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SPRING 2015 EDITION

Forefront
 

Profitability Measurement: Where to Begin?

As law firms continue to face pressure from clients who are seeking alternative pricing arrangements, or just want to control costs, those with a profit culture and a focus on the bottom line have a leg up. As Peter Drucker famously said, “What gets measured gets managed."

In today’s law firm business culture, numbers are driving decisions more than ever. Therefore, driving operational practices toward margin assessment is not only a worthy and important goal, it’s a necessity.

However, for firms that feel they are late to the party and aren’t quite ready to begin focusing on margins, it’s not necessary to start there.

Focus on Key Drivers First

Profitability improvement is a progression and can be accomplished without the specific use of margin numbers just by focusing on the key drivers of profit:

  • Pricing
  • Utilization and resource levels
  • Leverage
  • Overhead costs
  • Inventory management

A focus on these measures, without a margin calculation, is often the right place to begin implementing profitability assessments, and it can have a significant impact on performance. Typically, firms have issues in one or two key areas. A great way to improve overall profitability is by narrowly focusing on those areas instead of the overall margin amount or percentage. Improvement in individual areas can result in overall margin improvement.

As an example, let’s look at a firm with high growth rates, a solid leverage picture, and good control of overhead costs. Despite these strengths, profitability per partner is falling. Why is this? By taking a closer look at several subdrivers, you’ll see that while structural leverage is good (i.e., associate: partner ratio), the utilization picture is out of whack, and associates are only 80% utilized while partner utilization is at 100% (see the Figure 1). As a result, a portion of their associate cost is transformed from a variable or direct cost, to a fixed or indirect cost. The greater the structural leverage ratio, the bigger the problem.

Key Metrics

 

Bill Rate

Indirect Cost

FTE

Utilization

PPP

2013

Partner

675

100

75

96%

$725,000

Associate

400

55

225

90%

2014

Partner

705

102

79

100%

$702,000

Associate

425

65

233

80%

Figure 1: Subdrivers of Profitability

The best way to fix this problem is to put leverage into practice operationally. Partners should consider pushing work down to associates wherever appropriate. This maximizes their investment in these resources and frees up time to focus on higher-value work and to develop additional business. Of course, if this delegation isn't possible due to conflicts of interest or limited associate expertise, perhaps cultural issues tied to compensation could help balance the workload. Another way to fix the utilization problem is to change the structural picture by reducing overall leverage, but this can be a more painful process with less upside to profit for the firm.

As another example, consider a firm that continues to raise rates and passes them on to clients effectively, as evidenced by billing realization targets staying consistently in the low- to mid-90s on a percentage basis. But despite an increased hourly realization, and other measures such as productivity staying consistent, the firm is struggling to improve year-over-year profitability.

A deeper look at the firm's inventory management practices confirms that, indeed, the firm has successfully raised rates and passed them along to clients, but its billing speed has increased by more than 30% from 45 to 59 days (see Figure 2). This has eroded the ability to "pull through" revenue in the current year, effectively negating the in-year cash effect of increasing bill rates.

Key Metrics

Standard Rate

Bill Rate

Billing Realization

Utilization

Billing Speed

PPP

2013

555

525

95%

95%

45

$800,000

2014

570

542

95%

96%

59

$780,000

Figure 2: Inventory Management Performance

In both of these examples, a focus and improvement on a very specific metric—associate utilization and billing speed—would result in an increased profitability margin while avoiding the initial complexities of devising, deploying, and socializing a profit margin. Ultimately, once that socialization occurs, the conversations can get more sophisticated. But an important point is that it doesn't have to start there for real improvements to take place.

Dive Deeper for True Understanding

Once profitability has been explained, it's still going to take more than just those profit statements to explain what happened, whether analyzing the firm, a department, a client, or a fee earner. Remember, profit margins are just an expression of the drivers that are part of the overall model, and thus an ability to understand and quickly explain what changed will be even more critical once the firm has become accustomed to thinking in terms of profitability. As such, a robust business intelligence platform, with the ability to query, analyze, and report, in "right time," is critical to any profitability initiative. Additionally, a firm must intelligently select benchmarks, KPIs, and firm goals to make sense of the numbers that are generated from the system.

While all of these tasks may seem daunting, a real, positive return on the investment of business intelligence and profitability analysis is possible quickly, just by initially focusing on the improvement of one or two key metrics. While there are many complexities that can arise from the concepts and the technology, a simple focus on what can be addressed quickly, and the delivery of fresh, actionable information to the right audience, can provide the positive ROI that firms hope to achieve on these initiatives.


Wilson Legal Solutions

Wilson Legal helps law firms maximize the benefits of technology to reach new levels of operational efficiency and profitability. The company offers deep technical expertise, hands-on software experience, and best-practice insight to help firms leverage their investment in Elite practice management and business intelligence software. Click here for more information.

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