More and more law firms are adopting meaningful profitability analysis tools to measure their financial performance. This is a noteworthy and positive development.
The development is noteworthy because firms traditionally have been reluctant to assess profitability explicitly because of the risk of incentivizing undesirable partner behavior, particularly the risk of undermining collaboration and the assignment of the most appropriate lawyer to matters. A combination of a greater appreciation for the value of profitability assessment and an increased confidence in the judgment of firm partners appears to have overcome these concerns. As well it should have.
The development is positive for several reasons, some more obvious than others. Most significant, in my view, is the capacity of profitability analysis to guide firms to more efficient ways of delivering service.
The Basic Idea
The basic idea of profitability analysis is quite simple:
Quantifying the revenue and expenses associated with a given firm undertaking (e.g., a portfolio of engagements) and computing whether and to what extent the revenues exceed the expenses, thereby generating a profit.
For most businesses such [profitability] analysis is an essential element of strategic planning from Day One. Not so with law firms.
For most businesses such analysis is an essential element of strategic planning from Day One. Not so with law firms. Traditionally law firms have been content to manage their financial performance based on revenue (or “billings”), utilization, realization, and the income available for distribution to partners, labeling the latter number “profits” although it consists both of the compensation of the partners and their share of an undetermined profit.
The Benefits of Profitability Analysis
Firms will reap at least three material benefits from profitability analysis.
First, it will supplement the traditional law firm metrics. Fundamentally, it will add the relevant expense calculation to the equation. As my former partner, and legendary bond lawyer, Roger Davis was fond of saying, lawyers often “will spend a dollar to generate fifty cents of revenue.” Profitability analysis will reveal when they are doing that.
Second, it will enable firms to sharpen their execution to achieve targeted levels of income for their partners. Armed with the fuller picture, the firm can manage all elements better toward a profitable outcome.
Third, and most important, it will enable firms to see where the opportunities for greater efficiency lie. It will be a sort of GPS for revising the service model to respond to market demands for lower fees and to take advantage of the opportunities that technology and new design concepts offer.
In nearly all segments of law practice, firms are facing declining realization. The market is steadily and progressively paying less per unit of value delivered. Firms must find a way to respond to this development, without sacrificing quality. Meanwhile, firms face increasing costs for the traditional resources deployed in legal service: associates, technology, and facilities.
To reconcile these two dynamics, firms must revise their service models, to use a different combination of resources and deliver service in a different way. The expense dimension of profitability analysis provides essential guidance to design such a revised service model. By showing the firm exactly where the cost is being incurred, it enables focused examination of how the firm might do better.