear over money, and you will understand this behavior. So the solution is helping partners understand the low value of arguing and that the real goal is having a method that is not focused on an unachievable, absolute profitability, but instead on one that is instructive for how partners can improve profit.

I won’t go into detail here, but there are three basic profit methodologies a firm can utilize:

  1. Contribution Margin, 
  2. Gross Margin, and
  3. Net Margin. 

Each model treats partner compensation in a different way, either treating all as:

  1. a Labor Cost,
  2. All as Profit, or 
  3. has some method for segmenting a portion as cost, leaving the rest designated as profit. 

Which ones firm picks is not as important as just picking one.

Once a firm moves past adopting a methodology, they move on to step two.

Evangelizing

In this step it needs to be somebodies job to go around the firm presenting and talking with partners about the profit methodology. Relatively simple presentations showing how the model works for various types of work should be given. And then given again and again and again.

An ideal person for this is a pricing director, since they are in a primary role on this subject and over time will be the person who puts this all into action. Absent that, someone with a finance role will work, provided they present well to partners.

Step two is never done, since partners need to hear this message a few times for it to sink in. And firms are always adding new partners to the roster.

Education

Once we have some reasonable level of understanding, then a deeper education effort should be made. This puts the model into action with partners’ own financial information. This can be done with pricing requests or even better, with existing, ongoing matters. As we all know, clients are keen on cutting spend, so many matters have budgets or caps or some other fee deal that require partners to stay on top of fees. This is a great opportunity for them to see profit in action.

Throughout all three steps in this process, firm leadership should be supporting and sharing the message in firm-wide situations and in practice group meetings. In the third step, education can be done in individual partner evaluation situations too.

The Compensation Caution

When a firm pursues this path, they should be prepared for the compensation questions. Once partners figure this all out and understand that the way they price and manage their work drives profit, they will want to know how and if this all will impact their comp. Most firms at this point in time do not factor profitability in to individual comp. Even under this circumstance, it’s relatively easy to talk about how a rising tides raises all boats. And that story is going to be a good one to tell throughout this entire journey. The real goal of a culture of profit is not beating up people with marginal numbers. Instead the real goal is driving the whole range up.

Lawyers tend to see things in black-and-white, so they may see any numbers below an average or benchmark as failing. Throughout this culture change effort, you would do well to use the message that the goal is to increase profit across the board. You will have matters with high profit that can be made more profitable with minimal effort. Just because one is above average does not mean one has reached their potential. Of course you will find some work with “negative” profit. Be prepared for that. Firms chose to have a range of practices for many reasons beyond the profit of specific work.

As firms go down this road, it will raise new debates and discussions within the partnership. Firms will face new questions and may not have immediate answers. This is part of the value of creating a culture of profit. These are discussions you need to be having, but have been avoiding. The results will be a financially healthier firm. But a firm will need to be prepared and willing to openly discussing the new issues that come up.

Hit the Road

You may be thinking this road to profit sounds a bit bumpy, and you would be right. However, here’s the deal: You have to go down this road. Firms that avoid or delay this quest will be significantly handicapped in this changed, competitive legal market. Long-term, they will likely go under or at a minimum, be marginalized as lower profit firms.

Change is as Change Does

The real power of the profit culture comes in to play in driving change. People love to talk about all of the change that is needed in the legal industry. It’s been a while since I heard anyone say AFAs were a passing fad or that clients are going to pull back from discount requests. But even with the need for change being common knowledge, change is coming too slowly.

With a profit culture in place a firm creates a sense of urgency around change. Partners now have a clear reason to adopt change. It will no longer be a theoretical good idea, it will become an obvious, pressing need. Partners will now know what drives better margins and what they need to do to attain them. More importantly, they will know that everyone else also knows this and what their grade is within the partnership. And we know how type-A lawyers are. Having low profit numbers is like getting a C- in a law school class. No lawyer wants that grade, especially when your peers will see it.

