Creating value: The service profit chain and law firms

29 Jun 2012News

Simon Nash, HR director at Carey Olsen, discusses how the service profit chain can help your firm to become more profitable

Three things you will learn from this Masterclass:

How to understand the service profit chain in the law firm context
How value is subjective for both clients and the firm
The relationship between staff and client loyalty and firm profitability

In the first article in this series, it was demonstrated that differences in ?a firm’s long-term profits arise from ?the way in which the firm manages just four key variables: rate, leverage, margin and utilisation.¹

This analysis was based on David Maister’s professional service firm (PSF) profitability model. Maister’s analysis, which he derived from a classic industrial model for return on equity, looked at the firm as a manufacturer of billable hours, ?in which the firm is viewed as being like ?a production line.

Although this production line metaphor has its advantages, readers will have identified some of its drawbacks, chief of which are that it understates the role of clients, and especially the impact of their loyalty on firm profits, along with the impact of client loyalty and the elasticity of demand for legal services.

Another model that yields much fruit in the analysis of law firms is the service profit chain, which was developed by another Harvard Business School professor, Jim Heskett. Heskett has never been as well known as Maister in PSF circles. This is due in part to the relative lack of PSFs in his case studies and consulting projects.

This is a shame because his emphasis has been in exploring businesses in which client satisfaction is a key driver of financial profitability. He principally found examples of this in the hospitality, transportation and leisure sectors, at both the Fortune 500 and start-up levels.

Heskett’s service profit chain model is built on the premise that value is created ?in organisations through a cascading series of causes and effects, and that the most useful way to construct such a value chain is to start from the perspective of ?the client.

Why start with the client? Because that’s where the money starts and where the decisions are made that ultimately make the firm more or less profitable.

In this article, Heskett’s model will be unpacked in stages and applied to the modern challenge of the legal services context. It will be demonstrated that law firms, as business-to-business retailers of intangible transactional and advisory services, show particular sensitivity to the financial returns explained by Heskett’s analysis and also to the risks identified.

Client loyalty creates profits

The first link in the service profit chain (see Figure 1) is from profits to client loyalty. Remember that the service profit chain is read backwards, as it seeks to explain an upstream causation (which is within the control of management) of the downstream results (which are at the mercy of markets).

By profits, Heskett is interested in the medium-term organic creation of sustainably increasing earnings, rather than any short-term variation in quarterly figures. This is an emphasis that is readily translated into a law firm context.

Throughout the 1990s and the first decade of this century, business school research findings proved without question a strong link between client loyalty and higher profits. Indeed, one study found that even a five per cent improvement in client loyalty accounted for a 25 to 85 per cent increase in earnings. As ever, the challenge is to move from positive correlation in the data to an explanatory model of causation.

In this element of the service profit chain in particular, the causation is pretty unarguable. If clients are continually coming back for repeat business:

the costs of client acquisition will ?be lower; ?
productivity will be higher, as less ?time is wasted learning how a client likes things to be done; and ?
there is a predictability of service demand, which means the firm can resource up and invest in systems ?to service a certain level of work.

Now, it is accepted that, in some ?markets, the scarcity of supply can lead ?to a diminution of the impact of client loyalty upon repeat business. If, for example, you are a client who needs a lawyer specialising in a very niche area, then your decision is largely going to be driven by availability rather than preference.

At the other extreme, there are markets in which the relative infrequency of purchases makes client loyalty an indirect force, through the proxy of brand reputation and market rating, rather than through the direct relationships of loyal clients to their trusted firms.

These two exceptions are marginal, though, and the majority of legal services are provided in a genuine market in which a reasonably large number of competent providers compete for the business of a large number of repeat buyers.

Client satisfaction increases loyalty

It goes without saying that a loyal client is one that has been satisfied at least once in the past. The service profit chain goes further than this trite observation to posit a level of causality between clients who have had an exceptionally memorable service experience and those who become loyal ambassadors for the brand.

Heskett himself cites the case of Xerox, which found that the most satisfied 20 per cent of its commercial customers were 600 per cent more likely to recommend the company to other prospective customers. Xerox called this customer segment its ‘apostles’ and sought ways to leverage this enhanced level of loyalty in a mutually-reinforcing relationship.

In the legal sector, where the client to firm relationship is still much more personal than in many other fields, this effect of satisfaction driving loyalty is even more vital. Just as all organisations have their ‘apostle’ clients, one should not underestimate the impact of creating ‘terrorist’ former clients, who have experienced such a dissatisfying level of service that they feel compelled to convince the world not to use your firm.

Value-creating transactions increase client satisfaction

To recap so far, in the service profit chain, increased profits are the result of loyal clients, who are created from a larger pool of merely satisfied clients. What creates a satisfied client? Clients are satisfied by value-creating transactions. What is value in this context? In Heskett’s model, there are several important features.

First, it is a subjective measure. Value is only created for the client if the client perceives that the results of the transaction outweigh the price of the services provided. From the perspective of the firm, the transaction may be regarded as valuable if the service price exceeds the cost of services by an acceptable margin. Figure 2 shows this dichotomy.

Heskett’s second important point about value-creating transactions is that, although the creation of value is subjective to the client, the factors that contribute to the perception of value are virtually all inherent to the service provided and not incidental to it.

