Information: The Key to Successful Law Firm Management

As is the case for any profit-maximizing organization, a primary management concern for most law firms is profitability. Management wants to ensure the profitability of the firm as a whole, of practice groups, and of individual partners. Related to and supporting profitability is the management of key business-sustaining activities such as client development, staff coaching, and matter management. What information should a law firm's leadership team focus on to manage these effectively? This article discusses profitability drivers and the characteristics and content of useful management information reports that distill critical information to facilitate informed decisions by firm leadership.

Understanding Law Firm Profitability

Law firms face twin constraints on profitability: downward pressure on fees and upward pressure on costs. Large clients seek savings and greater fee predictability, driving a move to alternative fee structures. (See B. Baccus and F.L. Hirschberg, “Alternative Fee Arrangements: Meeting the Client's Needs While Maintaining Profitability,” Accounting and Financial Planning for Law Firms, v. 23 no. 6 (June 2010).) Historically, hourly rates remained consistent and increased periodically across work types and practice areas. With the trend in recent years to vary hourly prices across types of work and other flexible fee arrangements to emphasize linking prices to perceived value, managing profitability is no longer predictable. The critical issue today is to actively manage profitability, so as to understand and manage key drivers of practice economics ' at the firm, practice and individual level ' by work type and by client. Firm management teams can rely on usable information that allows them to examine the impact of variables other than hours and rates on profitability, and to make decisions accordingly.

The Profit Tree

Understanding how a firm earns a profit is a starting point for determining the indicators law firms need in management information reports. Many law firms find the profit tree in Figure 1, below, helpful in identifying key profit drivers. The tree broadly illustrates the variables that contribute to firm profitability.

[IMGCAP(1)]

Six key drivers are shown in light grey. These six drivers could potentially form the basis for dashboard reports at different levels in the organization to ensure the economic structure is correct for the work being delivered:

• Leverage: Ratio of staff to equity partners.
• Utilization rate: The hours charged as a percentage of the total hours a fee earner is contracted to work. For example, seven hours worked per day, five days per week for six weeks reflects an 87.5% utilization rate, assuming a targeted 40 hour week.
• Chargeable rate per hour: Value of work done in a period divided by total hours worked. To recognize how time affects profitability, chargeable rates need to be assigned to fee earners even for flat fee or other alternative billing arrangements. Chargeable rate is often calculated from historic information and determined on a “cost plus” method. The calculation is usually based on total revenue the firm requires to cover costs and deliver a desired profit margin, divided by historical billable hours, adjusted for the level of historical write-offs. This average rate is then adjusted by fee earner category. This chargeable rate therefore gives an indication of the necessary level of income required to cover firm-wide costs and deliver a profit if the fee earner achieves the desired number of billable hours.
• Realization rate: The difference between the chargeable per hour rate and the rate paid by the client after all write-offs, discounts, and other adjustments have been taken into consideration.
• Salary cost: Salary and other direct benefits (such as pension, health, etc.) paid to employed lawyers, including a notional salary for equity partners. This total amount is divided by all lawyers including equity partners to give an average salary cost.
• Overhead cost: All other non-salary costs, divided by the number of lawyers giving a per-lawyer overhead amount.

The profit tree provides valuable insights into a firm's performance including:

• How effectively it operates ' transforming inputs into outputs;
• How profitable it is;
• How it generates profit;
• How hard its people work; and
• Indications of market trends.

Examples

The profit tree does not always provide complete answers, but it provides vital indicators for further inquiry. Following are examples of how changes in key drivers can impact the actual and potential profitability of a law firm. These are hypothetical examples for illustration purposes only; each firm will have its own numbers and ratios.

Figure 2, below, illustrates the effect of increasing the realization by 5% while leaving other variables unchanged. This 5% increase in fee income causes firm profits to multiply by more than eight times, and earnings per partner to increase by 59%. Of course, the opposite of this multiplier effect is also true: A drop in the realization rate has an equally significant impact on the bottom line of the firm.

[IMGCAP(2)]

Figure 3, below, illustrates the effect of a 5% increase in utilization, leaving other variables unchanged. This increase leads to more than a 6% increase in fee income and improves firm profits by a factor of more than nine, while the per partner earnings rise by 69%.

[IMGCAP(3)]

Tailoring Management Information to Meet Management Needs

The profit tree yields an understanding of the major drivers that contribute to profitability. What information should be included in management reports? Reports with the following characteristics are functionally useful for making informed management decisions.