So – putting this all together, creating a culture of profit is necessary for law firms that want to thrive or even survive. It will be critical to their ongoing financial success and it will drive the change they desperately need to stay competitive in the market. As an added benefit, it will drive cost savings for clients.

So why aren’t all firms doing this?

In Part One of this series, we talked about how pricing is pulling towards the compensation challenge for law firms, based on how pricing is interwoven with profitability. In this next section we put forth a “Straw Man” for how compensation might change to better motivate profitable behavior by law firm partners.
Part Two
A Modest (and High-level) Compensation Proposal
What follows is a possible approach to developing a next-generation comp system for a law firm. This approach breaks down comp into a base, plus three different reward or bonus buckets, allowing a firm to reward all types of profit enhancing behavior from partners. The challenge for this system, and any system like it, will be striking the right balance between the three reward options. As previously noted, the balance will need to protect current revenue along with encouraging new revenue. And it will need to properly reward key partners, to retain them within the firm.
Baseline Worker Comp Reward
First – law firm partners need to continue to function as workers. Clients hire them because of their expertise. So any comp system will have to first account for that worker aspect. This proposed model sets a base level of billable effort (a.k.a. work), that all partners should reach. The exceptions (there are always exceptions) might be partners with leadership and administrative responsibilities.
Further refining this concept, we might divide the base level of compensation into two or three levels, where partners are rewarded as workers. This reflects the value of partners as workers and should likely reflect their experience levels. For argument’s sake, let’s set this threshold at 1000 hours. And for their 1000 hours, a firm would set base comp of at three levels (recognizing junior, mid-level and senior partner experience), so if all the partner does is bill (and collect) on the 1000 hours, they will be paid the base amount relative to their assigned level. This base level might be treated as a “labor cost” in a firm’s profitability model.
Of course, firms will set expectations that the base is not enough. Any partner functioning only at this level will likely be let go in short order since they would be only be a worker performing at a substandard level of effort.
Above the Base
Our theoretical firm has three options for a partner to increase their income (and keep their jobs).
Reward Option #1 – Be a better worker.
In this option, the partner would increase their billed and collected hours well above the 1000 hour mark. Our future firm might set a per hour ‘bonus’ for each partner level. Partners who fit solely into this category for comp might be high-level subject experts, such as first-chair trial lawyers, high-value niche regulatory experts, or others with higher effective billing rates.
There will be long-term challenges with partners who only function in this role, as they are truly serving in just a worker role. They may be highly specialized, high-demand workers, but they are not actively expanding the business. Consider a star player on a NFL Team. They will be paid very handsomely, but they don’t make decisions about the business.
Reward Option #2 – Maintain an existing, valuable client relationship
Many partners at firms inherit institutional clients of the firm. Keeping these clients happy has tremendous value. Although in a new model, keeping this client work profitable will be equally, if not more important. A client that brings in $2mm in fees might sound appealing, but if it cost the firm $3mm to serve that client, there is an obvious problem. So the compensation rewards for this option will be tied to maintaining revenue levels and improving the profitability of the revenue.
Here the comp reward can be tied to revenue and profit levels for existing clients. A partner pursuing this comp option will want a happy client and well-managed work. They will be concerned about practice management resources such as project management and practice innovation, and will be pushing for greater efficiencies and new value propositions in service offerings.
Reward Option #3 – Bring in new work
New work will come from both existing and new clients. From existing clients, this might be cross-selling new types of work or significantly expanding work in a given practice. In both circumstances, the revenue will need to be profitable or have the potential for profit. New work may initially be profit-challenged, but ultimately must fall within a firm’s acceptable level of profit. Of course, adding new, profitable revenue to a firm will have the highest value and be reflected in the comp systems as such.
Partners pursuing this option for comp will demand business development resources and differentiated service offerings. They will want to see efficiency enhancing efforts implemented to keep the services cost competitive, although they may not be the ones personally driving those innovations.
Combinations
Depending on the type of practice, a partner might enhance their comp through a combination of the three options. For instance, they may choose to bill a lot and bring in new work. In any event, partners who work hard across any of our options can be properly rewarded. But those that expand the business and enhance profit will be rewarded at the highest levels.
Note: For those partners still living in the old world (e.g. Tax lawyers), this new model will still be able to properly reward their efforts. Those in the old world can still be getting rate increases and still be getting work by being high-level subject matter experts. They would see rewards from all three options and thus be properly compensated.
This reward schema is different from many current law firm comp systems, as they tend to place first emphasis on a partner’s “worker” behavior at the highest value. “Hard work” is primarily perceived as having many billable hours. As billable hours is only one driver of law firm profit, the new models, like the one proposed here, will need to move away from that narrow thinking. Hard work comes in many other ways than just billing time. This new approach recognizes and rewards all of those efforts.
The Leap of Faith?
Regardless of the changes firms make to their comp systems, they will need to find some way to balance out how they reward various profit enhancing behaviors by their partners. They may choose to place greater emphasis on one option or another, but to have an effective comp system, they will want to include all three. Leaving one out and assuming or hoping their partners will still engage in that type of behavior is ill advised. Current comp systems reward “worker” behavior at a high level and as a consequence, partners will focus on that effort to the exclusion of most of the others.
As a former Knowledge Management (KM) professional, from personal experience I can tell you that partners (and lawyers in general) will not engage in efforts that do not impact their comp. One example is CRM. Law firms installed expensive enterprise software systems expecting lawyers to take the time to utilize them, adding valuable client data and leveraging that to bring in more work. Lawyers, for the most part, did not participate. The moral of this story is firms should not expect changes in behavior from lawyers unless they create a clear economic incentive for that change.
Where does that leave us? First – the traditional law firm compensation systems reward behavior that is outdated. They focus on rewards for hours and revenue. They tend to reward partners who bill a lot of hours, along with partners who bring in revenue, regardless of how profitable that revenue is. In today’s market, those rewards are not sufficient to drive profitable partner behavior. Innovative firms will start altering their compensation systems to reward partner behavior that drives a profitable practice in this changing, competitive market.