An illustration makes this clearer. Suppose you take your car in to be repaired by a registered dealer. You are greeted pleasantly by an attractive receptionist. You wait in a clean and modern lounge with good coffee and interesting reading materials. The engineer who advises you is knowledgeable, courteous and clean. The car is ready an hour earlier than expected. ?It is valeted and polished to a high shine. But it still won’t start.

In this example, no end of incidental extras – however delightful – can turn this failure of service into a value-creating transaction for the client.

Taking this analogy back into the context of legal services, the message to firms is to be obsessively meticulous about getting the legal documents right in every aspect. Many modern law firm partners will be very comfortable with this approach.

Implicit in Heskett’s position is a suspicion of superficial tricks and techniques in the name of client service or marketing. Here, the point is that sophisticated clients make buying decisions on the rational basis of professional service quality and then become loyal clients if they are satisfied by the consistent quality of that work.

Satisfied staff produce ?value-creating transactions

If it has been established that, ultimately, value is a result of the firm consistently delivering value to clients through superior legal work, then the next logical place to pause in our upstream journey is to ask who is delivering these quality legal services that produce value for clients?

In this respect, Heskett agrees with a large body of management research which suggests that people generally prefer to do a good job well and, given the right environment, will give their best to deliver client satisfaction.

David Maister, in his book Practice What You Preach, reaches a similar conclusion that the statistical correlation between employee satisfaction and client service quality was one of the highest correlates he could measure (b =.404).

Employee loyalty creates ?employee satisfaction

Of course, it’s not sufficient merely for employees to be happy in their work. They need to be productive, knowledgeable and appropriately confident in both their skills and their limitations.

Furthermore, the firm needs a significant proportion of its knowledge workers to have a long-term orientation, without which the processes of organisational learning and service quality become uneconomic.

The management literature on employee engagement has increased significantly over the past two decades, with the twin agendas of:

establishing which management practices show a high correlation with client loyalty and organisational profitability; and ?
moving beyond correlation to causation, to understand how specific management practices create value.

Within this literature, there is a remarkable consensus around the issues of respect and dignity at work, high standards of quality, participative management and clear communications as being strongly correlative to employee satisfaction, client loyalty and profitability.

Value-creating organisations produce employee loyalty

Taking the value chain a step further upstream, what sort of organisation creates an environment for employee loyalty? The answer, according to Heskett and a majority of other business school experts, is an organisation characterised by empowerment, positive delegation and coaching on-the-job.

At this stage in the service profit chain, we are into territory that many law firm partners find much more challenging. Downstream, the meticulous obsession with the quality of legal documents is familiar territory. Upstream, the organisational behaviours that have ?been consistently shown to deliver a ?high quality of professional service are found by many partners to be alien, ?difficult and uncomfortable.

Leadership systems produce ?value-creating organisations

Next is the question of what creates ?an empowered, participative and ?learning organisation. Heskett’s first answer is all about what may be ?termed leadership systems.

Here, we are looking at the specific practices of management or, in the legal context, partners, who ensure a high quality of work is created at every stage ?of a legal transaction.

Practices such as performance feedback, end of matter reviews, openness to suggestions and honest, transparent communications are all cited as critical contributors to a system of leadership.

Leadership systems that drive employee loyalty and value

Developing fee earners’ skills
Creating know-how
Ensuring quality
Performance-focused coaching
Transparent feedback
Empowered delegation
Aligned rewards
Clear employee communications

A leadership culture creates leadership systems

Underlying these management practices are a set of leadership values and a world view of business that underpins the tangible expressions of good management.

David Maister, in particular, dwells on this aspect in a number of his books. According to Maister, you can only get the sort of management practices that deliver client service quality if a core group of partners share a set of values that include some of those set out below (see box: Leadership values that enable a value-creating firm).

These are values that many law firm partners do not naturally tend towards. Astute readers may also recognise certain generational and gender-based trends within this value set, which actually gives hope to firms, as they can plan for succession to improve the culture of the firm when more direct methods have perhaps failed in the past.

Leadership values that enable a value-creating law firm

Openness
Optimism
Innovation
Collective mindset
Future/long-term orientation
Big picture focus
Enthusiasm for quality

Leadership culture can be both the cause and effect of value-creating business relationships

This brief survey of Jim Heskett’s service profit chain has taken us up the chain of causation from financial results, through the client value cycle, into the employee value cycles and ending at the leaders’ value cycle.

Leadership culture is not the finishing point, however, as the whole service profit chain can be seen to be part of a reinforcing feedback loop. Partners enjoy the greater fruits of success through this model, as it reinforces their desire to continue to create and deepen the leadership culture which ultimately delivers that success.

As a virtuous side effect of ?this cycle, many partners find it to ?be a more enjoyable way of working, leading to greater harmony in other aspects of life.

In conclusion, Maister’s frequently-made remark to law firms is very relevant: “To obtain superior returns, you don’t watch the money, you watch (and manage) the things that produce the money”. It couldn’t be simpler, but that does not make it easy to achieve.

Key takeaway points

The firm is a value chain, with loyal and satisfied clients as an outcome.
Value is subjective to the client and based on solutions to their real problems at an acceptable price.
Value is also subjective to the firm, based on the cost of providing the service and the profit margin that may be charged on it.
Recognise how value is created in your firm and where the blockages to value flow exist.
Manage causes upstream and their effects on results downstream.
Partners should focus on people management activities; clients and financial outcomes will flow from the value chain.

Endnote

1. See ‘People and profits’, Simon Nash, Managing Partner, Vol. 14 Issue 8, May 2012