Costs and Credits: Contrasting Views

[Editor's Note: A&FP reviewers rated Ed Wesemann's feature article from "much to agree with" to "excellent" to "super," but three Board members had differing views on specific points. The following exchange between Ed, John Alber and Jim Davidson is followed by a comment received later from Ed Poll. Yet another perspective on the question of associate profitability is being formulated by another discussant as an upcoming article.]

Using Empirical Data

John Alber [Technology Partner, Bryan Cave LLP]: I agree with Ed Wesemann that firms should not let inflexible cost allocation decisions (including those built into inflexible off-the-shelf software products) interfere with common sense and good judgment. Firms have to be careful in setting measures of any kind. One has to look only as far as that old warhorse realization to see the perils of slavish adherence to a measure at the expense of good sense. Some firms use realization as a measure of a practice's success, yet do not add good-sense checks and balances (eg, testing whether the rates on which realization is founded are sufficient to produce profits). As a consequence, these firms often encourage high-realization but low profit practices.

Ed's article has an implicit suggestion, however, that firms ought to steer clear of data warehouses and the like, lest they make bad cost allocation decisions. Law firms have long run their businesses on a kind of “Kentucky windage” ' a mix of lore, rumor and intuition. When large firms had a few dozen, or even a couple hundred, lawyers that may have worked. But we now have billion-dollar businesses and fierce competition, global competition. Lore and intuition have led more than a few firms to dissolution. Law is now a business that needs the disciplines that most of our clients ' including many partner-owned service businesses that operate remarkably like law firms ' long ago discovered. Among those disciplines is gathering business intelligence on the performance of the firm. Measuring profitability is fundamental to such efforts. And to measure profits, one must measure costs.

As any student of cost accounting will quickly discover, there are many ways to allocate costs, and the choices made in allocating those costs are critical. I recommend, and I'm sure Ed would agree, that firms should get the best possible advice in allocating those costs. My own firm sought out the dean of one of our nation's leading business schools, and a recognized cost accounting expert, to help us with our choices. We also sought out as our data-warehousing consultant a company with deep finance acumen in the service sector.

In vetting our cost allocation decisions, we examined a number of scenarios and rejected allocation decisions that produced undesirable results. I can't emphasize how careful that process was and how involved our firm's management was in the decision-making. As a consequence, the result is something we are very comfortable with.

Ed Wesemann: I don't mean to suggest that law firms should avoid using data warehousing software. That's a bit like saying that Mothers Against Drunk Driving is opposed to automobiles. I'm all for data warehousing and anything else that provides empirical data. What I'm opposed to is law firms mindlessly making decisions based on it.

[Editor's Note: For examples of just how mindful a firm can be about applying empirical data, see John Alber's November A&FP article on data warehousing and his article on business intelligence in our August-September special edition.]

Allocating Overhead

John Alber: Also, Ed argues for never allocating overhead to non-owner fee earners because those fee earners do not control decisions concerning overhead. That approach, too, can lead to “weird” results. For example, all firms have practice areas that are highly leveraged but that also discount heavily. Without allocating overhead to the fee earners in such practice areas, firms get a distorted picture of the economic realities of such practices. That can lead to bad pricing decisions, or any number of other bad decisions.

From our vantage, it made sense to allocate some overhead to every fee earner. But we did not do so on a per-capita basis. Rather, we made judgments that attempted to relate allocations to the earning potential of the fee earners. And this is accepted practice in many service sector businesses. The result is, we think, a balanced picture of our various practices.

Ed Wesemann: With respect to applying overhead to associates, I stand by the article's recommendation. In a perfect world a firm could pick and choose what portions of what cost go to whom. But then you come up with a result that none of the partners trust.

Cost of Associates

Joe Danowsky: Are there actually well-run law firms that hire young associates and then fire them because it turns out they cost too much?

Ed Wesemann: I agree that a well-run law firm would not fire associates because they cost too much. This is why I titled one of my books, The First Great Myth of Legal Management is That It Exists. Every time the economy takes a dip we see law firms lay off associates because the work they should be doing profitably is being sucked up by the partners who are doing it unprofitably.

