Measure for Measure: Client Profitability is the "Giant's Strength" Inside your Firm

03.01.04
By Deborah McMurray and Barbara Harrison Kaye
Published in Strategies: The Journal of Legal Marketing

Law firm marketers are typically familiar with the concept of firm revenue – from the billable hours that generate it, to the aggregate figures that we find listed in (and often submit to) various publications. However, the true measure of law firm business success isn’t hours and rates, it’s profitability. The profitability of your clients, that is.

Law firms typically categorize revenue by firm, office, practice or department, partner and lawyer. Such data is generally available to marketers, and plays a key role in developing marketing budgets and allocating marketing resources. However, to be truly effective as marketers, we should take the process a step further and also analyze profitability by these same categories. This requires entirely different data and a very different mindset. Profitability analysis requires looking at individual performance (partner and lawyer), any aberrations (individual, practice group or firm) from past levels, overall trends (Are certain practices more profitable than others? Which ones are becoming commoditized? Are certain practices declining?), and landmarks against which to benchmark.

The most common categories of numbers to study are most typically the province of a firm’s accounting department, and include: lawyer utilization (the percentage of a work week that a lawyer works, expressed as an annual percentage), realization (a lawyer’s billable time that is actually billed and collected), cash collection cycle (time between recording billable time and when it’s collected), and accounts receivable (A/R) and work in progress (WIP) aging (the method of dividing WIP and A/Rs into collection categories—i.e., 30, 60 or 90 days—for analysis purposes). This is the real foundation of firm performance. It shows where revenue is actually generated and how important different revenue categories are. Because the information is so financially oriented (and often so closely guarded), it may take overcoming internal cultural barriers in order for the marketing department to have access to it. However, the reward will be a marketing focus that truly reflects the viewpoint and priorities of senior firm management.

What’s most important in this analysis?

There are pitfalls to watch for in traditional profitability analysis. One is the presumption that all clients are created equal. Most law firms have the following mix: some clients who are loyal and profitable, many more who are marginally profitable, and still others who are not profitable at all.

Another problem with the traditional analysis is that it may not reveal if downturns in certain industries, such as telecom and energy, translate into lower revenue and profit from clients in those industries.

You should also know how the economy is affecting the mix of services that your firm is providing. History proves that what’s hot today may be cold tomorrow. (Are IPO services as big a part of your firm’s practice mix as they were several years ago? Are they coming back?) With strategic marketing guidance, law firm leaders can prepare for these industry cycles and ensure that their practice and client mix is balanced yet nimble enough to take advantage of the hot markets before their upswing. To the extent that you can contribute to this analysis and ensure that marketing strategies and tactics are prepared to reflect it, you are providing measurable value to your firm’s leadership – and confirming the importance of marketing as a strategic leadership tool.

Problem Clients

If your firm doesn’t deliver services via client teams already, analyzing profitability by client might be the spur to explore that approach. Looking at profitability by client and matter helps you understand who the "good" clients are, and this provides insight for how much and what kinds of resources to devote both to them and to the less- profitable ones. Marketers can get this process under way by interviewing firm lawyers and asking them to name their most difficult clients. Identifying irksome client behavior is often the first clue in identifying clients who aren’t adding to the bottom line.

In most industries, unprofitable customers (1) give very little business; (2) pay slowly, often asking for deep discounts or write-offs (or both), or they don’t pay at all; (3) make unreasonable and sometimes outrageous demands; and (4) don’t refer you.

In conversation, many law firm COOs and executive directors suggest that the "80-20 rule" roughly applies to their firms. If 80 percent of firm revenue comes from 20 percent of the clients, what does that say for the remaining 80 percent? Let’s assume 50 percent of the remaining clients are marginally profitable, and that the bottom 30 percent aren’t profitable at all. What can law firms do to turn this around? Should they fire the bottom 30 percent? Of course, that might be unrealistic—and some clients are maintained, even at marginal levels of profitability, for myriad reasons. Should they, by contrast, devote effort and resources to targeting more profitable services to clients that currently use less profitable services? That might be feasible, but only to the extent such clients are willing and able to pay. Either way, doing nothing about the laggard 80 percent is a recipe for financial trouble. So let’s look at some remedies for those that we’d like to make more profitable.

Enter your marketing professionals.

