Tackling the Wicked Problem - Increasing Profit (part 5)

In part 4 of this series, I illustrated how strategically prioritising revenue growth helps leadership teams further address the ‘wicked problem’ of continued success. This instalment explores how firms can consistently increase profit as part of tackling that same problem, highlighting some key areas that should be considered.

4. Increasing Profit

Profitability is one of the most interesting areas for leadership teams managing their firms. It is often contentious and sometimes misunderstood by the firm’s own partnership. Profit per Equity Partner (PEP) is the metric of profitability that is usually most scrutinised by the market and, as The Lawyer recently reported, firms are readying to report strong year ends at a time of global uncertainty. However, most firms are bracing for a tough year ahead, including potentially large revenue reductions. Therein lies the rub (as Arthur Sants notes in his article), because ‘a theoretical 5% slide in revenue, with no change to costs or partner headcount, could result in PEP drop of anywhere between 9 and 25%.’

Perhaps surprising to some, there are only a few levers that leadership teams can pull to truly affect the profitability of the firm. This list is lessened further still when considering that firms have historically been reticent to use some of those levers. Below I consider some of those options, areas to be wary and potential for change in the future.

Firms must have a commonly understood profitability methodology

Perkins Coie’s Chief Practice Management Officer, Toby Brown, was interviewed as part of Intapp’s recent Virtual Connect series. He stressed the importance of defining ‘profit’ in a way that is widely understood by the entire partnership. Ideally this should include a ‘prime metric’ that, might not be the only number reviewed, but serves as the key measurement. This should then be used by the leadership team consistently across all aspects of the business, from strategy through execution and into remuneration determinations.

There are a number of different lenses that can be overlaid, but at its core, this methodology likely contains the following components:

  • Hours Recorded – Write Downs = Hours Billed
  • Hours Billed x Hourly Rate = Billings
  • Billings – Write Offs = Revenue
  • Revenue – Costs (e.g. staff salaries & benefits, rent, IT, insurance, travel, etc.) = Profit
  • Profit – (Partner Distributions + Reinvestment Carryover) = £0

Most firms will likely use a far more complicated methodology than this. The point is that, whatever methodology they use should be consistently applied and widely understood. As Toby correctly surmised, this isn’t a one-off education, but rather an ongoing process of ensuring that the firm’s talent understand the basis of how the firm measures profit.

The profitability levers that firms can pull

Much akin to other commercial businesses, firm profitability is broadly defined by the delta between the revenue generated and the costs associated in running the business. Strategies to increase profit will usually focus on increasing revenue (while maintaining the same cost base), decreasing costs (while delivering the same revenue), or ideally attempting to do both at the same time. There are a number of elements on which firms may focus, but the five that stand out for me are:

profitability
 

  1. Plug the leakage

It is genuinely disturbing how much time firms ‘leak’ each year, especially when you bear in mind that currently billing time is the only way that the majority of firms make money. Using the simple profit methodology that I outlined above, firms regularly leak time (or the value of that time) at four levels:

 

  1. time not recorded in the first place (e.g. a lawyer consciously under recording due to how long the work took to finish),

  2. hours written down before billing (e.g. partner feels they shouldn’t charge for ‘excessive’ hours),

  3. discounted hourly rate (e.g. preferential rates agreed to win the instruction), and

  4. amounts later written off (e.g. bill felt to be too high by partner, or subsequent client push back).

 

Any of these four levels might make perfect commercial sense at the time, but the problem occurs when the firm does not have a holistic view of time and billings. In such cases, the time (and ultimately the revenue generated) is reduced at every level; sometimes to the point where the matter itself may by unknowingly unprofitable. Technology can definitely help, but it should ideally be accompanied with training and support, and a robust internal process for monitoring the relevant data.

client engagement lifecycle

  1. Improve internal process

Most firms have reduced business services costs to near bare minimum over the years, so the focus is not necessarily on further trimming headcount. Rather leadership teams should review their entire Client Matter Lifecycle and understand the interconnection of the various associated internal processes and systems. We have run such a review with a number of firms and, each time, were able to identify inefficiencies, duplications or actual gaps that were adding unnecessary delay to the firm’s matters. As I noted in a previous article, this review will also likely result in a better experience for the firm’s clients.