If a firm is losing money on its young associates, why doesn't it just stop hiring them? We hear such reasons as: “When we hire associates from law school, we can train them correctly.” Except that law firms lose more than half their law school hires in the first three years, and only about 10% make it through to partnership consideration. Law firms may have convinced themselves that their training is wonderful, but feedback from associates and any honest appraisal tells you that most firms have very little real training. You can't provide significant training while requiring 1800 billable hours.

Plus, the recent NALP study shows that the attrition rate among lateral associates is lower than law school hires. Further, the study shows that the majority of associates being promoted to partner in large law firms entered their firms as laterals, most in mid-level.

So, why do firms hire young associates if they're losing money on them? The answer is because it is an urban legend. Firms don't lose money on young associates. They just load them up with overhead so the partners look more profitable.

Joe Danowsky: Ed, are you perhaps viewing young associates as profitable because you're looking only at their operating expenses, while others who say they're not profitable are also counting recruiting and training expenses?

Ed Wesemann: Recruiting is an overhead expense by any cost accounting protocol. If a firm runs a big summer program and hires one associate, does it load the whole cost of the program on that one associate? Okay, throw in 25% of salary for recruiting costs. (That's what a headhunter would charge; if it costs a firm more, they should be outsourcing.) That's somewhere between $25,000 and $30,000 ' which comes to about $15 per hour if you amortize it all in the first year. And training … what training? How many non-billable hours do associates spend in training during their first 3 years? The answer, at least according to the associate interviews we do and the Am Law mid-level survey, is virtually none. Sorry, not buying it. There's an old joke about a guy who goes to the doctor and says, “It hurts every time I do this.” The doctor says, “Okay, don't do that.” If you really think your firm is losing money on young associates, stop hiring them.

Origination Credits

Jim Davidson [Consultant; Dir. of Finance (Ret.), Holland & Hart]: The final “basic concept” in Ed's article raises an elephant-in-the-room issue from a practical standpoint. The firm has to figure out how to determine originations.

New business coming into a firm is often not easily assignable to an individual or practice group. Most new business comes from existing clients or relatives of existing clients. The original originator of that client may have long since forgotten who the client is, or be no longer active with the firm. The work likely came in not by the specific effort of one or a few people, but by the overall relationship of a number of people in different practice areas who are involved in providing service to that client. Trying to sort all that out for a profitability calculation is extremely subjective and open to endless second guessing by all involved, especially those who in their minds were unfairly denied credit.

The latter group will be vocal far beyond its size, possibly killing the whole concept. Unfortunately it's hard to achieve a strong up-front consensus on how originations are determined.

Ed Wesemann: Dead on. I have never seen a firm that has the definitive system for measuring originations. At best it is a compromise that is equally offensive to everyone but the best that could get through the consensus process. But this further makes the case that measuring the profitability of practice groups, offices or individuals is at best a black science; such measures cannot be the absolute basis of decision making without the exercise of common sense.

Ed Poll (Coach & Consultant to lawyers and law firms): Ed Wesemann's article begins by saying that law firms now make decisions that are “supported by the numbers but intuitively seem wrong.” This takes me back many years to my experience in the food processing business, serving supermarkets. Buyers who grew up in the industry were still making decisions based on experience and intuition. When they retired, however, the younger buyers who took over no longer walked the aisles; there were too many stores and too many aisles! Instead they began making decisions based on computer printouts that were then newly available. Often these number-based decisions were wrong. For example, the new owners dropped many slower-moving or less profitable items, without realizing that those were the very products that retained customers who wanted a one-stop shopping experience.

While I therefore agree that numbers should not be the sole criterion in the decision-making process of running a law firm, I don't share the article's view on overhead allocation. Overhead may “belong” to the owners, but I believe it must be attributable to all fee earners, including non-owners. Without allocation ' whether per capita, pro rata based on billable rate, or by some other method ' one doesn't truly know what individual lawyers are contributing to firm profit.

Profit isn't everything. Investment in associates is appropriate. But that doesn't detract from the need to know what each lawyer contributes to the firm, as part of the evaluation process for that lawyer.

With regard to recruiting and training costs for associates: recruiting costs vary, but all lawyers should have training and education costs attributed to them. Without additional education, lawyers fail to stay at the top of their craft. Educating seasoned lawyers may in fact be more costly than educating associates.

