Matter Profitability: When Metrics Mislead

Law firms often mislead themselves when they draw conclusions about profitability based on individual metrics without adequately considering how the metrics interrelate. In particular, isolated improvement of one or more measures may impair rather than improve the net contribution of a matter and therefore partner and firm profitability.

Profitability Factors

The well-known DuPont formula to determine return on equity was adapted by David Maister for professional services firms in his 1993 book Managing the Professional Service Firm. In Maister's formula:

PPP = Margin x Rate x
Billable Hours per timekeeper x
Leverage

Note that “Rate” in this formula means the effective rate, which comprises two components that firms typically measure: standard billing rates and realization percentage. Whether realization is based on fees that are billed or collected depends on the firm's revenue accounting convention.

A growing number of firms have focused on “matter profitability” in the last few years. To the astonishment of many, they found when combining the metrics in Maister's formula that many of their past beliefs about profitability were shattered. The matter with the highest collections, the practice area with the highest rates, and the location with the greatest billable hours per lawyer sometimes proved less profitable than formerly believed.

To better understand these counterintuitive results, let's consider a series of examples that explore the links between profitability and Maister's formula.

Allocating Expenses

One of the first steps to implementing profitability is to allocate expenses to timekeepers. Reaching consensus within a firm on how to allocate costs to timekeepers typically entails not only careful analysis but a great deal of negotiation. We will simply assume that the firm has arrived at some reasonable method of cost allocation.

Note: Firms often debate the relative merits of including or excluding partner/shareholder compensation in the cost allocation assumption. There are strong arguments on both sides, but the author believes that the relative profitability between matters is virtually the same under either method.

For simplicity, this article will assume that the firm is a LLC where shareholders are paid through the payroll system; therefore shareholder compensation is known with certainty. Please contact the author if you would like copies of these tables prepared on a contribution basis (ie, with partner/shareholder income excluded). Making profitability comparisons on a contribution basis requires a number of calculation changes, one of which is that the results be normalized to show return per partner hour.

[IMGCAP(1)] (Table 1)

This example assumes that the associate's compensation and benefits total $130,000 and that the allocated share of overhead expenses is a weighted allocation of approximately 75% of the shareholder's. Shareholder compensation is $400,000. Actual compensation paid may be greater, but the example assumes that any excess relates to compensation paid for activities other than as a working lawyer.

Once expenses have been allocated to the timekeepers, the next step is to calculate the costs on a per hour basis. Dividing total expenses by the actual hours worked, the associate's cost is $128.95 per hour, and the shareholder's fully loaded cost as a working lawyer is $343.75 per hour.

Comparing Matter Profitability

With the hourly costs determined, we will now consider three different scenarios for a single matter.

[IMGCAP(2)] (Scenario 1)

In Scenario 1, the associate works and collects 500 hours at a standard billing rate of $175, and the shareholder works and collects 250 hours at a standard billing rate of $300. Assuming an overall collection realization of 94%, the associate will collect $82,250 while the shareholder collects $70,500.

One of the fundamental bases of accounting is the matching principle, which holds that expenses related to revenue should be recognized at the time that the revenue is recognized. (This basic principle applies regardless of the accounting method used.)

Costs therefore are calculated as the hours collected multiplied by the cost per hour from Table 1. Subtracting each timekeeper's cost from his/her revenue results in that timekeeper's contribution. Combining the contribution of all timekeepers yields the overall net contribution. In scenario 1, the net contribution for the matter after shareholder compensation is $2,339.

In Scenario 2 we assume that the shareholder works 100 fewer hours than in Scenario 1. As the associate is less experienced, he works an additional 150 hours to provide the same quality of legal service that it would have taken the partner 100 hours to perform. (Obviously this 1.5-to-1 conversion factor is a simplification, but comparison requires some way to hold quality constant.)

[IMGCAP(3)] (Scenario 2)

The billing rates for each timekeeper remains unchanged from scenario 1, but the rate realization has now dropped to 92%. The per hour cost rates remain the same. Using the same calculations as in Scenario 1, Scenario 2 results in a net contribution of $10,672.

[IMGCAP(4)] (Scenario 3)

In Scenario 3, the shareholder records 100 more hours than in Scenario 1 (perhaps because s/he is being pressured to achieve higher billable hours). Maintaining the quality relationship as in the first two scenarios, the associate works 150 fewer hours in this scenario. Realization in scenario 3 increases to 96%; net contribution after shareholder compensation is now a loss of $5,844.

Table 2 summarizes and contrasts the key performance indices of the three scenarios.

