Profit Improvement for Small Law Firms

Posted on August 13, 2014

Financial performance in the legal profession is best described as patchy. Some firms are doing exceedingly well, others are muddling along and a lot are struggling. Whilst the more financially successful firms share some strategic and operational traits, there is no one true model for guaranteed success.

Understanding and managing the economic drivers of your practice will make it profitable –and keep it that way.The following sections address common challenges facing legal practices and the relevant performance measures owners and managers need to be conscious of.

ProfitabilityLaw firm profitability is a function of several elements. These are best explained by David Master’s formula which describes profitability as a function of the employed fee-earner leverage, price, time utilisation, the realisation of effort and profit margin.

This can be summarised as:NPPP = (1+L) x WR x CH x R x M

Where:•NPPP is the net profit per equity principal

•L is leverage which refers to the number of employed fee earners per equity principal

•WR is the weighted hourly rate of all fee earners in the practice

•CH are the average annual chargeable hours generated per fee earner

•R is the realisation of work in progress (i.e. the percentage billed after WIP write-offs)

•M is the profit margin

Table 1 provides a snapshot of the profitability of well established small practices and the related profit drivers.

The above table shows there is little difference in many of the profit drivers, particularly between the mid profit and low profit firms. All that is required for significant profit improvement is an incremental movement on any one of the profit drivers

Delegation

In many practices delegation is often poor. Whilst leverage is one of the key profit drivers of a legal practice, itis only successful when each of the fee earners are fully utilised. Consequently the historical measure of leverage using headcount can be distorting.

A more effective approach to considering leverage is to look at ‘hours’ leverage which is the ratio of employee chargeable hours to equity principal chargeable hours. By calculating and managing hours leverage firms are able to identify and improve key components of performance such as:

•whether or not practice groups are appropriately staffed

•the effectiveness of delegation within practice groups

•where time is being written off

Hours leverage is appropriate for firms of all size. Among other things it encourages principals to focus on the performance of their team as a whole, rather than their personal billings. Well managed firms have a greater hours leverage than they do headcount leverage. Table 2 provides a comparison of these two measurements.

The large discrepancy between headcount leverage and hours leverage for the low profit and mid profit firms indicates poor delegation and underutilisation of the employed fee earners.

Pricing and Cost of Production

Irrespective of the rates charged in your firm, the essential consideration is the cost to produce the legal service. High performing firms know the hourly cost of production of each individual fee earner and the exact cost of any fixed fee work. This cost of production underpins all pricing decisions be they hourly rate or fixed fee.

These firms know that each practice area will have a different cost of production based on how the practice is structured, the salaries paid, the overheads consumed and the level of utilisation of fee earners. In this environment a broad brush price setting approach where the firm pegs its rates to a narrowly sampled market rate means that some firms will win and some will lose.

Table 3 provides a snapshot of the hourly rates in smaller practices.

Chargeable Hours

Regardless of pricing strategy, in the crudest analysis law firms sell time. This time may be packaged a number of ways (e.g. fixed fee or hourly rate), but the primary input is the time spent by the lawyers on client matters.

The amount of chargeable hours (or effective chargeable hours – calculated by dividing billings by charge rate) varies significantly between solicitors and firms. Approaches used in high performing firms to ensure lawyers achieve their hourly budgets are:

•meeting daily with junior lawyers to help them plan their day – the open door policy works well in conjunction with structured daily meetings, but is a poor substitute

•reviewing the file load of all lawyers to ensure they have properly prioritised their time and that no critical dates slip through the net

•a one-on-one meeting each week with each fee earner to discuss objective and subjective performance issues

•6 monthly file closing days where all lawyers bring their difficult files. The group as a whole work through each file with the aim of closing or advancing as many as possible. In addition to the obvious financial benefits there is a positive impact on lawyer stress levels as their difficult files have been turned into fees.

Realisation

Realisation refers to the percentage of work-in-progress (WIP) on matters that is invoiced to clients. Research shows the realisation for many practices was decreasing and WIP write-offs were on the rise.

In a busy practice one would not expect reduced realisation – quite the opposite. Low realisation is usually a combination of:

•poor pricing for fixed fee matters

•inappropriate structure of practice groups

•firms submitting lowball pricing to secure the work

•poor training of juniors

•junior lawyers doing work that cannot be charged

These factors can contribute to what may become a culture of write downs in a practice. This is a situation where principals are almost programmed to write off significant amounts of WIP to meet their perception of value.

Firms with strong realisation have a rigorous billing system in place. Solicitors do not sign off on the final invoice. If there has been a culture of write downs in the firm, the managing partner has to review all WIP write offs over a certain (small) percentage

Margin management

The salaries overheads and profit margins in a firm will be impacted by the practice structure.

A well-leveraged firm will most likely have a salaries margin (excluding the equity principals) of greater than 40%. This will usually result in a profit margin (before principals salaries) of less than 30%. The overall profitability of such a firm in terms of net profit per principal will be quite high as the profit is shared among fewer principals.

Conversely, a non leveraged firm usually has a lower salaries margin and a very high profit margin. This high profit margin does not accurately reflect the profitability of the firm as no salary cost of the equity principals is taken into account. Usually the net profit per principal of low leveraged firms is low unless their charge rates are significantly higher than average.

Salary margin, overhead margin and profit margin are all lag indicators. In terms of directly managing the margins there is very little that you can do except reduce expenses.

Next steps

Successful practices have achieved incremental improvement over time in many of the above performance indicators. This has lead to increases profit optimisation and a financially robust practice.

Benchmarking is the process of calculating the key performance indicators of your firm and assessing your performance against appropriate targets or benchmarks. By using benchmarks to understand the gaps in your firm you can readily identify where to focus your efforts to improve performance. Getting agreement on the change required will be made easier if you can educate your people by demonstrating the benefits of change.

To measure the performance of your firm and improveyour profitability visit www.legalbenchmarking.com.au

Your subscription provides you with access to these law firm performance tools throughout the financial year:

• An instant comprehensive report highlighting factors impacting performance

• The ability to select benchmarks appropriate for your firm

• Excel export for you to tailor your own graphs and reports

• Comprehensive salary and charge rate application assess salaries, budgets, productivity and charge rates for all personnel by years experience

• Scenario modelling to conduct ‘what if’ analysis on your firm – an ideal training tool for partners and lawyers

• A web teleconference with FMRC consultants to discuss your survey results and appropriate strategies

Sam Coupland

Director, FMRC

P +61 2 9262 3377

E enquiries@fmrc.com.au