[Editor's Note: A&FP reviewers rated Ed Wesemann's feature article from "much to agree with" to "excellent" to "super," but three Board members had differing views on specific points. The following exchange between Ed, John Alber and Jim Davidson is followed by a comment received later from Ed Poll. Yet another perspective on the question of associate profitability is being formulated by another discussant as an upcoming article.]

Using Empirical Data

John Alber [Technology Partner, Bryan Cave LLP]: I agree with Ed Wesemann that firms should not let inflexible cost allocation decisions (including those built into inflexible off-the-shelf software products) interfere with common sense and good judgment. Firms have to be careful in setting measures of any kind. One has to look only as far as that old warhorse realization to see the perils of slavish adherence to a measure at the expense of good sense. Some firms use realization as a measure of a practice's success, yet do not add good-sense checks and balances (eg, testing whether the rates on which realization is founded are sufficient to produce profits). As a consequence, these firms often encourage high-realization but low profit practices.

Ed's article has an implicit suggestion, however, that firms ought to steer clear of data warehouses and the like, lest they make bad cost allocation decisions. Law firms have long run their businesses on a kind of “Kentucky windage” ' a mix of lore, rumor and intuition. When large firms had a few dozen, or even a couple hundred, lawyers that may have worked. But we now have billion-dollar businesses and fierce competition, global competition. Lore and intuition have led more than a few firms to dissolution. Law is now a business that needs the disciplines that most of our clients ' including many partner-owned service businesses that operate remarkably like law firms ' long ago discovered. Among those disciplines is gathering business intelligence on the performance of the firm. Measuring profitability is fundamental to such efforts. And to measure profits, one must measure costs.

As any student of cost accounting will quickly discover, there are many ways to allocate costs, and the choices made in allocating those costs are critical. I recommend, and I'm sure Ed would agree, that firms should get the best possible advice in allocating those costs. My own firm sought out the dean of one of our nation's leading business schools, and a recognized cost accounting expert, to help us with our choices. We also sought out as our data-warehousing consultant a company with deep finance acumen in the service sector.

In vetting our cost allocation decisions, we examined a number of scenarios and rejected allocation decisions that produced undesirable results. I can't emphasize how careful that process was and how involved our firm's management was in the decision-making. As a consequence, the result is something we are very comfortable with.

Ed Wesemann: I don't mean to suggest that law firms should avoid using data warehousing software. That's a bit like saying that Mothers Against Drunk Driving is opposed to automobiles. I'm all for data warehousing and anything else that provides empirical data. What I'm opposed to is law firms mindlessly making decisions based on it.

[Editor's Note: For examples of just how mindful a firm can be about applying empirical data, see John Alber's November A&FP article on data warehousing and his article on business intelligence in our August-September special edition.]

Allocating Overhead

John Alber: Also, Ed argues for never allocating overhead to non-owner fee earners because those fee earners do not control decisions concerning overhead. That approach, too, can lead to “weird” results. For example, all firms have practice areas that are highly leveraged but that also discount heavily. Without allocating overhead to the fee earners in such practice areas, firms get a distorted picture of the economic realities of such practices. That can lead to bad pricing decisions, or any number of other bad decisions.

From our vantage, it made sense to allocate some overhead to every fee earner. But we did not do so on a per-capita basis. Rather, we made judgments that attempted to relate allocations to the earning potential of the fee earners. And this is accepted practice in many service sector businesses. The result is, we think, a balanced picture of our various practices.

Ed Wesemann: With respect to applying overhead to associates, I stand by the article's recommendation. In a perfect world a firm could pick and choose what portions of what cost go to whom. But then you come up with a result that none of the partners trust.

Cost of Associates

Joe Danowsky: Are there actually well-run law firms that hire young associates and then fire them because it turns out they cost too much?

Ed Wesemann: I agree that a well-run law firm would not fire associates because they cost too much. This is why I titled one of my books, The First Great Myth of Legal Management is That It Exists. Every time the economy takes a dip we see law firms lay off associates because the work they should be doing profitably is being sucked up by the partners who are doing it unprofitably.