Today’s chief marketing officers and business development professionals know that one-size-fits-all doesn’t work as a business-model. The business model that works for a firm’s most loyal, top 20 percent, doesn’t always work for the rest. Don’t try to make Cinderella’s slipper fit the less attractive step-sisters.

Law firm clients can be categorized in many ways, including the following:

  • Industry
  • Size of company
  • Revenue to the firm
  • Frequency of hiring the firm
  • Service area utilization (How many firm practices do they use?)
  • How many other firms they use and for what services (competitive intelligence)
  • Typical service team required to handle work (associates? senior partners? paralegals?)
  • Average matter value
  • The average time they take to pay their bills

Armed with billing history and trend data, the marketing department can point out the structural impediments to profitability in the delivery of services to certain types of clients, especially those that fall in the marginally profitable or unprofitable categories. Solutions might include, for example, bonus billing for unique services, staffing modifications or packaging services differently—perhaps even developing new services to meet changing market or industry needs. The goal in categorizing types of clients is to find creative ways to make lower-end clients as profitable as possible.

Analyzing Client Profitability

In the simplest of terms, profit can be determined by taking the total annual gross revenue by client and subtracting the costs associated with serving that client, including how long the firm has to wait for the payments (the collection cycle time mentioned earlier), a percentage of overhead costs, associate and staff salaries, and partner compensation. Don’t forget to subtract business development costs, such as travel, meals, and entertainment, and the cost of nonbillable time dedicated to the client.

If gross annual revenue for the XYZ Co. is $1 million and it’s served primarily by two senior partners, plus two midlevel partners, then XYZ may not be very profitable. In fact, the firm might be losing money if this client is associated with high-compensation lawyers, slow payment, write-downs or write-offs, and high business development expenses.

The problem with this simple financial analysis is that it captures only traditional data, primarily billable hours and revenues, instead of client and market profitability data. Developing a new business model for XYZ might lead to alternative fee arrangements—fixed fees for routine work, task-based billing for certain matters—or a different service-team structure that involves more paralegals and associates and much less partner time. "Productizing" certain service deliverables, another option, involves a pricing structure that is value-based, rather than hours-based. Such alternatives may make your firm more responsive to client needs, and thus increase the volume of profitable work. While the decisions are likely up to firm management, marketing’s profitability analysis can be the catalyst to begin the process.

"Institutionalizing" Clients

Typically, institutional clients that aren’t looking to hire the best "big dog" lawyers for specific matters are more profitable—mainly because they become more loyal to the firm and its lawyers, and the value of the relationship builds over time. The advantage to a client is that each primary firm develops an "institutional memory" about the company that is hard to replace. The longer and deeper the relationship, the more value it brings to both parties. Marketing often and should play a role in developing strategy with lawyers to further entrench the relationship.

The downside is that institutional clients often ask for discounted hourly rates—ranging from 10 percent to 20 percent. If your firm has a profit margin in the 30 percent to 40 percent range, then a 15 percent discount from standard rates cuts that profit margin in half, to just 15 percent. Any write-offs, write-downs and other bill disputes make your margin even smaller. The key to managing this dilemma is honest and direct communication with the client about the best ways to deliver the right services at the right price. Again, the marketing department can help focus the effort with effective analysis that identifies the most profitable services and effective tools to educate the client on why those services are the most valuable to them.

Law firms are designed to be "for profit" enterprises. At a recent San Francisco Legal Marketing Association panel discussion on "Law Firm Economics," the lawyer panelists (all industry leaders) agreed that hourly rates cannot continue to rise. At the "expert" level, a lawyer can ask for as much as $1,000 per hour, but at the mid-range and lower levels, rates will be hammered down. And everyone believes the cost of doing business will continue to increase. So where will this profit margin come from?

The answer lies in how well your lawyers manage their client relationships. Knowing who’s profitable and who isn’t is a critical step. This analysis can signal systemic problems that can be fixed and client behavior and profitability issues that can be addressed—by structuring different service-delivery models, by staffing differently, by bonding more strongly, or, when necessary, by referring clients or certain client matters to a law firm better suited to handle their needs. Insightful marketing professionals who can understand the role of profit, identify where profit is generated, structure business development strategies that emphasize profitable work, and help communicate the value of that work to clients will immeasurably strengthen their firms – and strengthen their own standing as valued strategic counselors to senior firm management.

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