Managing Fiscal Fundamentals

[Last month, in Part One, the author introduced the overall challenge of fiscal management in a law firm, and explained key metrics for understanding cash flow, cash gaps and revenue (collected fee receipts).]

This article's explanation of key performance metrics for law firms continues with measures for productivity, pricing and profit margin. We'll conclude with a brief discussion on where to focus in addressing profitability concerns, plus a few general comments on the effective use of numerical results in the larger context of organizational management.

Productivity. Productivity is a second critical metric for successful firms. In order to measure productivity, prepare revenue comparisons on a full-time-equivalent fee earner basis.

Irrespective of the business model a law firm uses, the firm cannot be profitable if its fee earners do not generate adequate revenue per capita. That is so because compensation is the single largest expense in a law firm. The fee earners consume 62% of every dollar of collected fees. With administrative and support staff included, that metric increases to 77% of every dollar of collected fees. Measuring this is akin to measuring return on assets in most other businesses. Your people are a very mobile and easily perishable asset. How well they are recruited, developed and deployed is vital to the firm's bottom line.

Another useful productivity measure is revenue per fee earner compared against the same fee earners from the prior period. (Count only those fee earners employed for both periods.) Analogous to same-store sales in retail, this metric culls out growth and part-year startup or phase-out anomalies. This metric deserves wider use in the legal profession, since it tells a slightly different story about what is happening to the base business.

Productivity is determined by how hard people work (utilization or billable hours), how much they can charge for their services (pricing or billing rates) and how efficient they are in converting the value of time worked into cash (realization). You begin by managing the outcome, ie, collected fees. If that metric is not satisfactory, you examine the pricing, utilization and realization data.

Caution is advised when managing billable hours. Getting a requisite number of hours on the books is not the required outcome, collecting the requisite levels of fees is. All too often the author has observed hours-driven cultures falling short because the hours produced did not convey value to the client and ultimately did not produce fee receipts.

Even worse were the implications for client satisfaction and employee morale. The firm's need to generate billable hours is counter to the client's desire for value and efficiency. Clients perceive when a matter is being over-worked or over-staffed, and the result is lowered satisfaction. Since high client retention rates require very high client satisfaction, even a small decrease from 'very satisfied' to 'mostly satisfied' has profound adverse implications.

Concern about pressing associates for more hours is pervasive, particularly when the market is slowing or wages are high. But creating various scorecards illuminating the associates' deficiencies ignores the cause. Associates are already success driven (as lawyers tend to be), and they understand that high salaries include high expectations of hard work. Generational work ethic differences are not the problem either. What is needed is counseling at the partner level to develop associates and involve them in meaningful work, and then to push work out to them.

Pricing. Pricing is an art that must be practiced by all billing lawyers. Whether hourly rates, fixed fees, contingencies or other means are used to calculate the charge for services rendered, pricing requires discerning the value of the solution to the client and then getting the client to accept that valuation. Lawyers price best when they can see the value of a solution in the eyes of the client.

Pricing is also more successful if the lawyer prices services in a manner consistent with how the client's business is run. One lawyer for a major commercial real estate developer priced services on a square-foot basis. This helped the developer better account for his legal costs in advance, so he began to use this lawyer exclusively. The lawyer understood his own business and the developer's business sufficiently to make competitive pricing offers. Small projects probably did not cover their costs, but large projects were quite remunerative (not unlike the world of the developer) ' and the developer did mostly large projects.

Profit Margin. The last basic concept is profit margin. In law firms, profits are generally considered to be income per equity partner. That is not a precise economic definition, since partners also render billable services that would otherwise require the cost of another producer, thereby reducing profits. However, income per equity partner is an easily determined number and a metric that is readily available in the marketplace.

Addressing and Averting Profitability Problems

When there are concerns about the level or direction of a firm's profit margin, it is natural to start a cost control initiative. With respect to goods and services, managers already understand that cost control is an ongoing exercise in today's dynamic marketplace.

But law firms still commonly make the significant error of building in a high fixed cost of operations; it is far safer if a firm can arrange for large operational expenses to vary with revenues. Unfortunately, labor, occupancy and technology consume 87% of every fee dollar. Those costs are not easily changed in the short run (partly due to contractual obligations and partly due to the difficulty partners have in making radical and unfavorable personnel decisions). The remaining overhead is not all that variable either.

Nevertheless, the single most important cost initiative that law firms can undertake is to increase their flexibility in overhead. The place to start is the direct cost of producing revenues ' fee earner compensation. Labor costs are predominantly salary and deferred salary (bonuses implemented as an extra year-end paycheck). Controlling labor cost does not mean paying people less. It does mean having pay programs that can adjust to revenues in a way that does not require drastic measures. Further, it requires associate pay programs that are merit- and market-based rather than the monolithic lockstep system traditionally employed by law firms.

The number two cost is occupancy, followed closely by technology and marketing. Occupancy is a long-term commitment that could result in sticker shock when new terms are negotiated. One silver lining of a slowing economy can be a reduction in that pressure. As recently reported, however, some landlords are contemplating more aggressive lease terms for law firms to protect their own interests in the event a tenant falters.