If a firm is losing money on its young associates, why doesn't it just stop hiring them? We hear such reasons as: “When we hire associates from law school, we can train them correctly.” Except that law firms lose more than half their law school hires in the first three years, and only about 10% make it through to partnership consideration. Law firms may have convinced themselves that their training is wonderful, but feedback from associates and any honest appraisal tells you that most firms have very little real training. You can't provide significant training while requiring 1800 billable hours.

Plus, the recent NALP study shows that the attrition rate among lateral associates is lower than law school hires. Further, the study shows that the majority of associates being promoted to partner in large law firms entered their firms as laterals, most in mid-level.

So, why do firms hire young associates if they're losing money on them? The answer is because it is an urban legend. Firms don't lose money on young associates. They just load them up with overhead so the partners look more profitable.

Joe Danowsky: Ed, are you perhaps viewing young associates as profitable because you're looking only at their operating expenses, while others who say they're not profitable are also counting recruiting and training expenses?

Ed Wesemann: Recruiting is an overhead expense by any cost accounting protocol. If a firm runs a big summer program and hires one associate, does it load the whole cost of the program on that one associate? Okay, throw in 25% of salary for recruiting costs. (That's what a headhunter would charge; if it costs a firm more, they should be outsourcing.) That's somewhere between $25,000 and $30,000 ' which comes to about $15 per hour if you amortize it all in the first year. And training … what training? How many non-billable hours do associates spend in training during their first 3 years? The answer, at least according to the associate interviews we do and the Am Law mid-level survey, is virtually none. Sorry, not buying it. There's an old joke about a guy who goes to the doctor and says, “It hurts every time I do this.” The doctor says, “Okay, don't do that.” If you really think your firm is losing money on young associates, stop hiring them.

Origination Credits

Jim Davidson [Consultant; Dir. of Finance (Ret.), Holland & Hart]: The final “basic concept” in Ed's article raises an elephant-in-the-room issue from a practical standpoint. The firm has to figure out how to determine originations.

New business coming into a firm is often not easily assignable to an individual or practice group. Most new business comes from existing clients or relatives of existing clients. The original originator of that client may have long since forgotten who the client is, or be no longer active with the firm. The work likely came in not by the specific effort of one or a few people, but by the overall relationship of a number of people in different practice areas who are involved in providing service to that client. Trying to sort all that out for a profitability calculation is extremely subjective and open to endless second guessing by all involved, especially those who in their minds were unfairly denied credit.

The latter group will be vocal far beyond its size, possibly killing the whole concept. Unfortunately it's hard to achieve a strong up-front consensus on how originations are determined.

Ed Wesemann: Dead on. I have never seen a firm that has the definitive system for measuring originations. At best it is a compromise that is equally offensive to everyone but the best that could get through the consensus process. But this further makes the case that measuring the profitability of practice groups, offices or individuals is at best a black science; such measures cannot be the absolute basis of decision making without the exercise of common sense.

Ed Poll (Coach & Consultant to lawyers and law firms): Ed Wesemann's article begins by saying that law firms now make decisions that are “supported by the numbers but intuitively seem wrong.” This takes me back many years to my experience in the food processing business, serving supermarkets. Buyers who grew up in the industry were still making decisions based on experience and intuition. When they retired, however, the younger buyers who took over no longer walked the aisles; there were too many stores and too many aisles! Instead they began making decisions based on computer printouts that were then newly available. Often these number-based decisions were wrong. For example, the new owners dropped many slower-moving or less profitable items, without realizing that those were the very products that retained customers who wanted a one-stop shopping experience.

While I therefore agree that numbers should not be the sole criterion in the decision-making process of running a law firm, I don't share the article's view on overhead allocation. Overhead may “belong” to the owners, but I believe it must be attributable to all fee earners, including non-owners. Without allocation ' whether per capita, pro rata based on billable rate, or by some other method ' one doesn't truly know what individual lawyers are contributing to firm profit.

Profit isn't everything. Investment in associates is appropriate. But that doesn't detract from the need to know what each lawyer contributes to the firm, as part of the evaluation process for that lawyer.

With regard to recruiting and training costs for associates: recruiting costs vary, but all lawyers should have training and education costs attributed to them. Without additional education, lawyers fail to stay at the top of their craft. Educating seasoned lawyers may in fact be more costly than educating associates.