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. 

Image [cc] MyLifeStory

Dan: My Law Firm Right-Sizing idea received so much positive feedback, it encouraged me to think even deeper on the subject.

Jane: “Deeper” as in all the way to the bottom of the kiddie pool?

Dan: “Kiddie Pool” as in where your limited thinking keeps you Jane? So here’s my next great idea for law firms. We all want to cut costs so we can make more money. So why stop at non-lawyer staff?

Jane: “We” must mean the Gang of Benevolent Partners.So this is already shaping up to be another top idea from Dan The Great Thinker.

Dan: Now we’re paddling in the same boat! So here’s the thing. All the reports show firms have more lawyers than they need – something in the neighborhood of 10%. So firms should “let go” of 20% of the lawyers. Wallah! More profits!

Jane: So top level thinking and the use of New Math all at the same time, eh? If your firm is 10% overstaffed in the lawyer ranks, why would you fire 20%? Is this another “hire back what you need scheme?”

Dan: Jane – Your limited brain is showing … again. No, we wont be hiring them back. That’s the beauty of the whole idea. In the Good Ole Days, we thought 1900 hours of billable time was good. In my new plan, 2500 hours is going to be even better. I’ve been reading up on this profitability thing. Basically all the hours above 1900 are gravy. So why would we stop there? We want to be “above average” as a firm. Not some run-of-the-mill shop.

Jane: Ahh – yes, your brilliance is yet again emerging from the clouded haze of your bodily gasses.

Dan: Again – we’re in the same boat. It’s so wonderful to watch when you finally “get it” and embrace my New Normal Thinking.

Jane: Your New Normal, is like actually more like 19th Century Sweat Shop Normal. Let’s do some more math and see if you can keep up. To bill 2500 hours, an associate will need to work 3000 hours at a minimum. To work that much, each lawyer will need to work 11.5 hour days and not take any vacations or holidays off. Or in a slightly better sounding version, they could work 8 hours a day, seven days a week, every week.

