Managing a smaller law firm can be a very time consuming business given that the partners usually have heavy fee earning roles as well as attending to business development and client relationship management. As a consequence, profitability management tends to be done after the event, often by simply focusing on the cash that has come in and gone out: an increase in cash is taken to mean all is well while a decrease signals the opposite. The problem is that in most cases there is a time delay between the profit being earned and the cash it generates being received. Hence any deterioration in profit is likely to be well underway by the time the cash flow suggests that there is a problem.
In addition it is important to maintain a focus on business development to ensure that there is a strong and consistent flow of instructions into the firm. Without that flow, revenue and profits will fluctuate quite significantly and this makes profit management even more difficult.
In what follows we suggest five relatively simple techniques that will allow partners to better manage profitability and, in so doing, be more profitable.
Technique 1: Manage profits separately from cash
Generating profit is a separate function from collecting the cash due from invoices rendered to clients. A declining cash balance certainly indicates a problem but it might not be a profitability issue. It might be that partners have not invoiced for work that has been done profitably or it might be that invoices have been issued and clients are very slow paying. On the other hand, the firm has to pay much its expenses each month so the firm is in effect funding its clients for as long as it takes for clients to pay.
The first step is to ensure invoices are sent out as soon as possible. Seek to negotiate interim invoicing for longer term projects and try to agree monthly invoicing with clients. Set a target for the outstanding amount of unbilled work (work in progress) and unpaid invoices (debtors or AR.) Without a target there is no pressure on partners to get invoices out to clients promptly and to chase up slow payers. An easy target is to make it a percentage of budget annual revenue – say 25% (equivalent to three months revenue). So if revenue is HKD10.0m then 25% would be HKD2.5m or 3 months of revenue. (Annual revenues of HKD10.0m average HKD833k per month or HKD2.5m for 3 months). If it is felt that 25% is too low, given the nature of the firm’s business, then increase it but it should not go above 40% of annual revenue (4.8 months). Focus on keeping the work in progress and debtors within the target. Few firms in the world today, both large and small, allow their work in progress and debtors to exceed 50% of revenue.
Technique 2: Record time daily
Several studies we have conducted show that a failure to record time on client work daily leads to an erosion of billable time that increases the longer it takes to record the time. In fact doing it weekly rather than daily leads on average to around 15% of billable time unrecorded, in other words, time lost from the firm’s records. For hourly rate priced work this means that the price charged will be less than the actual time spent. On fixed price work it will look as if a matter was profitable when it might not have been.
With today’s electronic phones and other portable technology, there is no excuse for partners (and others) to not record their time daily. Poor time recording not only means that some time is lost but it also results in a distortion of the metrics for assessing profitability. For example, productivity will look low and it might be assumed that people have capacity for more work when they are, in fact, very busy. Hence time recording also helps with knowing whether fee earners are sufficiently productive, a key metric in managing profitability. (See also Technique 4.)
Many firms, who now operate on fixed fees for work, assume that there is no point recording the time taken because the hours do not determine the price. This is faulty thinking. While the price might be set by the client, the firm needs to know what the cost was in doing the work on the matter. If the time spent on the matter is not recorded accurately, then the direct cost cannot be determined. Without this it is not possible to see if the profit on the work was sufficient and, if it is not, how to get the cost down next time the same work is done. To not record the time makes it appear as if a matter was profitable when it was not and runs the danger of unprofitable (or low profit) work being repeated time and again.
By knowing the profit earned on a matter, attention can be given to making the work more efficient resulting in reducing the cost and improving the profit. Alongside this, some firms are making a decision to not do some work because the market price is too low for them to earn the required level of profit (given their cost base) and it is better to focus their time on work where the required profit can be achieved. Too many small firms continue doing work that is at a low (or no) profit and wonder why they cannot improve the profitability of the firm. In a price pressured market no business can afford to keep selling its ‘product’ at a low or no profit for any period of time. Law firms are no different and are learning that they either have to reduce the cost of generating the work or to stop doing that work if they want to have a profitable business.
Technique 3: Identify realisable revenue monthly
Knowing what is the realisable value of work done each month is fundamental to managing profitability. Management should have, from the budget, a good estimate of the average monthly expenses. Estimating what revenue can be expected to flow from the work done in a month allows an estimate of profit to be made. Estimating the amount that is likely to be invoiced to clients is based on the work actually done in a month. For fixed fee work this can be based on the hours spent in a month as a percentage of the total hours budgeted for the work and this percentage then applied to the fixed fee. Hourly rate priced work can be based on the time recorded in a month with partners assessing how much of that is likely to be billed and the applicable rate. (This is another reason for accurate time recording.)
Partners sometimes say this is not always possible until they actually invoice the work but we disagree. There should be no problem with fixed fee work. In today’s world, hourly rate priced work should not be undertaken without some idea as to the end price the client will accept. Some discussion with a client up front will clarify this, or, where a partner knows the client very well there might be a good sense as to what the client will pay. It might not be totally accurate but it should be within around plus or minus 5% of the eventual invoice. The key point here is that it provides an estimate of the profit by month and any deterioration can be seen quickly and not wait until the cash inflow starts to decline.