[IMGCAP(5)] (Table 2)

Insights for Matter Profitability

While the exact outcomes of the above illustrations are of course dependant on their detailed assumptions, we can derive some general lessons from their variability.

Size of Matter

The first traditional belief these scenarios challenge is that the more a firm charges a client for the same output, the greater the net contribution. For those who doubt that this belief is widespread, you need only consider the number of firms that reinforce this principle by paying higher compensation to the shareholder with the larger book of business.

As the summary in Table 2 illustrates, however, lower collections on a matter can result in a higher net contribution. This insight has some firms reconsidering the measures they employ for shareholder compensation purposes.

Client Pressure on Fees

Firms often perceive client fee pressures as unfair. What many informed clients are saying, however, is what the three scenarios illustrate. Clients know that they will obtain excellent quality legal services from most firms; what they are asking for is to achieve the best value as well. Scenario 2 gave the client the best value because it provided the same quality services at a lower fee. In this case, moreover, the best value to the client also resulted in the greatest net contribution for the matter; so perhaps your clients are not asking for the impossible after all!

Rates

The usual assumption is that higher rates drive greater contributions. While that logic is true for an individual timekeeper, it may not hold true when judging the interaction among timekeepers working together on a matter. Recall that the billing rates for individual timekeepers remained the same; the change in the effective rates was due to the mix of timekeepers working on the matter. The scenarios demonstrate that the highest effective billing rate and collection rate may not result in the greatest net contribution.

Realization

Similar to rates, the usual assumption is that the greater the realization, the greater the net contribution. That's true if you hold all the other profitability drivers constant, but in these particular scenarios, the one with the lowest realization actually resulted in the greatest net contribution.

Billable Hours per Timekeeper (Utilization)

Maximizing the billable hours per timekeeper is clearly one of the key drivers of profitability and always has a strong correlation to firm profits, assuming that timekeepers' efforts are directed to profitable work.

Another key to utilization, however, is that the right person with the right skill mix and billing rate does the work. Partners trying to achieve their own billable hour targets doing work that could be done more cost effectively by associates or paralegals are not directing their efforts to their most profitable activities. Focusing on attracting new work or maintaining relationships with existing clients may result in greater long-term profits to the firm.

Leverage

There is a general assumption that clients do not want their matters staffed by less experienced lawyers because they would likely spend more time doing the same work than experienced lawyers. Insofar as extra time can in fact compensate for lesser experience, these scenarios demonstrate that a client may receive better value by having the work done by more junior timekeepers.

This is not to suggest that all a firm need do to improve profit is increase leverage; there is a limit to which any matter can be leveraged. Also, a review of the Am Law 200 firms shows that the relationship between leverage and profit per partner, while positive, is not very strong on its own.

The real message that these scenarios present is that a matter with higher leverage will result in a higher return assuming no adjustment of the other metrics on an individual lawyer basis.

Firms may wish to consider the typical policy of a single standard billing per timekeeper regardless of the service model (ie, leverage). For example, if your client insists that you do not utilize junior lawyers for their work, you in turn should request a higher billing rate to offset the otherwise reduced contribution. Of course, the opposite is also true: if clients are willing to accept greater use of juniors, they will benefit from a lower effective rate, and perhaps the firm may also be willing to further discount from the standard rates. The negotiations can become a two-way street as this relationship is explained to your clients.

Net Income Profit Margin

This is one of the most misused metrics of all. Net Income is defined as revenue less expenses, excluding amounts paid to shareholders. When partner/shareholder compensation is not included in the margin calculation, lower leverage actually translates to a higher margin, since the revenue is balanced against a lower amount of associate-paralegal compensation. Scenario 3 illustrates this point, as it has the lowest leverage and the highest margin ' but also the lowest net contribution.

Conclusion

So when are the old reliable metrics of Rates, Billable Hours, Leverage and Margin not so reliable? The answer is when they are viewed in isolation and used to draw conclusions beyond the limitations of what they faithfully measure.

Profits are equal to revenues less expenses. Metrics that measure only the revenue side do not give the firm a complete picture of overall profitability. A firm needs to tackle the cost side ' with a reasonable and agreed-on framework for allocating costs ' and then develop measures of profitability at the matter level that include all the metrics discussed here.

Illustrating the interrelationships of the metrics on a single report (benchmarked between largest client, practice areas, etc.) will enable your lawyers to better understand the actions they should take to improve profitability. With the interplay and combined results of all the measures made visible, firm management can make better strategic decisions as to the types of work it wishes to take on and how to effectively staff and price matters for optimal firm profitability and value to the client.