Align Management Information with the Firm's Strategy and Structure

A firm cannot effectively utilize management information in isolation. As a preliminary matter, it is important to take into consideration the law firm's strategy when identifying information to be included in management reports. High-quality management information can provide a sound basis for future decision-making when the management team knows the firm's end goal. With a clear understanding of the firm's strategy and business planning processes comes an understanding of what underlying “drivers” can or should be adjusted to achieve the desired results. The following examples illustrate how identified drivers relate to overarching strategies (although, of course, they may not be the only ways of achieving them). A strategy demanding growth in new markets will incur additional cost; sustaining profit, therefore, will require a focus on business development and new or increased revenue streams. Alternatively, if the firm's strategy is to grow existing markets, it may be possible to hold business development, overhead, and other related costs neutral, while growing revenue and/or utilization. If, as has been common recently, the firm's strategy is to defend market share and protect profitability, the drivers to focus on are reducing costs and improving utilization.

It is also critical for law firms to align business strategy with economic structure. The business strategy should clearly articulate the types and value of work that the firm, practice, and partners plan to deliver to clients. To effectively implement the business strategy, the firm's management information processes must report on and monitor:

• The pricing bands in which the majority of the work falls;
• Whether there is appropriate leverage for the type of work; and
• Direct cost levels.

Monitoring direct cost levels ensures they are matched to the value of the delivered work.

Ensure Management Information Is Usable

Not only must the tracked information be conceptually consistent with the law firm's business strategy, but it should also be presented in a usable format. Most law firms have abundant information available. However, to best facilitate decision making, it is essential that the information be collected and displayed in a way that is consistent, clear and concise, and supportive of the firm's culture.

The management reports of many law firms are not useful for supervising personnel, managing resources, and making critical decisions, because they do not have these characteristics. Reports frequently mix up the timing of expenses and revenues, not accurately comparing the cost of generating revenue. Some management reports reflect re-purposed information (i.e., gathered for other reasons), thereby potentially ignoring some data that are essential to supporting management. For example, re-purposed data may provide financial information more suitable for tax purposes than for management. Some report formats bury critical data in masses of detail, ignoring the “pyramid” approach to reporting (starting with the “big picture” and progressing to detail as required). The following tips outline how to avoid management reports that are counter-cultural and impair what the firm is trying to achieve.

Consistent. It is imperative that management information reports be internally consistent in both format and content. Consistently formatted reports provide the same categories of information to all levels of the organization with the appropriate amount of detail, i.e., the firm-wide reports provide “big picture” summaries of the same information provided in reports at the practice area and individual partner level. Content should also be internally consistent. For example, to accurately identify the cost of generating revenue, it is important that management information reports reflect revenue and expenses from the same time frame. Time frame consistency in management reports includes promptly reported time to accurately reflect revenue generation, and recognition of costs when they actually accrue, even though most U.S. law firms use a cash accounting basis for traditional financial reports. In establishing management reports, decisions regarding “fixed” drivers should also adhere to principles of consistency. For example, once a determination is made regarding the annual number of available hours, this number should not vary. Otherwise, comparisons of different periods will become meaningless.

Concise and clear. There is an adage, “You can't manage what you don't measure.” Equally apt, however, is the concept that what is being measured must be clear. The most effective management reports are as brief as possible and present only the data required to facilitate decision-making. A single summary page provides a manager with the information necessary to identify potential issues on which to focus attention. This single-page report should highlight variances from budget, particularly negative variances. It is imperative that the number of key performance indicators is kept as low as possible and the management team watch the most meaningful indicators.

Supportive of culture. It is vital to ensure that the content and distribution of management information reports support the firm's actual or desired culture. For example, widely disseminated reports that display the performance data for specific individuals may undermine team-building efforts. Advance consideration of who will be permitted to view information such as peer performance and utilization metrics can obviate potential cultural problems.

Conclusion

Although the focus of this article is on profitability, managing also involves ensuring that partners and staff contribute to efforts that indirectly support the success and profitability of the firm. Management information, therefore, needs to provide insight into areas such as business development, the education and developmental progress of fee earners and staff, client acquisitions and losses, and the type of work generated. The principles discussed above also apply to these management reports. The fundamental concept is a top-down approach focusing on what each level of manager, from managing partner down, requires to enable him or her to quickly and regularly identify variances in the plan, whether it relates to profitability or other measured areas.

Mark R. Kudel is a director in Huron Consulting Group's Legal Consulting practice based in New York, and John Cussons is a manager based in London. Huron's Legal Consulting practice provides services that add value to law firms and corporate legal departments by helping to control costs, enhance client service delivery, and increase operational effectiveness. The authors can be contacted at [email protected] and [email protected], respectively.