Dan: Again … same boat. This is working out well. “Our” new firm is going to be the profit envy of BigLaw. I say “our” firm since you are starting to sound like partner material Jane.

Jane: By “partner material” you must mean someone willing to employ abusive labor practices in order to get rich.

Dan: Wow. It’s like we’re sharing the same brain Jane. I’m drafting your partner acceptance letter as soon as we’re done with this stimulating conversation.

Jane: The only stimulation you need is electroshock therapy Dan. With any luck that will loosen your bowels and take some of the pressure of your brain. Sometimes I wonder how you actually make it through the day without accidentally shooting yourself.

Dan: Now we’re back to normal – typical ignorant hussy talk. Your feeble attempt to change the subject to gun control, just killed your partnership opportunity.

Jane: Point well made.

Image [cc] J. Gabas Esteban

Jordan Furlong takes on PPP in a recent post. In his usual fashion, he methodically explores what PPP is and makes a strong case for why it needs to be abandon as a profit metric for firms.

But, in typical Dan and Jane fashion, I feel compelled to raise my voice and retort, “Jordan, you ignorant slut.”*  Although he makes many arguments for why and how PPP might be a negative force, he misses the main point of why PPP or any other law firm profit metric exists. They exist to drive behavior. Firms need their partners to behave in profitable ways and need to set clear expectations of what those ways are. Without a clear expectation, firms can fully expect partners to perform in whatever way enhances their self interest, regardless of its impact of the economic health of the firm.

Giving Jordan credit, currently firms seem to only have the goal of improved profits (however they might be defined). I am in complete agreement that for firms to be successfully for the long haul, they need a better goal: something like being the best and most cost effective at addressing their clients’ legal needs. Focusing on client needs does lead to success. But then we still need to define success. And ‘profitable’ needs to be part of that definition.

The fact that a given PPP number is not a true mean or median is beside the point. The real point is whether profits are healthy. PPP is actually a fiction, like most profit methodologies. However, without having profit be part of ‘success’, then a firm risks going out of business and ending its ability to be the best at addressing client legal needs.

I would add I believe there is a need for a real debate over which profit methodologies do make sense for law firms. The Law of Unintended Consequences is quite strong so a poor choice can lead to bad outcomes. For traditional business this same challenge shows up in how sales people are compensated. Various sales bonus incentives drive different behavior. When deciding on which approach to use, a business has to be very thoughtful of which behaviors will motivate salespeople while still driving a ‘successful’ business. This is why sales comp packages are constantly being re-tuned. Partner comp will need to strike the same balance alongside a thoughtful profit approach.

To our good fortune, the upcoming P3 Conference on Pricing, Practice Innovation and Project Management has a session on this topic. For those interested in participating in such a dialog, I encourage you to consider attending this excellent program.

Now it’s Jordan’s turn to make a questionable reference to my parentage.


*Jordan and I are good friends so he knows this is made in jest and with full expectation of a similar, Jane-like retort from him.

Image [cc] CN Impressions

I read a great interview of an EVP from a major financial institution recently. It had two value points for me. The first was the international economic data he explained. He basically said everything is in place for a major expansion, except nobody seems to be paying attention. Whether that bodes well or ill for law firms is yet to be seen.


The second value point was more pressing for law firms. The final interview question was: What keeps you up a night? The EVP had a succinct and focused answer: Talent. He went on to explain that his senior management team needs to be “best in class.” For him this meant a combination of subject matter expertise, willingness to work hard and the ability to bring in business. Or in other words: Get the business and keep the client happy. He knows these goals will drive his business, both in terms of revenue and profitability.

So where are law firms on such a scorecard?

Traditionally law firms viewed talent as purely subject matter experts. Lawyers would gain a seat at a firm based on law school performance and then rise through the ranks to partner based on their lawyering abilities. So being “best in class” meant you were a high-level subject matter expert willing to work hard.

But that is no longer enough. For starters, keeping clients satisfied is only indirectly measured at firms. When a client goes from being a large one, to a less large one, management does take some notice. But even then, reductions in fees can easily be explained by episodic litigation or any number of other factors seemingly out of the partner’s control.

