Measuring Profitability

06.20.03
By Deborah McMurray and Barbara Harrison Kaye
Published in Legal Times

Law firm leaders closely correlate profitability to revenue. But even if revenues are rising slightly in the largest firms, as a recent Citigroup "Flash Survey" indicated, it doesn’t necessarily mean that profits are correspondingly rising. It’s time to put the emphasis where it belongs—not on hours and rates, but on profitability. The profitability of your clients, that is.

There are sophisticated ways to analyze and manipulate numbers, but a straightforward, simple approach yields consistently useful data. Law firms typically categorize revenue by firm, office, practice or department, partner, and lawyer. Many firms take it a step further and also analyze profitability by these same categories. They look for the following in these numbers: individual performance (partner and lawyer), any aberrations (individual, practice group, or firm), 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 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).

What’s missing in this analysis?

While useful, this analysis presumes one thing: that all clients are created equal. But most firms have 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. 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.

Problem Clients

If your firm doesn’t deliver services via client teams already, analyzing profitability by client might prompt you to explore that approach. Looking at profitability by client and matter helps you understand who the "good" clients are, and this provides insight for dealing with the less- profitable ones. Start with your intuition—name your 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. 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 you have to wait for the payments, 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.

The advantage of a new business model for XYZ is that many of the changes suggested above lend predictability to working with their outside counsel, something corporate counsel say they desperately want. By being more responsive to the client’s needs, the law firm serving XYZ has a chance of actually enhancing the relationship with its general counsel and making XYZ a more profitable client of the firm.

To make this work, the two senior partners currently serving XYZ must wean themselves from day-to-day control. Senior partner oversight is appropriate, but the numbers simply don’t work if four partners spend the bulk of their time on this client.

‘Institutionalizing’ Clients

Most law firms want "institutional" clients because they perceive that these clients are less likely to follow a departing partner. But how many institutional clients actually exist in firms today? Clients are as mobile as lawyers. Today’s corporate legal departments are resisting institutionalization. Many want to spread their work around, and believe they can hire the best "big dog" lawyers for specific matters.

At the same time, many other Fortune 500 corporations are reducing their outside firms by half, or more. These companies are formalizing and standardizing, to the extent possible, their relationships with law firms. There isn’t always downward pressure on fees, but fee arrangements or structures are always a key consideration for these chief legal officers and general counsel.

It’s ironic that the same law firms that want "more of the client" also resist adopting a compensation system that would actually encourage lawyers to grow their client relationships in a multidisciplinary fashion. Firms with comp systems heavily weighted on origination and hours billed give partners too much financial incentive to hold on to their clients and not engage in cross-selling.

Typically, institutional clients 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 plays 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. Resolve to communicate honestly and directly with the client about the best ways to deliver the right services at the right price.

Law firms are designed to be "for profit" enterprises. At a recent 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. Clients want their companies to be profitable, but they want their law firms to be profitable, too.

Deborah McMurray is a strategic marketing consultant to the legal industry and a former law firm marketing director. She can be reached at mcmurray@contentpilot.net.

Barbara Harrison Kaye is chief marketing officer at Thacher Proffitt & Wood in New York. A fellow of the college of Law Practice Management of the American Bar Association, she can be reached at bkaye@tpwlaw.com.

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