Some very interesting blog posts (and commentary) have been made over the past week or so around how law firms currently measure law firm profitability, with particular emphasis on whether or not the current prevailing preference of using average Profit Per Partner (PPP) is the right methodology to be using (see Jordan Furlong’s post on Law 21 Death to “Profit Per Partner” and Toby Brown’s response on the 3 Geeks and Law blog Why have a profit methodology – both of which are excellent).
The purpose of this post – my first for some time following holidays and a change in job – is not to add my 2 cents worth to the discussion between Jordan and Toby; but, given the timing of the topic in general, to raise the question of whether or not now is the time for law firms to look at breaking with the RULES when analysing their firm’s profit and losses (P&L)?
I first came across the concept of “RULES” in the early 2000s. Taken from Robert J Arndt’s relatively short (at 31 pages) 1988 publication Identifying profits (or losses) in the law firm the acronym “RULES” stands for:
- Realization – of billing rates
- Utilization – of attorneys
- Leverage – of lawyers
- Expense – control of (both the fixed and variable kind), and
- Speed – of the firm’s billings and collections.
There is absolutely no doubt that the use of “RULES” has been the preferred “go to” metric for law firms who are looking to mine their financial information beyond the mere top level question of whether or not the firm made any money this year. Indeed, if used properly, use of “RULES” should allow firms to further analyse:
- which lawyers and partners are making a profit,
- which practice areas are making a profit,
- which matters are more profitable than others, and
- which clients are more profitable than others.
Given the intense nature of law firms, and especially among partners looking at their equity points and the divvying up of profits at the end of each year, RULES seems a fair and equitable profitability measure.
But, a lot has changed in the legal sector over the past three to four years. So the time has probably come to now ask the question:
Are RULES still the most appropriate measurement of a law firm’s profit or loss?
To answer this question we would need to look at each of the components and ask whether or not it is applies in the era of the “new normal”?
Realization is generally accepted as being the amount collected (ie, in the bank) against the effort to produce (ie productivity); or, as Altman Weil recently defined it: “realization is fees collected divided by the standard value of the time worked“.
On an individual fee earner basis, what this means is that if you set your fee earner a standard billable hourly rack-rate of [say] $100, and they charge the client $90 per hour (after write-offs etc) for work done, and for which the client pays $85 per hour (after asking for a discount etc) for the work, then the realization rate is 85% [I note that some firms adopt the practice of looking at realization as being the amount paid against the amount billed (94.44% in this example) but this is not the methodology used in RULES].
On the other hand, if the same fee earner does a fixed fee job for $1,000 and it only takes them 5 hours to do the job (cost of $500), then the realized rate is $200%.
While this may have been a good indicator of individual lawyers’ profitability in the past, in the era of the “new normal” more and more clients will not pay for their lawyers on a fully rack-rated hourly basis. At the same time, law firms have been slow to learn how to price for their services in any way other than hourly rates (ie, this job will take me 5 hours times $100 per hour = $500 for the fixed fee).
The combination of these two failings goes some way to explaining why industry trends have seen realization rates declining – from 88% in 2008 to 84.5% in 2010 – and, unless law firms become much better at pricing their services, this metric will very shortly become meaningless.
Utilization is the yardstick by which we determine how busy fee earners are. To determine this we look at the annual budget of hours the firm has set each relevant fee earner against the amount of billable time they have put on their time-sheets (daily, weekly, monthly or annually).
There are two principal flaws with this use of utilization:
- the first is that the annual billable hour figure is a moving goal post. Not too long ago, expected annual number of hours per fee earner were in the 1,400 to 1,500 range. Today it is not uncommon to see figures of 1,700 to 1,900 hours per year being thrown around.
- the second, and more important, reason is that utilization sees an hour billed as “king”. Indeed, an hour billed to a client while sitting in your office trumps a non-billable hour sitting in your client’s office talking about their business – regardless of the fact that others in your firm may actually get 50 hours of billable time because of that hour. Moreover, an hour doing pro-bono work for the good of your community or KM in creating precedents documents is, by use of this system, essentially a wasted hour.
In the era of the “new normal”, where clients are looking for, among other things, an understanding of their business (non-billable hours spent attending industry events) and corporate social responsibility, utilization seems an outdated profit related performance metric.
Leverage is the number of fee earners you have to partners.
A reading of Maister’s Managing the Professional Service Firm will tell you that leverage is a key component of a law firm’s profitability. In order for a law firm to be more profitable, the maximum amount of work possible must be pushed down the chain to the more junior ranking lawyers.
Unfortunately, this too is problematic in the new normal. Clients today are simply not willing to pay for junior fee earners to work on their files in the same way as was previously acceptable. Indeed, it’s not uncommon these days to see clients refusing to pay for associates less than 3 years PQE in requests for proposals. On this point law firms do appear to be taking note. Take a cursory look at any number of law firm websites and you’ll likely see the firm positioning its team as being “partner lead” (as opposed to the old language of “partner supervised”).
The unfortunate knock-on effect of this, however, is that law students are becoming increasing pessimistic that they will get training contract in the first place and retention rates of trainees is probably at an all-time low – not to mention the fact that this goes against the very concept of “leverage”, once again makes this a somewhat meaningless metric of a firm’s profitability in the era of the “new normal”.
Expenses are both fixed (ie rent) and variable (ie salaries and bonuses) and are always going to be an important factor in determining a law firm’s profitability.
The only issue I take with law firms’ approach to expenses at the moment is the belief that cutting expenses will help to maintain or increase profitability. While this will have some part to play, studies from the likes of Bain & Company show that an increase of price – if properly managed – is far more successful in increasing profitability than a reduction of costs. But as reducing your own internal costs is an easier conversation for law firms to have, this remains the current preferred method.
Speed of collection is generally determined as being the time from when you did the work to the time you are paid for that work.
Sometimes known as “lock-up” days, speed of collection will have a massive effect on the firm’s profitability. Not only is this the case because firms have to borrow in order to operate their business during the time the payment remains outstanding, but also because there appears to be a direct correlation between clients who want discounts to the number of outstanding days of payment (with the longer you take to get paid, the higher the chances are your client is asking you for a discount).
But here’s the crux: law firms are actually getting worse at this! According to a recent report in Lawyers Weekly:
“Firms in the $5m-$10m revenue bracket had an average lock-up of 203 days, while firms raking in $10m-$20m in revenue had an average lock-up of 174 days. Small and large firms had a lower average rate of 139 and 134 days respectively”.
All I can say to this is that if you are waiting half a year to get paid for work you’ve already done, then you really have no one to blame but yourself if you are not making a profit!
WHAT’S THE ALTERNATIVE?
While I don’t advocate that law firms throw the baby out with the bath water just yet, I am of the opinion that law firms do need to start looking at alternative calculations when determining their profitability.
Having looked at the issue for some time, I have a number of views of my own as to how this might work, but would be interested to hear your views.