Law firms often mislead themselves when they draw conclusions about profitability based on individual metrics without adequately considering how the metrics interrelate. In particular, isolated improvement of one or more measures may impair rather than improve the net contribution of a matter and therefore partner and firm profitability.

Profitability Factors

The well-known DuPont formula to determine return on equity was adapted by David Maister for professional services firms in his 1993 book Managing the Professional Service Firm. In Maister's formula:

PPP = Margin x Rate x
Billable Hours per timekeeper x
Leverage

Note that “Rate” in this formula means the effective rate, which comprises two components that firms typically measure: standard billing rates and realization percentage. Whether realization is based on fees that are billed or collected depends on the firm's revenue accounting convention.

A growing number of firms have focused on “matter profitability” in the last few years. To the astonishment of many, they found when combining the metrics in Maister's formula that many of their past beliefs about profitability were shattered. The matter with the highest collections, the practice area with the highest rates, and the location with the greatest billable hours per lawyer sometimes proved less profitable than formerly believed.

To better understand these counterintuitive results, let's consider a series of examples that explore the links between profitability and Maister's formula.

Allocating Expenses

One of the first steps to implementing profitability is to allocate expenses to timekeepers. Reaching consensus within a firm on how to allocate costs to timekeepers typically entails not only careful analysis but a great deal of negotiation. We will simply assume that the firm has arrived at some reasonable method of cost allocation.

Note: Firms often debate the relative merits of including or excluding partner/shareholder compensation in the cost allocation assumption. There are strong arguments on both sides, but the author believes that the relative profitability between matters is virtually the same under either method.

For simplicity, this article will assume that the firm is a LLC where shareholders are paid through the payroll system; therefore shareholder compensation is known with certainty. Please contact the author if you would like copies of these tables prepared on a contribution basis (ie, with partner/shareholder income excluded). Making profitability comparisons on a contribution basis requires a number of calculation changes, one of which is that the results be normalized to show return per partner hour.

[IMGCAP(1)] (Table 1)

This example assumes that the associate's compensation and benefits total $130,000 and that the allocated share of overhead expenses is a weighted allocation of approximately 75% of the shareholder's. Shareholder compensation is $400,000. Actual compensation paid may be greater, but the example assumes that any excess relates to compensation paid for activities other than as a working lawyer.

Once expenses have been allocated to the timekeepers, the next step is to calculate the costs on a per hour basis. Dividing total expenses by the actual hours worked, the associate's cost is $128.95 per hour, and the shareholder's fully loaded cost as a working lawyer is $343.75 per hour.

Comparing Matter Profitability

With the hourly costs determined, we will now consider three different scenarios for a single matter.

[IMGCAP(2)] (Scenario 1)

In Scenario 1, the associate works and collects 500 hours at a standard billing rate of $175, and the shareholder works and collects 250 hours at a standard billing rate of $300. Assuming an overall collection realization of 94%, the associate will collect $82,250 while the shareholder collects $70,500.

One of the fundamental bases of accounting is the matching principle, which holds that expenses related to revenue should be recognized at the time that the revenue is recognized. (This basic principle applies regardless of the accounting method used.)

Costs therefore are calculated as the hours collected multiplied by the cost per hour from Table 1. Subtracting each timekeeper's cost from his/her revenue results in that timekeeper's contribution. Combining the contribution of all timekeepers yields the overall net contribution. In scenario 1, the net contribution for the matter after shareholder compensation is $2,339.

In Scenario 2 we assume that the shareholder works 100 fewer hours than in Scenario 1. As the associate is less experienced, he works an additional 150 hours to provide the same quality of legal service that it would have taken the partner 100 hours to perform. (Obviously this 1.5-to-1 conversion factor is a simplification, but comparison requires some way to hold quality constant.)

[IMGCAP(3)] (Scenario 2)

The billing rates for each timekeeper remains unchanged from scenario 1, but the rate realization has now dropped to 92%. The per hour cost rates remain the same. Using the same calculations as in Scenario 1, Scenario 2 results in a net contribution of $10,672.

[IMGCAP(4)] (Scenario 3)

In Scenario 3, the shareholder records 100 more hours than in Scenario 1 (perhaps because s/he is being pressured to achieve higher billable hours). Maintaining the quality relationship as in the first two scenarios, the associate works 150 fewer hours in this scenario. Realization in scenario 3 increases to 96%; net contribution after shareholder compensation is now a loss of $5,844.

Table 2 summarizes and contrasts the key performance indices of the three scenarios.

