Managing Practice Group Profitability

Economic conditions have forced law firms to focus on the need to address the profitability of their individual offices, practices, and client relationships. Few firms have paid enough attention to whether specific practice areas are profitable. Generally, management simply focused on performance of the firm as a whole, which has been generally improving from year to year. Managers might have worried about specific practice areas, but little analysis was done.

Anecdotal evidence sometimes suggests that a practice group is not profitable, yet little hard evidence is produced in many firms. While this might cause a practice area to come under significant criticism from partners in other practices, creating significant management and morale problems, little is done formally to assess the problems and potential solutions. Rather, partners in the particular practice area under a microscope are being told to 'shape up,' and might even see their compensation cut, but typically little help is provided.

Managers can no longer ignore the performance of individual practices, hoping problems will correct themselves. Firms everywhere are venturing into various types of reporting and 'profit center accounting,' typically based on the performance of individual practice groups and even specific clients. However, they take a variety of approaches to these analyses, and the differences can cause severely different analytic outcomes.

Most managers agree that whether a practice group is profitable depends on whether it generates enough revenue, after paying for all costs including timekeeper compensation, to still show a 'profit.' (Of course, this definition will inevitably result in some 'unprofitable' practices.) If this is accepted, then analyzing practice group profitability requires decisions on two key analytic questions. First, the firm must decide how to allocate revenue to the practice group. Does the practice get credit for all fee receipts for the lawyers and other timekeepers assigned to the group? Should the practice receive 'credit' for some fees worked by other practices on matters originated by another practice group? How are realization and write-offs to be handled? If the receiving practice group is routinely being delegated 'service-type work' that doesn't command high hourly rates, which group should bear the burden of those low rates?

The second key question is how to allocate costs to a practice group. Usually, all timekeeper direct costs such as wages, allocable payroll taxes, and benefits should be assigned to the principal practice group (expenses should follow revenue in this case). The complicating factor is 'firm' overhead, i.e., costs borne centrally in support of the entire firm, and general operating costs, such as rent, secretarial support, and the like. Services of the accounting department, the library, the firm's Executive Director, and other costs are generally 'firm overhead costs.' Obviously, deciding the components of this overhead pool is an important question. For example, should the compensation of the managing partner be included in firm overhead? What about the space costs associated with central accounting? What about secretaries who specifically support timekeepers assigned to the practice group? Obviously, the question is complex. At some level, the complexity of the allocation process may begin to outweigh the benefits of the analysis.

Once the composition of the overhead pool is determined, it must be allocated. There are many options for the allocation methodology. Overhead can be allocated on a per-lawyer basis, per-person basis, on revenue generated, on billings processed, or by various other means. Some firms allocate different parts of the firm overhead pool on different criteria, further complicating the decision. For example, the salary of the Executive Director might be allocated on a per-lawyer basis, and the cost of the accounting department allocated based on the volume of billings processed.

A Simplistic Approach

These choices create many possible approaches to profitability analysis. However, most firms that analyze practice group profitability take a simplistic approach:

1) Assign revenue based on the fees collected for the working time of the individual lawyers and other timekeepers based in the practice area.

2) Assign overhead and operating costs to a pool and then allocate that pool on a per-timekeeper (or lawyer) basis. More sophisticated firms that have been preparing these types of analyses for some time will tell you that the allocation of overhead should be 'weighted' depending upon timekeeper status. Generally speaking, paralegals are allocated far less general overhead than associates, who are allocated less than a partner. As a general guideline, consider assigning a partner 100% share; an associate 70%; and a paralegal 30%. Understand, circumstances will be different from firm-to-firm.

This approach has the advantage of simplicity. However, it obscures contributions to firm economic performance other than working time. One successful firm used this approach to decide that the practice group where the highest paid rainmaking partners were based was unprofitable, because there wasn't enough working revenue generated there to cover these lawyers' compensation. It ignored the fact that the partners in that practice generated substantial work being handled in other practice groups.

Almost any approach to analyzing practice group profitability can be criticized. The problem is that once a method is used and shown to the partners generally, it tends to become institutionalized. Poorly done analyses can result in internal divisiveness and morale problems among partners. This is a key reason some firms never attempt such analyses. We caution firms to ignore the temptation to circulate the results to all partners. Instead, these analyses should be kept within the firm's management group and shared only with the practice leader in the context of how to improve profitability of their practice group. All practice groups are not the same. These reports can form a reasonable basis for establishing practice group profitability goals and become a good measuring stick for meeting expectations.