As is the case for any profit-maximizing organization, a primary management concern for most law firms is profitability. Management wants to ensure the profitability of the firm as a whole, of practice groups, and of individual partners. Related to and supporting profitability is the management of key business-sustaining activities such as client development, staff coaching, and matter management. What information should a law firm's leadership team focus on to manage these effectively? This article discusses profitability drivers and the characteristics and content of useful management information reports that distill critical information to facilitate informed decisions by firm leadership.

Understanding Law Firm Profitability

Law firms face twin constraints on profitability: downward pressure on fees and upward pressure on costs. Large clients seek savings and greater fee predictability, driving a move to alternative fee structures. (See B. Baccus and F.L. Hirschberg, “Alternative Fee Arrangements: Meeting the Client's Needs While Maintaining Profitability,” Accounting and Financial Planning for Law Firms, v. 23 no. 6 (June 2010).) Historically, hourly rates remained consistent and increased periodically across work types and practice areas. With the trend in recent years to vary hourly prices across types of work and other flexible fee arrangements to emphasize linking prices to perceived value, managing profitability is no longer predictable. The critical issue today is to actively manage profitability, so as to understand and manage key drivers of practice economics ' at the firm, practice and individual level ' by work type and by client. Firm management teams can rely on usable information that allows them to examine the impact of variables other than hours and rates on profitability, and to make decisions accordingly.

The Profit Tree

Understanding how a firm earns a profit is a starting point for determining the indicators law firms need in management information reports. Many law firms find the profit tree in Figure 1, below, helpful in identifying key profit drivers. The tree broadly illustrates the variables that contribute to firm profitability.

[IMGCAP(1)]

Six key drivers are shown in light grey. These six drivers could potentially form the basis for dashboard reports at different levels in the organization to ensure the economic structure is correct for the work being delivered:

• Leverage: Ratio of staff to equity partners.
• Utilization rate: The hours charged as a percentage of the total hours a fee earner is contracted to work. For example, seven hours worked per day, five days per week for six weeks reflects an 87.5% utilization rate, assuming a targeted 40 hour week.
• Chargeable rate per hour: Value of work done in a period divided by total hours worked. To recognize how time affects profitability, chargeable rates need to be assigned to fee earners even for flat fee or other alternative billing arrangements. Chargeable rate is often calculated from historic information and determined on a “cost plus” method. The calculation is usually based on total revenue the firm requires to cover costs and deliver a desired profit margin, divided by historical billable hours, adjusted for the level of historical write-offs. This average rate is then adjusted by fee earner category. This chargeable rate therefore gives an indication of the necessary level of income required to cover firm-wide costs and deliver a profit if the fee earner achieves the desired number of billable hours.
• Realization rate: The difference between the chargeable per hour rate and the rate paid by the client after all write-offs, discounts, and other adjustments have been taken into consideration.
• Salary cost: Salary and other direct benefits (such as pension, health, etc.) paid to employed lawyers, including a notional salary for equity partners. This total amount is divided by all lawyers including equity partners to give an average salary cost.
• Overhead cost: All other non-salary costs, divided by the number of lawyers giving a per-lawyer overhead amount.

The profit tree provides valuable insights into a firm's performance including:

• How effectively it operates ' transforming inputs into outputs;
• How profitable it is;
• How it generates profit;
• How hard its people work; and
• Indications of market trends.

Examples

The profit tree does not always provide complete answers, but it provides vital indicators for further inquiry. Following are examples of how changes in key drivers can impact the actual and potential profitability of a law firm. These are hypothetical examples for illustration purposes only; each firm will have its own numbers and ratios.

Figure 2, below, illustrates the effect of increasing the realization by 5% while leaving other variables unchanged. This 5% increase in fee income causes firm profits to multiply by more than eight times, and earnings per partner to increase by 59%. Of course, the opposite of this multiplier effect is also true: A drop in the realization rate has an equally significant impact on the bottom line of the firm.

[IMGCAP(2)]

Figure 3, below, illustrates the effect of a 5% increase in utilization, leaving other variables unchanged. This increase leads to more than a 6% increase in fee income and improves firm profits by a factor of more than nine, while the per partner earnings rise by 69%.

[IMGCAP(3)]

Tailoring Management Information to Meet Management Needs

The profit tree yields an understanding of the major drivers that contribute to profitability. What information should be included in management reports? Reports with the following characteristics are functionally useful for making informed management decisions.