The ability to bring in business has become a more prominent factor for evaluating law firm partners, but this is still in a transition in terms of being a “best in class” measure. For instance, laterals are evaluated on billings, however the profitability of that revenue is not typically measured.

My 2 cents: Today’s Managing Partners should be “kept up at night” on the talent issue as well. But they should revise and expand their definition of talent at the partner level. In order to do this effectively, they will need to start measuring partners with different metrics.

One of the last things the EVP mentioned was that he knew where he had “best in class talent” and where he didn’t. So he spent his energy on making sure the “best” was happy and was pursuing talent to replace those that don’t make the grade. Another good lesson for law firms.

Image [cc] loungerie

I have previously called out 2012 as The Year of Pain for law firms. The basic premise is that market demand is flat (per the many market reports) and that firms have run out of cost cutting ideas, such that costs are rising (also per the many market reports). The result will be a drop in profit for firms across the market.
But equally interesting is that the pain will not be felt the same across all firms. Another recent market phenomenon is dispersion. In the good-ole days, law firm profitability moved in a group-like fashion. All boats generally moved up with the tide. However, the market is now experiencing more dispersion, in that some boats are sinking while others may be rising. So then the question becomes: Why?

Why are some firms succeeding in this challenging market while others are struggling? Here is my hunch. A number of articles and posts might suggest it is superior management or leadership. That may play some small role, but it is my sense most firms are run as true partnerships. With consensus building and various other efforts, law firm leadership has to please its partners. So unlike a traditional business, leadership does not make such direct strategy decisions and thus have less impact on the success of the enterprise.

Absent that factor, I think there will be two other factors that determine which firms rise and which take the other road.

#1 – Types of Practices and Clients

Less by strategy and more by chance, some firms have less price sensitive practices. Most large firms have always had a mix of practices with varying levels of profitability, however now that fact is becoming much more apparent. So if a firm has a substantial practice or set of practices with rates clients still pay, then they will likely be on the rise. Although I would add – don’t expect this advantage to sustain. For the most part, these profitable practices will feel the pain soon enough. Pricing pressures are sweeping through the market. It’s just that some practices are feeling the effects sooner than others.

On the other side of this coin, there are clients from certain industries putting more fee pressure on law firms. So more by luck (although some may claim leadership and ability to know the future), certain firms who don’t represent such client markets will prosper above others.

#2 – Location

A number of firms are relocating back-office functions to lower rent locations. The idea here is pursuing long-term overhead cost reductions. Well guess what? Some firms are already located in these lower rent locations. So they already have the advantage of lower rent, and lower pay for both staff and lawyers.

As I note, these are hunches. I have not seen any market surveys yet that would direct;y confirm or dispute these factors as true drivers.

Come 2013, I guess we will all find out.

Leading up to this final installment in our series – we have defined profitability for firms, described the four profit drivers and looked at how the market is pushing on all of this. In this post we take on how Legal KM can re-focus its efforts to help firms respond to all of this pressure.

The Hill Looks Steep

Significant challenges present significant opportunities. Yes – law firms are facing intense market pressures. No – law firms have not yet truly faced the challenge.

This presents a tremendous opportunity for Legal KM (LKM). Perhaps the biggest challenge here is the lack of understanding by law firm partners and leaders as to the underlying issues. Shockingly (or not), most partners have little understanding of what makes legal work profitable. They hold fast to the old model that hours and realization lead to more income for them. Although in some practices and markets a variation of this reality still holds true, for the most part it does not. Clients increasingly are holding the line on rates driving down realization. And clients are no longer willing to pay for however many hours a law firm bills on a task or matter.

Opportunity #1

Historically LKM has had minimal participation on the financial side of law firms. Many times client and matter billings are presented with portals or on dashboards, however these are usually relatively simple metrics. These tools do not typically show profitability or help partners appreciate the impact of our four drivers on their wallets. Firms will struggle greatly with change if they do not even know where to start. It is the old and familiar tale of “follow the money.”