Define the Purpose of the Analysis

To avoid creating internal conflicts when analyzing practice group profitability, it is important that the purpose be clearly understood and well defined in advance. This should be the first step in conducting any profitability analysis. Until the purpose is clear, it is impossible to determine an appropriate analytic approach.

A few examples will clarify the importance of defining the purpose:

One firm wanted to use profitability analysis as an element in setting compensation. For this purpose, it is crucial that no element of contribution be overlooked. Therefore, besides the simplified analysis suggested above, the firm also did an analysis of the work 'imported' and 'exported' among the various practices. This helped determine not just who was doing the work, but where the work was coming from. In addition, the firm looked deeper to understand which practice groups (and partners) were generating new work, and which were resting on accomplishments of the past. Finally, the firm considered the less tangible benefits, such as firm prestige and additional business loyalty from key clients and the need to have certain practices to service the requirements of key firm clients, even though the chargeable rates may be lower. Management determined that is was fair to discount, to some degree, lower hourly rate since the practice was important for the firm to maintain for its key clients.

A second firm wanted to know whether its economic performance would improve if a practice group were no longer part of the firm. Here, the firm found that its central administrative costs would not change if the practice group were gone. A certain amount of structure was necessary to support the rest of the firm. Therefore, the firm only considered the marginal costs and revenues associated with the office, and made no overhead allocation. Management concluded that the practice group enhanced the economic performance of the firm, albeit marginally. Management concluded that this practice was not going to warrant investment for growth.

These two cases illustrate the importance of deciding the purpose of the analysis before beginning it.

It should be noted that profitability analysis is better suited to some goals than to others. For example, it is a very bad idea to rely heavily on practice group profitability in setting compensation. Deserving individuals in a relatively weak practice group are often under-compensated when this is done, which might result in unwanted departures. This would only make the situation worse.

Analyzing Profitability

Once you determine why the analysis is being done, you can develop the analytic framework. This generally requires addressing the cost and revenue questions discussed above. In addition, management should decide whether to address more complex profitability issues. For example, should certain practices be charged with the cost of capital committed to their operations? How should lawyer turnover in a practice group be factored into the analysis? How should practice groups be 'charged' for importing work from other practices? Should revenue somehow be reduced if clients in a practice group take extraordinarily long, on average, to pay their bills? How should firms account for discounted hourly rates for certain clients? How should investments in contingent matters be handled? These and other questions can be important at some times, and less so at others.

The initial analysis should be done by the firm's administrator and controller, working closely with the managing partner. However, before making decisions based upon the analysis, consider soliciting input from select practice group leaders. Frequently, explanations for poor performance ' or caveats about good performance ' are known by practice leaders and can improve the quality of firm decisions.

Managing Information

Once committed to paper, profitability analyses often take on lives of their own. Partners seeking ammunition to advance their own agendas will seize upon evidence that 'they were right,' whether or not an analysis was designed to address the particular question. 'Proving' that one practice group is a major drag on economic performance may be the quickest route to significant internal conflict, particularly when economic performance is generally weak. If such an analysis is to be shown to partners generally, it should be accompanied by a specific plan to improve the lagging performance.

Unless there is a compelling reason to address such questions within the partnership as a whole, it may be better for managers to address these issues privately with the relevant parties. Analytic tools can help managers improve the firm's overall performance by focusing on the performance of individual business units. Doing so is an appropriate management function that will become more and more common as firms learn to treat themselves more as the significant businesses they are. However, there is rarely much benefit derived from involving all partners in the effort. Generally, the managing partner should be responsible for addressing issues of economic performance, whether at the level of the practice group or client team. The managing partner can then approach partners with appropriate steps to address the specific issues identified.

Howard Mudrick is President of HM Solutions, a Dallas management-consulting firm that specializes in working with law firms. His expertise includes strategic planning, financial management, law firm mergers, design of partner compensation and capital systems, and he conducts numerous law firm retreats every year. He is a fellow in the College of Law Practice Management.