A monthly report can then be prepared showing the estimated revenue each month and year to date the total actual costs, split between direct costs (fee earner salaries and related costs and a cost for a partner), and overheads measured against the budget for the month and year to date. The overhead costs should be relatively stable and are usually allocated monthly as one twelfth of the annual total. The revenue less the direct costs gives the contribution margin which, given the relatively fixed nature of overheads, is the determining number in regard to profit. A declining contribution margin will result in lower profit unless overheads can be reduced and this is hard in the short term. Monitoring this report every month against a budget starts to give control over profitability.
Technique 4: Focus on two key variables
There are two variables that are critical in measuring profitability and both depend on accurate time recording. (Without accurate time recording it is not possible to estimate the revenue earned for the period as discussed in technique 3 above.) The first is called the cost multiple: it is the revenue earned in the period divided by the direct costs of generating that revenue. (Note above in technique 3, direct costs include fee earner salary costs and a cost of a partner.) So with revenue at HKD10.0m and direct costs at HKD4.0m the cost multiple would be 2.5: every HKD1k of salary cost in the firm is generating HKD2.5k in revenue. This is a key reason we suggested separating direct costs from revenue in technique 3.
This is one of the most important variables for managing profitability. It can be applied to the firm as a whole, to a matter or to an individual. For most firms a good profit can be earned if the cost multiple is between 2.5 and 3.0, depending on overheads. (If profit is poor and the cost multiple is 3 then overheads are likely to be too high for the type of business.) A decline in the cost multiple will be associated with a declining profit and the benefit of this variable is twofold. First, it isolates the problem in that the decline in profit will almost certainly be due to not generating sufficient revenue from fee earners given their cost: so the solution will be to generate more revenue or reduce the direct costs. The second benefit is that it provides one measure for a fee earner’s financial performance: a cost multiple can be set for each fee earner (including partners) and, given their cost, an expected revenue target can be calculated. Hence in the event the actual cost multiple declines it is possible to drill down to where the problem is.
The second variable is the profit per fee earner. A declining cost multiple will result in a declining profit per fee earner (with the same number of fee earners) and this variable allows for an easy calculation to be made of the impact on partner profitability (well before annual accounts are prepared.) For example, assume a profit per fee earner (the profit calculated in technique 3 divided by the number of fee earners) of HKD1.0m in a firm with 5 equity partners and 15 other fee earners, 20 in total (so HKD20.0m profit in total, being 20 times HKD1.0m). The profit per partner can be calculated by multiplying the profit per fee earner by the leverage plus one: the leverage in this example is 1:3 (5 equity partners divided into 15 other fee earners equals 3); i.e. on average each partner has three other fee earners so the group is four, including the partner. So a leverage of 3 plus 1 equals 4 fee earners, and 4 times the profit per fee earner of HKD1.0m equals HKD4.0m, the same as dividing the total profit of HKD20.0m by 5 equity partners.
Of course it is important to maintain the productivity of fee earners but the cost multiple summarises the result of both productivity (billable hours) and pricing. Given the direct costs, a decline in the cost multiple can be due to a low level of productivity or discounting rates or spending time on a matter that is not recoverable, or some combination of all three. It doesn’t take long to find the cause of a decline in the cost multiple and corrective action can then be taken quickly to reverse the trend.
Technique 5: Control overhead expenses
It goes without saying that overheads also need to be controlled. As noted above, the cost multiple might be at an acceptable level but a too high level of overheads will lead to a reduction in profit. The issue here is that overheads need to be at a level that will support the business to operate effectively and efficiently: simply cutting overheads because profits are down might damage the business more. Hence the importance of the cost multiple that isolates whether the problem is overheads or the conversion of direct cost into revenue. Given the level of overhead required for the business to operate, there will be a combination of direct cost and revenue necessary to earn a competitive level of profitability. Management need to examine this from both ends: given the overhead required, what is the result for direct costs and revenue – and vice versa?
One way to assess what is an appropriate level of overhead is to work back from the expected revenue. If the cost multiple (revenue divided by direct costs) is 2.5, then direct costs will be 40% of revenues: with revenues of HKD10.0m, direct costs will be HKD4.0m (2.5 times HKD4.0m equals HKD10.0m). This leaves 60% for profit and overhead. For many firms overheads constitute around 30% to 35% of revenue so leaving a profit of between HKD2.5m and HKD3.0m. Whether this is sufficient to reward partners allowing for the fact that a partner cost is already in direct costs will depend on the number of partners and their expectations. (Smaller firms can sometimes operate with a percentage of around 25% but this depends on rent and other costs of course.) Another exercise that can be done is to examine where fee earners spend their time other than on client work and decide whether some activities would be better done by back office staff or by technology. An analysis can then be made to identify what additional billable time can be generated and what the impact of this might be on revenue, costs and profit.
Profitability in a law firm, large and small, is a competitive tool. Without an appropriate level of profit a firm cannot hire the best people let alone retain their stars. It cannot invest in the support services required to ensure the firm operates effectively and efficiently: this is becoming acute for many firms as the need to invest in more and more expensive technology along with new systems and processes is vital for a firm to retain its competitiveness. In other words there is a level of profitability that a firm needs to earn, given its market position, to ensure it can continue to compete with its direct competitors. A failure to achieve this level will lead to a continuing deterioration in market position, the loss of clients, the loss of good people and possibly to the eventual demise of the firm. It is crucial that partners understand what has to be done to manage profitability and allocate time each month to do it.