Align Management Information with the Firm's Strategy and Structure

A firm cannot effectively utilize management information in isolation. As a preliminary matter, it is important to take into consideration the law firm's strategy when identifying information to be included in management reports. High-quality management information can provide a sound basis for future decision-making when the management team knows the firm's end goal. With a clear understanding of the firm's strategy and business planning processes comes an understanding of what underlying “drivers” can or should be adjusted to achieve the desired results. The following examples illustrate how identified drivers relate to overarching strategies (although, of course, they may not be the only ways of achieving them). A strategy demanding growth in new markets will incur additional cost; sustaining profit, therefore, will require a focus on business development and new or increased revenue streams. Alternatively, if the firm's strategy is to grow existing markets, it may be possible to hold business development, overhead, and other related costs neutral, while growing revenue and/or utilization. If, as has been common recently, the firm's strategy is to defend market share and protect profitability, the drivers to focus on are reducing costs and improving utilization.

It is also critical for law firms to align business strategy with economic structure. The business strategy should clearly articulate the types and value of work that the firm, practice, and partners plan to deliver to clients. To effectively implement the business strategy, the firm's management information processes must report on and monitor:

• The pricing bands in which the majority of the work falls;
• Whether there is appropriate leverage for the type of work; and
• Direct cost levels.

Monitoring direct cost levels ensures they are matched to the value of the delivered work.

Ensure Management Information Is Usable

Not only must the tracked information be conceptually consistent with the law firm's business strategy, but it should also be presented in a usable format. Most law firms have abundant information available. However, to best facilitate decision making, it is essential that the information be collected and displayed in a way that is consistent, clear and concise, and supportive of the firm's culture.

The management reports of many law firms are not useful for supervising personnel, managing resources, and making critical decisions, because they do not have these characteristics. Reports frequently mix up the timing of expenses and revenues, not accurately comparing the cost of generating revenue. Some management reports reflect re-purposed information (i.e., gathered for other reasons), thereby potentially ignoring some data that are essential to supporting management. For example, re-purposed data may provide financial information more suitable for tax purposes than for management. Some report formats bury critical data in masses of detail, ignoring the “pyramid” approach to reporting (starting with the “big picture” and progressing to detail as required). The following tips outline how to avoid management reports that are counter-cultural and impair what the firm is trying to achieve.

Consistent. It is imperative that management information reports be internally consistent in both format and content. Consistently formatted reports provide the same categories of information to all levels of the organization with the appropriate amount of detail, i.e., the firm-wide reports provide “big picture” summaries of the same information provided in reports at the practice area and individual partner level. Content should also be internally consistent. For example, to accurately identify the cost of generating revenue, it is important that management information reports reflect revenue and expenses from the same time frame. Time frame consistency in management reports includes promptly reported time to accurately reflect revenue generation, and recognition of costs when they actually accrue, even though most U.S. law firms use a cash accounting basis for traditional financial reports. In establishing management reports, decisions regarding “fixed” drivers should also adhere to principles of consistency. For example, once a determination is made regarding the annual number of available hours, this number should not vary. Otherwise, comparisons of different periods will become meaningless.

Concise and clear. There is an adage, “You can't manage what you don't measure.” Equally apt, however, is the concept that what is being measured must be clear. The most effective management reports are as brief as possible and present only the data required to facilitate decision-making. A single summary page provides a manager with the information necessary to identify potential issues on which to focus attention. This single-page report should highlight variances from budget, particularly negative variances. It is imperative that the number of key performance indicators is kept as low as possible and the management team watch the most meaningful indicators.

Supportive of culture. It is vital to ensure that the content and distribution of management information reports support the firm's actual or desired culture. For example, widely disseminated reports that display the performance data for specific individuals may undermine team-building efforts. Advance consideration of who will be permitted to view information such as peer performance and utilization metrics can obviate potential cultural problems.

Conclusion

Although the focus of this article is on profitability, managing also involves ensuring that partners and staff contribute to efforts that indirectly support the success and profitability of the firm. Management information, therefore, needs to provide insight into areas such as business development, the education and developmental progress of fee earners and staff, client acquisitions and losses, and the type of work generated. The principles discussed above also apply to these management reports. The fundamental concept is a top-down approach focusing on what each level of manager, from managing partner down, requires to enable him or her to quickly and regularly identify variances in the plan, whether it relates to profitability or other measured areas.

Mark R. Kudel is a director in Huron Consulting Group's Legal Consulting practice based in New York, and John Cussons is a manager based in London. Huron's Legal Consulting practice provides services that add value to law firms and corporate legal departments by helping to control costs, enhance client service delivery, and increase operational effectiveness. The authors can be contacted at [email protected] and [email protected], respectively.