Economic conditions have forced law firms to focus on the need to address the profitability of their individual offices, practices, and client relationships. Few firms have paid enough attention to whether specific practice areas are profitable. Generally, management simply focused on performance of the firm as a whole, which has been generally improving from year to year. Managers might have worried about specific practice areas, but little analysis was done.

Anecdotal evidence sometimes suggests that a practice group is not profitable, yet little hard evidence is produced in many firms. While this might cause a practice area to come under significant criticism from partners in other practices, creating significant management and morale problems, little is done formally to assess the problems and potential solutions. Rather, partners in the particular practice area under a microscope are being told to 'shape up,' and might even see their compensation cut, but typically little help is provided.

Managers can no longer ignore the performance of individual practices, hoping problems will correct themselves. Firms everywhere are venturing into various types of reporting and 'profit center accounting,' typically based on the performance of individual practice groups and even specific clients. However, they take a variety of approaches to these analyses, and the differences can cause severely different analytic outcomes.

Most managers agree that whether a practice group is profitable depends on whether it generates enough revenue, after paying for all costs including timekeeper compensation, to still show a 'profit.' (Of course, this definition will inevitably result in some 'unprofitable' practices.) If this is accepted, then analyzing practice group profitability requires decisions on two key analytic questions. First, the firm must decide how to allocate revenue to the practice group. Does the practice get credit for all fee receipts for the lawyers and other timekeepers assigned to the group? Should the practice receive 'credit' for some fees worked by other practices on matters originated by another practice group? How are realization and write-offs to be handled? If the receiving practice group is routinely being delegated 'service-type work' that doesn't command high hourly rates, which group should bear the burden of those low rates?

The second key question is how to allocate costs to a practice group. Usually, all timekeeper direct costs such as wages, allocable payroll taxes, and benefits should be assigned to the principal practice group (expenses should follow revenue in this case). The complicating factor is 'firm' overhead, i.e., costs borne centrally in support of the entire firm, and general operating costs, such as rent, secretarial support, and the like. Services of the accounting department, the library, the firm's Executive Director, and other costs are generally 'firm overhead costs.' Obviously, deciding the components of this overhead pool is an important question. For example, should the compensation of the managing partner be included in firm overhead? What about the space costs associated with central accounting? What about secretaries who specifically support timekeepers assigned to the practice group? Obviously, the question is complex. At some level, the complexity of the allocation process may begin to outweigh the benefits of the analysis.

Once the composition of the overhead pool is determined, it must be allocated. There are many options for the allocation methodology. Overhead can be allocated on a per-lawyer basis, per-person basis, on revenue generated, on billings processed, or by various other means. Some firms allocate different parts of the firm overhead pool on different criteria, further complicating the decision. For example, the salary of the Executive Director might be allocated on a per-lawyer basis, and the cost of the accounting department allocated based on the volume of billings processed.

A Simplistic Approach

These choices create many possible approaches to profitability analysis. However, most firms that analyze practice group profitability take a simplistic approach:

1) Assign revenue based on the fees collected for the working time of the individual lawyers and other timekeepers based in the practice area.

2) Assign overhead and operating costs to a pool and then allocate that pool on a per-timekeeper (or lawyer) basis. More sophisticated firms that have been preparing these types of analyses for some time will tell you that the allocation of overhead should be 'weighted' depending upon timekeeper status. Generally speaking, paralegals are allocated far less general overhead than associates, who are allocated less than a partner. As a general guideline, consider assigning a partner 100% share; an associate 70%; and a paralegal 30%. Understand, circumstances will be different from firm-to-firm.

This approach has the advantage of simplicity. However, it obscures contributions to firm economic performance other than working time. One successful firm used this approach to decide that the practice group where the highest paid rainmaking partners were based was unprofitable, because there wasn't enough working revenue generated there to cover these lawyers' compensation. It ignored the fact that the partners in that practice generated substantial work being handled in other practice groups.

Almost any approach to analyzing practice group profitability can be criticized. The problem is that once a method is used and shown to the partners generally, it tends to become institutionalized. Poorly done analyses can result in internal divisiveness and morale problems among partners. This is a key reason some firms never attempt such analyses. We caution firms to ignore the temptation to circulate the results to all partners. Instead, these analyses should be kept within the firm's management group and shared only with the practice leader in the context of how to improve profitability of their practice group. All practice groups are not the same. These reports can form a reasonable basis for establishing practice group profitability goals and become a good measuring stick for meeting expectations.