Capturing, understanding and delivering this financial knowledge will have high value for firms. Better and easier to understand profit metrics will lead to improved decision making by firm leadership. These same metrics will also be used by the frontline lawyers enabling better resource management decisions.

Currently many law firm financial departments are being pushed to the limits just trying to stay up on traditional reporting requests, as more firm partners are demanding timely financial information. Run – don’t walk, to your financial department and offer to help them find some breathing room.

Opportunity #2

Another opportunity presented by this situation is what might be called “re-engineering the practice.” Without going into a lot of detail, it is obvious that firms will need to change the ways in which they deliver their services to drive profitability. The profit driver Leverage can be a powerful tool. But pushing work down only works when a firm has the right systems in place to support that shift. Legal Project Management (LPM) a current hot topic cannot function without supportive LKM systems in place. This does not mean LKM should necessarily try to co-opt LPM, but instead find ways to drive the success of LPM efforts. If a firm does not have any process improvement or LPM, then LKM can help initiate those efforts. If LPM is being utilized, LKM can supplement and enhance those efforts. Firms need this help. LKM is just the type of resource to step-up and make it happen.

Other Opportunities

Hopefully these two opportunities help illuminate the path forward for LKM. Find the pain in your firm and address it. Focus on the greatest level of pain. One might argue that “search” is a pain for law firms, and they would be right. But this type of pain is not touching the decision makers of law firms in meaningful ways. Instead, what most firms are concerned about right now is flat revenue, rising costs and the possibility of reductions in partner incomes. LKM will do well if it focuses on addressing those pain points.

Having defined profitability and categorized the four drivers of profit for firms, in Part 4, we now turn to the market’s impact. 

Why Does This All Matter?

Over the past five to ten years, there has been a significant shift in the economics of the legal market. Previously law firms were able to raise rates to increase profit, typically 8-10 percent each year, with costs growing at only 4-5%. These rate increases resulted in increased profit. About 10 years ago, things began to change. The market finally became saturated with a sufficient number of lawyers (a.k.a. supply) so economic forces took over and started to impact prices. At first, firms felt this in realization. Clients began asking for discounts. However, at the same time, firms continued their price increases, so profits were only marginally impacted.

Two other forces came to bear in the market. The first was technology. Accelerated changes in technology enabled new competitors and encroachers. However, this change has been on a slow burn. The other force was The Recession, beginning in 2008. This forced in-house counsel to increase rate pressure on firms. Leadership in client companies no longer accepted “I can’t” as an answer from the General Counsel (GC) when asked to lower legal costs. Previously the GCs would say they couldn’t predict litigation or deals and therefore could not control costs. The CEOs finally said “enough.” The amount of legal work was not the question. The cost of it was. So clients really turned up the pressure on firms on price, to the point of demanding rate freezes. The days of significant rate increases and high realization were over.

Firm were pushed from a “cost-plus” business model, where profit was built in to the price (hourly rates) to a profit margin model. Now the game is managing costs of delivery such that a reasonable margin is made.

If you consider the four drivers of profit, the first three are clearly under intense pressure from market forces. Rate increases for firms have dropped from 8-10% per year to about 3-4%. Realization has also been dropping, currently at about 86% of standard rates. Finally with over-capacity in the lawyer ranks at most firms, productivity is dropping as well, driving up cost rates. This leaves firms with leverage as the only real alternative for counter-acting the other market forces. You might think this would give a clear direction for firms to respond to market pressures.

However, in this new economic world we have a significant challenge: Firms have not recognized the change. The vast majority of partners and firm leaders still focus on hours billed and realization to maintain profitability. Most firms did implement efforts to try to control costs. However, these controls were not focused on lowering the cost of delivery, but instead were just administrative overhead cost reductions. These overhead reductions have helped stem the tide, and allowed holding ground on profits. This approach will not sustain as no business can cut its way to growth. Instead, investment in new methods and technologies is needed if firms expect to grow their markets and enhance their profitability.

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.