What Do You Mean My Clients Are Not Profitable? Using Profitability Data to Improve Decision Making By: Donald G. Evans

Reprinted with permission from Legal Management News, the newsletter published by the Oregon Chapter of the Association of Legal Administrator, Spring 2006.

“To improve the utility of financial information, financial managers need to develop tools that permit the measurement of financial performance at a number of levels.”

“The dissemination of cost data for each timekeeper is designed to permit more effective decisions on the part of those in supervisory capacities.”

Introduction

Leaders of successful law firms understand that financial information is one of their critical resources and that broader access and usage of such information is critical to improving a law firm’s financial performance.

Financial information has the potential not only to assist in increasing profitability but also to improve the quality of both tactical and strategic decision making. But how do you measure the profitability? How do you measure the adequacy of profitability? How do you decide which practice groups or industries should be targeted for investment and which targeted for contraction? What financial information is needed by practice group chairs and supervising attorneys to assist in their decision making? How does a firm develop financial data for the preparation of a fixed-fee proposal or measure the performance of those managing fixed-fee work?

This article will present a framework to help law firm managers answer such questions critically and creatively. Knowing the answers may constitute the difference between muddling through and managing with confidence and foresight.

The Forces Driving Change

During the last two decades of the twentieth century, the competitive environment for law firms has increased dramatically. Clients are more sophisticated and demanding. Whether it be an insurance company’s use of outside counsel or a technology company’s desire to employ an incentive-based system for compensating its lawyers, the message is clear: clients want to pay less for legal services but receive higher quality and more responsive services. Competition among law firms is more intense than ever, with some firms seeking to expand their geographical presence, while others focus on specific practice areas.

Most law firms operate without cost systems. However, this does not mean that they operate without financial systems. Law firms typically manage operations through budgetary control of departmental costs, where budgets are established for each department and financial performance is measured and managed by comparing actual results with those budgeted. Although this approach may permit departmental-level control of expenses, it does not permit assessing the costs of providing various legal services or the measurement of the profitability of clients, industries, practice groups, supervising attorneys, etc. This lack of information has not been a concern for many decades because most law firms have been operating in benign, noncompetitive markets. Lacking strong competitive pressures, law firm managers have had little demand for this type of cost information. As a result, the financial systems in most law firms have been very simple, allowing managers to budget expenses by department and to measure and monitor actual spending against departmental budgets.

To improve the utility of financial information, financial managers need to develop tools that permit the measurement of financial performance at a number of levels: matter, client, and practice group being among the more important.

A Different Approach

A firm’s financial statement does not contain information necessary for allocating resources and managing the profitability of practice areas, individual matters, and clients. Managers need to link the cost of the resources they employ to the revenues earned by the services provided to clients. Only by understanding such linkage and the interplay with rates charged can wise decisions be made about the market segments to be served, the services to be offered to clients, and the mix of resources to be employed to deliver these services.

Traditional cost accounting, which segments costs into fixed and variable components, does not work for law firms. Unlike manufacturing companies, law firms cannot begin their analysis with the cost of a step in a manufacturing process. Rather, law firms must start with the assumption that there is only one cost — that of the total firm, which is fixed at least over the short term. The task is to assign all of a firm’s costs to the timekeepers with the objective of establishing a cost per hour that permits measuring the cost of services provided to the firm’s clients. 

To utilize a law firm’s cost information in an “enlightened” way, financial managers will have to step out of their traditional roles currently focused on cost controls, transaction processing, and reporting to contribute to strategic organizational objectives in ways never before imagined. Fortunately, increasing demands for information are taking place when the costs for collecting, processing, analyzing, and reporting information are decreasing by many orders of magnitude.

Myths

There are a number of myths surrounding the use of cost data. Among them are:

Myth #1: The bigger the book the better. Lawyers need a paradigm shift in the way they think about the value of their work. Currently, there is a great deal of emphasis placed on the size of one’s book of business, without regard to the profitability of that book. Decisions involving compensation, resource allocation, and the like will benefit from the presence of profitability data.

Myth #2: Rates per hour are set by adding the desired profit to the cost. Law firm leaders and those responsible for individual client matters should focus on effectively managing their resources, rather than on hourly rates. Such a focus can both reduce the cost to clients and increase the return to the law firm. Competition is not going to permit continued emphasis on cost-based pricing (taking projected costs and adding a desired level of margin to determine the hourly rate). Prices will be set by the market with profit being a function of how well costs are managed.

Myth #3: Developing cost-based data is divisive. There are many who believe that the existence of such data would prove divisive and lead to a great deal of finger pointing. However, finger pointing will occur whether or not there is a cost-based system in place. Moreover, ignorance is simply not a good management principle.

Myth #4: The objective of developing cost-based data is control. Lawyers need to recognize that a law firm is a business and that financial information is needed to effectively manage the business. Keeping in mind the business context, the dissemination of cost data for each timekeeper is designed to permit more effective decisions on the part of those in supervisory capacities. The intent is not to control, but to communicate.

Summary

If a law firm’s accounting system fails to provide useful data for measuring the efficiency of processes and the profitability of practice groups, clients, and supervising lawyers, the ability of law firm managers to do their jobs successfully will be diminished. Absent a broad analytical approach providing a framework for integrating tactical and strategic decision making, managers will not be able to manage the many changes in direction they will be facing in the more competitive arena of the future.

The above is a presentation made by Don Evans in San Francisco in July 2004.   Don is founder and president of dgevans consulting. He has 35 years of management experience, with the last 19 years as Chief Operating Officer of prominent Oregon, Washington, and California law firms. His experience includes extensive work with business strategy and the alignment of the elements that drive improved performance. Don is a graduate of the University of Oregon and holds an MBA from the University of California, Berkeley.   He can be contacted at don@dgevansconsulting.com

Editor: Marianne M. Lawhead (mlawhead@sheastokes.com) (This publication is the property of the Atlanta Association of Legal Administrators. Reproduction or reprint without prior permission is strictly prohibited. Click here to request reprint permission.)

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