Managing for Success: Keeping the Numbers in Perspective

The most successful law firms do many things well. They attract and retain the right people, are focused and productive, and obtain interesting clients and work. They also achieve strategic alignment of their clients, industries, geographic presence, practice specialties, and pricing, as well as operational alignment of their structure, governance, systems, culture and leadership. The key fiscal concepts and metrics discussed above provide an indirect way to quantify the success of your firm's management in these varied tasks.

Each law firm must determine the type of practice it wants and then what business model will be successful for that practice. Will the key profit driver be margin or leverage or productivity? The conventional wisdom states that you want to maximize all of the profit levers (rates, utilization, realization, margin and leverage). But we all know that an insurance defense firm must operate with a different business model than an emerging business corporate boutique; the former relies on productivity and leverage, the latter on high pricing with little leverage. Both can be successful. Both can fail. The challenge is to manage each to its appropriate business model.

Although managing by the numbers has a certain attraction, it is managing people that leads to change in the numbers. The hard part about managing is that you must be able to preserve relationships at the same time that you honestly and candidly counsel individuals on performance. These relationships include those between two people (mentors and mentees, supervisors and supervisees) as well as those among team members and peers. Managing people especially requires effective communication ' and voice-mail, electronic mail, memos and handwritten comments in the margins of work products will provide only a small fraction of what is necessary. Fortunately these challenging aspects of management can also be the most rewarding.

In your managerial application of fiscal fundamentals, use the numbers to isolate problems and issues. Look at the data in a variety of ways. Consider what outcomes you want; have a game plan before you go to your people, but be willing to alter your plan if appropriate. When you discuss what you've discovered, make sure that the facts are indeed accurate and that you have properly interpreted them. Get a dialogue underway early on as to how corrective action could be implemented. Support change efforts and make sure all concerned have needed resources and skills. Then follow up to encourage the successes and to help fine-tune when things go awry.

In sum, managing for success requires that you stay on top of how your firm is performing and recognize early warning signals that the key fiscal metrics can provide. Equally important, you must remain visible as a manager and attend to issues as soon as they arise.

James D. Cotterman is a principal with management consultants Altman Weil, Inc. in Newtown Square, PA. He advises clients on economic issues, mergers and acquisitions, compensation systems, governance and management. Having served for two editions as lead author and editor of the ABA-published book Compensation Plans for Law Firms, Jim is currently preparing the 4th edition. A licensed CPA and member of AICPA, Mr. Cotterman also holds Operations Management and MBA degrees from Syracuse University.

[Last month, in Part One, the author introduced the overall challenge of fiscal management in a law firm, and explained key metrics for understanding cash flow, cash gaps and revenue (collected fee receipts).]

This article's explanation of key performance metrics for law firms continues with measures for productivity, pricing and profit margin. We'll conclude with a brief discussion on where to focus in addressing profitability concerns, plus a few general comments on the effective use of numerical results in the larger context of organizational management.

Productivity. Productivity is a second critical metric for successful firms. In order to measure productivity, prepare revenue comparisons on a full-time-equivalent fee earner basis.

Irrespective of the business model a law firm uses, the firm cannot be profitable if its fee earners do not generate adequate revenue per capita. That is so because compensation is the single largest expense in a law firm. The fee earners consume 62% of every dollar of collected fees. With administrative and support staff included, that metric increases to 77% of every dollar of collected fees. Measuring this is akin to measuring return on assets in most other businesses. Your people are a very mobile and easily perishable asset. How well they are recruited, developed and deployed is vital to the firm's bottom line.

Another useful productivity measure is revenue per fee earner compared against the same fee earners from the prior period. (Count only those fee earners employed for both periods.) Analogous to same-store sales in retail, this metric culls out growth and part-year startup or phase-out anomalies. This metric deserves wider use in the legal profession, since it tells a slightly different story about what is happening to the base business.

Productivity is determined by how hard people work (utilization or billable hours), how much they can charge for their services (pricing or billing rates) and how efficient they are in converting the value of time worked into cash (realization). You begin by managing the outcome, ie, collected fees. If that metric is not satisfactory, you examine the pricing, utilization and realization data.

Caution is advised when managing billable hours. Getting a requisite number of hours on the books is not the required outcome, collecting the requisite levels of fees is. All too often the author has observed hours-driven cultures falling short because the hours produced did not convey value to the client and ultimately did not produce fee receipts.

Even worse were the implications for client satisfaction and employee morale. The firm's need to generate billable hours is counter to the client's desire for value and efficiency. Clients perceive when a matter is being over-worked or over-staffed, and the result is lowered satisfaction. Since high client retention rates require very high client satisfaction, even a small decrease from 'very satisfied' to 'mostly satisfied' has profound adverse implications.

Concern about pressing associates for more hours is pervasive, particularly when the market is slowing or wages are high. But creating various scorecards illuminating the associates' deficiencies ignores the cause. Associates are already success driven (as lawyers tend to be), and they understand that high salaries include high expectations of hard work. Generational work ethic differences are not the problem either. What is needed is counseling at the partner level to develop associates and involve them in meaningful work, and then to push work out to them.

