Managing Profitability as a Competitive Tool

In every region of the world competitive forces in the legal market continue to increase. Whether a firm is small, medium, large or global, it is vital that firms seek continually to outperform their competitors if only to retain the business they have, let alone grow. There are a number of factors that determine whether a firm is competitive or not and only one is the technical expertise of its lawyers. Among the other factors is the firm’s profitability. A firm that has a lower profitability than its immediate competitors over a number of years will find it increasingly difficult to compete with them.

This is not only about what the partners as owners earn, important as that is, but also about the ability of the firm to invest in sustaining a competitive position in the market. If a partner or partners in the firm feel they are not earning enough then they might leave for another firm, threatening the firm’s long-term future. Equally, however, if the owners keep up their incomes by not investing in the firm’s future development, the firm will likely decline in competitiveness and also face an uncertain future.

Investments Come in Several Forms

One form of investment a firm must make to maintain its competitive position is in active business development and client management programmes. This takes time and money. If a firm cuts back on this area, it could enable a firm’s competitors to target and potentially take its important clients. A second key form of investment is recruiting talented fee earners, either or both staff and partners. There will be a need to pay market rates and to recognise that there can be a significant time lag between someone joining and then becoming profitable. A third key area is technology and back office staff to support fee earners. Without this, fee earners will operate somewhat inefficiently. As a result, they either will be forced to write off costs (and profit) to keep prices at an acceptable level or will lose work because it is too highly priced.

A common feature of firms facing a profit level below competitors is that they cut back on these investments in order to achieve a short-term improvement in profitability. If maintained, the competitiveness of the firm will suffer, and it will lose ground to firms who continue to invest in enhancing these key areas. For a firm to succeed over the longer term, it is essential for it to have a profit level sufficient to reward partners and staff at competitive rates, as well as to invest in activities that will continuously enhance its competitiveness.

Managing Key Variables

Profit is earned when revenue exceeds all costs. The number of partners will be one determinant as to whether the profit is sufficient. The investment needs of the firm are the second determinant. The two together provide a basis for budgeting what the profit needs to be in any one year. The second item is the cost basis necessary for it to perform at the required level to be competitive. There is a base overhead cost and the direct costs of fee earners. These costs cannot be changed easily in response to short-term fluctuations in demand. Fee earners cannot be fired if demand drops and then brought back quickly when demand increases; property costs or rent tend to be tied to long-term lease requirements. Salaries and property are the two largest costs in a law firm and neither can be easily manipulated in the short term without damaging the long-term future of the firm.

Hence short-term profit management comes back to managing the key components of revenue generation. Of course adjustments can be made to the cost structure over the medium to longer term but in the short term, profit management has more to do with revenue management than reducing costs. On the subject of costs, we advocate that a ‘notional salary cost’ be imputed for partners in the management accounts information. Given they are generating revenue the cost base should include a charge for them so that the firm’s cost base reflects the true cost of operating the business. Hence in the management accounts, partners would be shown as receiving a salary and then a share of the remaining profit.

There are two critical variables that need to be managed here. The first is the profit per fee earner (“PPFE”) and the second is the relationship between direct costs (mostly the salaries of fee earners including the charge for partners) and revenues: this is the cost multiple. Lying behind these variables is the utilisation of fee earners (being the number of billed hours they generate) and the price charged for those hours. An example will illustrate how these variables work.

How PPFE and the Cost Multiple Work

Assume a firm has five partners and 15 other fee earners (ie, 20 fee earners in total). Assume also that a competitive reward for partners is HK$5 million each and that HK$1.5 million of this is in the salary costs: so a minimum profit would be HK$17.5 million (5 x HK$3.5 million) plus, say, HK$2.5 million for investments, a total of HK$20 million. Given there are 20 fee earners, the PPFE will need to average HK$1 million each (20 x HK$1 million = HK$20 million). Assume also that overheads in total come to HK$16 million and fee earner salaries are HK$24 million (including a charge for partners). Revenue will need to be HK$60 million in order to cover these costs.

This means that each fee earner needs, on average, to generate revenue of 2.5 times their salary cost to reach the revenue target. This is the cost multiple: with a direct salary cost of HK$24 million, dividing that into the revenue target of HK$60 million results in a ratio of 2.5. So for every HK$100 of salary cost each fee earner needs to generate HK$250 in revenue to reach the revenue target. If they achieve that and costs meet budget then the PPFE will be HK$1 million.

The PPFE is a consequence of the fee earner salary cost plus a percentage charge for overheads as a deduction from the revenue generated by each fee earner. Using our example above, the average fee earner salary cost is HK$1.2 million (20 x HK$1.2 million = HK$24 million). On average each fee earner will need to generate revenues of HK$3 million (20 x HK$3 million = HK$60 million). Overheads of HK$16 million represent HK$800k per fee earner. So the full average cost per fee earner is salary of HK$1.2 million plus overheads of HK$800k (66.7 percent) equals HK$2 million. By generating an average of HK$3 million they will produce a PPFE of HK$1 million.

Setting Firm-Wide Targets

In order to generate this revenue the number of hours they bill and the average hourly rate will be important as is the volume of work available to ensure they can bill the required hours. The key issue is that the firm-wide targets should be the cost multiple and the PPFE and not utilisation and prices. Different fee earners might have different combinations of hours and prices that achieve the firm-wide targets so these need to be set for each fee earner and not be targets for all fee earners. Instead of requiring all fee earners to generate 1,500 billed hours and an average hourly rate of HK$2,000 (which would give revenue of HK$3 million), one fee earner might be required to charge 1,800 hours at an average rate of HK$1,667 per hour while another might charge 1,200 hours at an average rate of HK$2,500 per hour. Different types of work will have different pricing structures and setting a firm wide requirement might penalise some and result in others undercharging.

The cost multiple has a key role at the individual level. While the target might be 2.5 times direct salary costs across the firm, each fee earner will have a revenue target based on his or her salary costs. A senior fee earner on a salary of HK$2 million will be required to generate HK$5 million in revenue; a junior fee earner on HK$800k will be required to generate HK$2 million. If each fee earner generates revenues that are 2.5 times their salary cost then the firm will hit its revenue and profit targets, provided overheads do not exceed budget.

By focusing on the cost multiple and the PPFE at the firm wide (and department) level, management will be more likely to achieve their budget revenue and profit targets than setting one level of utilisation and price across the firm and trying to manage these. The latter can be done for each individual given the type of work they are doing and their level of seniority in order to meet the firm’s targets for PPFE and the cost multiple. If each individual achieves these then they will meet the firm’s targets. If an individual is not achieving his or her targets for both the cost multiple and PPFE then management can dig deeper to see if it is due to an hours’ deficiency or a price problem (or both).

Hodgart Associates Ltd, Managing Director

Mr. Hodgart is recognised as the leading strategic change consultant to professional service firms in Europe and one of the few leaders globally. His client base includes some of the leading firms in all major professions as well as a wide range of smaller to mid-market firms in many countries. While based in London, he worked mainly at an international level.

Mr.Hodgart has written extensively on management issues facing professional firms. Prior to his career as a consultant, he had a successful career as a professional cyclist competing successfully in major road races and tours.