  1. Allocate work effectively

Probably one of the hottest areas in law firm management at the moment, because most leadership teams have recognised that work is not consistently being allocated to the right people. This touches on some of the most important considerations for firms:

  1. Diversity – is the firm balanced in its distribution of work, or are their unconscious or inherent biases?

  2. Development – is talent consistently being provided with the right quality/quantity of work for their own development?

  3. Margin – are matters efficiently allocated and staffed to maximise the return for the firm?

Again, technology can play a vital role in easing the process, but any new approach in this area will only thrive if the firm works on evolving culture beyond partners working with blinkers set around their own smaller teams.

  1. Reduce unnecessary non-billable activity

Firms place high regard on the non-billable time of their lawyers – in some cases around half of partner time (or perhaps a 1,000 hours) per year is expected to be spent on developing the business. Depending on charge out rates, this could be anywhere from £250k to £1m (or more) of ‘value’ that the firm sees in that lawyer focusing on something other than billing. Strange then that lawyers are still tasked with much of the administration activity that could, and should, be within the purview of technology and business services. Stranger still when we consider that, in many cases, the business services teams would achieve a better result quicker.

  1. Increase leverage ratios

Definitely a balancing act but, on the whole, the most profitable partners in a firm when you consider their ‘team’ contribution tend to be the ones that have a higher leverage ratio (i.e. fee-earners per partner) than the firm average. Arguably one of the easiest mathematical ways to increase profitability, but the success of this approach does depend on the partner in question being able to best utilise increased resources and manage the wider team without any discernible drop in productivity. Perhaps particularly of importance in the current market, this approach also assumes that there is sufficient work to occupy a larger team – as Arthur Sants rightly notes, it’s the highly leveraged firms that will be the most nervous going into any prolonged downturn.

Beware the challenges of a relatively fixed cost base

This is by no means an exhaustive list, and there are a number of sub-areas where firms can normally achieve anywhere from marginal to fairly substantial improvements. However, most firms have a relatively fixed cost base, the three major components of which tend to be partner/lawyer costs, business services costs and office costs. There is little to be saved for most firms in further rationalisation of their services teams and, at least currently, office costs tend to be fixed for a number of years. If we accept that firms are still relatively loathed to reduce partner or lawyer numbers, then at least two things would also appear to be true:

  • Any other cost saving initiatives, while important for other reasons (e.g. client satisfaction, talent development, morale, etc.), are likely to have a proportionally small impact on profit levels.

  • Efficiency initiatives that free up partner or lawyer time will not improve profitability (and could have the opposite effect), unless accompanied with corresponding strategies to increase revenue using that newly available time.

As one COO of an international law firm recently said to me, you can conduct all of the margin analysis you want in deciding whether to accept work but, unless the firm is operating at or close to 100% utilisation, then the relatively fixed cost base means that taking on any work is likely better than getting no work.

firms need to embrace flexibility

The firm of the future – flexibility in all things

At a recent gathering of Managing Partners to discuss the impact of the COVID-19 pandemic, one attendee summed up the firm of the future in one word: flexibility. I couldn’t agree more. Firms need to take the opportunity provided by these challenging times to look at every aspect of the way they conduct business and challenge themselves to embrace flexibility going forwards. Be that adopting agile working, a ‘hub and spoke’ approach to fixed premises, embracing integrated cloud platform technology, or value-based pricing; there are a multitude of ways that firms can proactively evolve to better meet the needs of their clients (and their talent) in the future.

The firms that truly adopt a flexible mindset for the future will secure the best talent, the best clients and the best work – increased profit will undoubtedly follow suit.

In the next part of my series, I consider how firms should consistently review their strategy for developing talent. In the meantime, you can explore more inspiration and resources for leaders & professionals, including our latest COVID-19 law firm research findings.

Written by:

Guy Adams

General Manager, Leaders and Professionals Solutions

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