Define the Purpose of the Analysis

To avoid creating internal conflicts when analyzing practice group profitability, it is important that the purpose be clearly understood and well defined in advance. This should be the first step in conducting any profitability analysis. Until the purpose is clear, it is impossible to determine an appropriate analytic approach.

A few examples will clarify the importance of defining the purpose:

One firm wanted to use profitability analysis as an element in setting compensation. For this purpose, it is crucial that no element of contribution be overlooked. Therefore, besides the simplified analysis suggested above, the firm also did an analysis of the work 'imported' and 'exported' among the various practices. This helped determine not just who was doing the work, but where the work was coming from. In addition, the firm looked deeper to understand which practice groups (and partners) were generating new work, and which were resting on accomplishments of the past. Finally, the firm considered the less tangible benefits, such as firm prestige and additional business loyalty from key clients and the need to have certain practices to service the requirements of key firm clients, even though the chargeable rates may be lower. Management determined that is was fair to discount, to some degree, lower hourly rate since the practice was important for the firm to maintain for its key clients.

A second firm wanted to know whether its economic performance would improve if a practice group were no longer part of the firm. Here, the firm found that its central administrative costs would not change if the practice group were gone. A certain amount of structure was necessary to support the rest of the firm. Therefore, the firm only considered the marginal costs and revenues associated with the office, and made no overhead allocation. Management concluded that the practice group enhanced the economic performance of the firm, albeit marginally. Management concluded that this practice was not going to warrant investment for growth.

These two cases illustrate the importance of deciding the purpose of the analysis before beginning it.

It should be noted that profitability analysis is better suited to some goals than to others. For example, it is a very bad idea to rely heavily on practice group profitability in setting compensation. Deserving individuals in a relatively weak practice group are often under-compensated when this is done, which might result in unwanted departures. This would only make the situation worse.

Analyzing Profitability

Once you determine why the analysis is being done, you can develop the analytic framework. This generally requires addressing the cost and revenue questions discussed above. In addition, management should decide whether to address more complex profitability issues. For example, should certain practices be charged with the cost of capital committed to their operations? How should lawyer turnover in a practice group be factored into the analysis? How should practice groups be 'charged' for importing work from other practices? Should revenue somehow be reduced if clients in a practice group take extraordinarily long, on average, to pay their bills? How should firms account for discounted hourly rates for certain clients? How should investments in contingent matters be handled? These and other questions can be important at some times, and less so at others.

The initial analysis should be done by the firm's administrator and controller, working closely with the managing partner. However, before making decisions based upon the analysis, consider soliciting input from select practice group leaders. Frequently, explanations for poor performance ' or caveats about good performance ' are known by practice leaders and can improve the quality of firm decisions.

Managing Information

Once committed to paper, profitability analyses often take on lives of their own. Partners seeking ammunition to advance their own agendas will seize upon evidence that 'they were right,' whether or not an analysis was designed to address the particular question. 'Proving' that one practice group is a major drag on economic performance may be the quickest route to significant internal conflict, particularly when economic performance is generally weak. If such an analysis is to be shown to partners generally, it should be accompanied by a specific plan to improve the lagging performance.

Unless there is a compelling reason to address such questions within the partnership as a whole, it may be better for managers to address these issues privately with the relevant parties. Analytic tools can help managers improve the firm's overall performance by focusing on the performance of individual business units. Doing so is an appropriate management function that will become more and more common as firms learn to treat themselves more as the significant businesses they are. However, there is rarely much benefit derived from involving all partners in the effort. Generally, the managing partner should be responsible for addressing issues of economic performance, whether at the level of the practice group or client team. The managing partner can then approach partners with appropriate steps to address the specific issues identified.

Howard Mudrick is President of HM Solutions, a Dallas management-consulting firm that specializes in working with law firms. His expertise includes strategic planning, financial management, law firm mergers, design of partner compensation and capital systems, and he conducts numerous law firm retreats every year. He is a fellow in the College of Law Practice Management.