[IMGCAP(5)] (Table 2)

Insights for Matter Profitability

While the exact outcomes of the above illustrations are of course dependant on their detailed assumptions, we can derive some general lessons from their variability.

Size of Matter

The first traditional belief these scenarios challenge is that the more a firm charges a client for the same output, the greater the net contribution. For those who doubt that this belief is widespread, you need only consider the number of firms that reinforce this principle by paying higher compensation to the shareholder with the larger book of business.

As the summary in Table 2 illustrates, however, lower collections on a matter can result in a higher net contribution. This insight has some firms reconsidering the measures they employ for shareholder compensation purposes.

Client Pressure on Fees

Firms often perceive client fee pressures as unfair. What many informed clients are saying, however, is what the three scenarios illustrate. Clients know that they will obtain excellent quality legal services from most firms; what they are asking for is to achieve the best value as well. Scenario 2 gave the client the best value because it provided the same quality services at a lower fee. In this case, moreover, the best value to the client also resulted in the greatest net contribution for the matter; so perhaps your clients are not asking for the impossible after all!

Rates

The usual assumption is that higher rates drive greater contributions. While that logic is true for an individual timekeeper, it may not hold true when judging the interaction among timekeepers working together on a matter. Recall that the billing rates for individual timekeepers remained the same; the change in the effective rates was due to the mix of timekeepers working on the matter. The scenarios demonstrate that the highest effective billing rate and collection rate may not result in the greatest net contribution.

Realization

Similar to rates, the usual assumption is that the greater the realization, the greater the net contribution. That's true if you hold all the other profitability drivers constant, but in these particular scenarios, the one with the lowest realization actually resulted in the greatest net contribution.

Billable Hours per Timekeeper (Utilization)

Maximizing the billable hours per timekeeper is clearly one of the key drivers of profitability and always has a strong correlation to firm profits, assuming that timekeepers' efforts are directed to profitable work.

Another key to utilization, however, is that the right person with the right skill mix and billing rate does the work. Partners trying to achieve their own billable hour targets doing work that could be done more cost effectively by associates or paralegals are not directing their efforts to their most profitable activities. Focusing on attracting new work or maintaining relationships with existing clients may result in greater long-term profits to the firm.

Leverage

There is a general assumption that clients do not want their matters staffed by less experienced lawyers because they would likely spend more time doing the same work than experienced lawyers. Insofar as extra time can in fact compensate for lesser experience, these scenarios demonstrate that a client may receive better value by having the work done by more junior timekeepers.

This is not to suggest that all a firm need do to improve profit is increase leverage; there is a limit to which any matter can be leveraged. Also, a review of the Am Law 200 firms shows that the relationship between leverage and profit per partner, while positive, is not very strong on its own.

The real message that these scenarios present is that a matter with higher leverage will result in a higher return assuming no adjustment of the other metrics on an individual lawyer basis.

Firms may wish to consider the typical policy of a single standard billing per timekeeper regardless of the service model (ie, leverage). For example, if your client insists that you do not utilize junior lawyers for their work, you in turn should request a higher billing rate to offset the otherwise reduced contribution. Of course, the opposite is also true: if clients are willing to accept greater use of juniors, they will benefit from a lower effective rate, and perhaps the firm may also be willing to further discount from the standard rates. The negotiations can become a two-way street as this relationship is explained to your clients.

Net Income Profit Margin

This is one of the most misused metrics of all. Net Income is defined as revenue less expenses, excluding amounts paid to shareholders. When partner/shareholder compensation is not included in the margin calculation, lower leverage actually translates to a higher margin, since the revenue is balanced against a lower amount of associate-paralegal compensation. Scenario 3 illustrates this point, as it has the lowest leverage and the highest margin ' but also the lowest net contribution.

Conclusion

So when are the old reliable metrics of Rates, Billable Hours, Leverage and Margin not so reliable? The answer is when they are viewed in isolation and used to draw conclusions beyond the limitations of what they faithfully measure.

Profits are equal to revenues less expenses. Metrics that measure only the revenue side do not give the firm a complete picture of overall profitability. A firm needs to tackle the cost side ' with a reasonable and agreed-on framework for allocating costs ' and then develop measures of profitability at the matter level that include all the metrics discussed here.

Illustrating the interrelationships of the metrics on a single report (benchmarked between largest client, practice areas, etc.) will enable your lawyers to better understand the actions they should take to improve profitability. With the interplay and combined results of all the measures made visible, firm management can make better strategic decisions as to the types of work it wishes to take on and how to effectively staff and price matters for optimal firm profitability and value to the client.