Pricing. Pricing is an art that must be practiced by all billing lawyers. Whether hourly rates, fixed fees, contingencies or other means are used to calculate the charge for services rendered, pricing requires discerning the value of the solution to the client and then getting the client to accept that valuation. Lawyers price best when they can see the value of a solution in the eyes of the client.

Pricing is also more successful if the lawyer prices services in a manner consistent with how the client's business is run. One lawyer for a major commercial real estate developer priced services on a square-foot basis. This helped the developer better account for his legal costs in advance, so he began to use this lawyer exclusively. The lawyer understood his own business and the developer's business sufficiently to make competitive pricing offers. Small projects probably did not cover their costs, but large projects were quite remunerative (not unlike the world of the developer) ' and the developer did mostly large projects.

Profit Margin. The last basic concept is profit margin. In law firms, profits are generally considered to be income per equity partner. That is not a precise economic definition, since partners also render billable services that would otherwise require the cost of another producer, thereby reducing profits. However, income per equity partner is an easily determined number and a metric that is readily available in the marketplace.

Addressing and Averting Profitability Problems

When there are concerns about the level or direction of a firm's profit margin, it is natural to start a cost control initiative. With respect to goods and services, managers already understand that cost control is an ongoing exercise in today's dynamic marketplace.

But law firms still commonly make the significant error of building in a high fixed cost of operations; it is far safer if a firm can arrange for large operational expenses to vary with revenues. Unfortunately, labor, occupancy and technology consume 87% of every fee dollar. Those costs are not easily changed in the short run (partly due to contractual obligations and partly due to the difficulty partners have in making radical and unfavorable personnel decisions). The remaining overhead is not all that variable either.

Nevertheless, the single most important cost initiative that law firms can undertake is to increase their flexibility in overhead. The place to start is the direct cost of producing revenues ' fee earner compensation. Labor costs are predominantly salary and deferred salary (bonuses implemented as an extra year-end paycheck). Controlling labor cost does not mean paying people less. It does mean having pay programs that can adjust to revenues in a way that does not require drastic measures. Further, it requires associate pay programs that are merit- and market-based rather than the monolithic lockstep system traditionally employed by law firms.

The number two cost is occupancy, followed closely by technology and marketing. Occupancy is a long-term commitment that could result in sticker shock when new terms are negotiated. One silver lining of a slowing economy can be a reduction in that pressure. As recently reported, however, some landlords are contemplating more aggressive lease terms for law firms to protect their own interests in the event a tenant falters.

Managing for Success: Keeping the Numbers in Perspective

The most successful law firms do many things well. They attract and retain the right people, are focused and productive, and obtain interesting clients and work. They also achieve strategic alignment of their clients, industries, geographic presence, practice specialties, and pricing, as well as operational alignment of their structure, governance, systems, culture and leadership. The key fiscal concepts and metrics discussed above provide an indirect way to quantify the success of your firm's management in these varied tasks.

Each law firm must determine the type of practice it wants and then what business model will be successful for that practice. Will the key profit driver be margin or leverage or productivity? The conventional wisdom states that you want to maximize all of the profit levers (rates, utilization, realization, margin and leverage). But we all know that an insurance defense firm must operate with a different business model than an emerging business corporate boutique; the former relies on productivity and leverage, the latter on high pricing with little leverage. Both can be successful. Both can fail. The challenge is to manage each to its appropriate business model.

Although managing by the numbers has a certain attraction, it is managing people that leads to change in the numbers. The hard part about managing is that you must be able to preserve relationships at the same time that you honestly and candidly counsel individuals on performance. These relationships include those between two people (mentors and mentees, supervisors and supervisees) as well as those among team members and peers. Managing people especially requires effective communication ' and voice-mail, electronic mail, memos and handwritten comments in the margins of work products will provide only a small fraction of what is necessary. Fortunately these challenging aspects of management can also be the most rewarding.

In your managerial application of fiscal fundamentals, use the numbers to isolate problems and issues. Look at the data in a variety of ways. Consider what outcomes you want; have a game plan before you go to your people, but be willing to alter your plan if appropriate. When you discuss what you've discovered, make sure that the facts are indeed accurate and that you have properly interpreted them. Get a dialogue underway early on as to how corrective action could be implemented. Support change efforts and make sure all concerned have needed resources and skills. Then follow up to encourage the successes and to help fine-tune when things go awry.

In sum, managing for success requires that you stay on top of how your firm is performing and recognize early warning signals that the key fiscal metrics can provide. Equally important, you must remain visible as a manager and attend to issues as soon as they arise.

James D. Cotterman is a principal with management consultants Altman Weil, Inc. in Newtown Square, PA. He advises clients on economic issues, mergers and acquisitions, compensation systems, governance and management. Having served for two editions as lead author and editor of the ABA-published book Compensation Plans for Law Firms, Jim is currently preparing the 4th edition. A licensed CPA and member of AICPA, Mr. Cotterman also holds Operations Management and MBA degrees from Syracuse University.