Driving profitability: How to solve your firm's profitability problems

Shrutisha Morris, financial controller at Weightmans, discusses how to improve firmwide profitability

 

Many law firms and their leaders are under intense pressure to operate more efficiently and react to new ways of buying legal services. With alternative business structures (ABSs) looming, it seems as though this position is likely to intensify over the next few years in England and Wales.

 Some firms will use ABSs to their advantage (much as they did with LLPs, which had a slow adoption rate); others will be waiting to see what opportunities they bring to their practice over the next few years. For most firms, however, a steady but cautious approach to the next financial year is likely to be adopted, focusing around maintaining their client bases and maximising profitability.

There are many factors which can have the biggest impact on profitability and the long-term financial performance of law firms. The relative impact of each of these drivers varies from firm to firm. However, the solution to a law firm’s profitability problems is almost always found in one or more of the following.

 

Pricing

The chargeable hour metric is viewed by some as inefficient, with clients believing alternative billing arrangements enable them get the best service for the right price.

This isn’t always the case, however, as clients will continue to be prepared to pay premium prices for unique high-level skills (when they are needed). Emerging and tricky areas of the law will continue to need bespoke answers, which inevitably will be charged on an hourly rate basis.

The most important step in effective pricing is tailoring it to the client’s needs and aligning the firm’s cost structure to facilitate profitable trading, while meeting the price expectations of the client.

The key drivers of pricing decisions continue to be a focus on value (or perception of value) to clients, responding to market forces against direct competitors and, of course, ensuring the current cost basis is covered.

Alternative fee arrangements such as fixed fees, contingent fees and volume discounts have proven to be a big change for law firms, but can help to address the needs of different clients.

Planning, managing and resourcing engagements correctly are key to ensuring alternative fee arrangements can maintain the firm’s profit margins.

Fixed-price work cannot be managed the same way as hourly rate work, as it requires a greater degree of planning and delegation, which is much more prescribed than hourly-rate work.

Scoping the engagement into prescribed tasks will mean cost and price estimates can be developed which achieve the required profit margin. When communicating fees to clients, ensure the assumptions are clearly stated to ensure any deviation from the scope is chargeable.

Hourly-rate work is still a prominent part of legal services and is essential for certain types of clients/services, but the key is getting the balance right.

A high volume of fixed-fee work which ticks over month after month cushions the firm against potentially more specialised work, which can demand a higher margin but is not always readily attainable.

 

Realisation

Realisation rates measure the difference between what a lawyer records as time and what percentage of that time is billed to the client.

Many firms overlook realisation and focus purely on the chargeability or utilisation of staff. Although this is important in the traditional law firm model, the only way to ensure a profitable business model when delivering on alternative fee arrangements is to maximise realisation and minimise a top-heavy staff mix.

 Too many firms have a high volume of clients who, over the years, have grown in size and complexity but are still being serviced at low fees to maintain them. This can actually have an adverse effect on profitability if all of the work continues to be done at partner level due to a historical relationship with the client.

If you look at the realisation across the entire portfolio clients, it would be interesting to note whether a loss on some of these clients actually makes a difference to the overall profitability of the firm.

The profitability of new work needs to be considered at the outset and its effect on the future margins of the firm when devising pricing strategies and fee arrangements. Are you budgeting correctly, when tendering for work and making the correct assumptions? It surely cannot be worthwhile to get work in at a huge discount and to continue to service it with associates and partners’ time. If clients are only paying for economy, why give them business class?

Maintaining a client base in this way can only reduce profits in the long term, while other newer companies are offering the same services at a lower cost base. Firms have to be bold and persuade partners to delegate down where appropriate, freeing up their time to focus on the specialised, hourly-rate work which can demand higher rates/margins.

The message is simple: get the leverage right. Better leverage can be achieved by well documented case flows and practice notes, which aid junior members to perform much of the case handling. New paralegal hubs should be created and utilised around the firm, especially in a commoditised environment where volume matters.

Quality is of course of primary importance as well, and should be achieved by ensuring enough time is invested in training and developing staff, which results in a more skilled hierarchy, with fewer knowledge gaps in the team. Time invested today will reap benefits in future profitability.

Leverage isn’t just about staff costs: an increased use of IT and automated processing can help to reduce leverage and the need for highly-skilled staff undertaking the work. Most firms are not always quick enough to respond to changes in technology and the need for a reduction in staff numbers, but as prices are being squeezed, so are margins, and being proactive will ensure no surprises in future.

Realisation is a short-term driver that partners and fee-earners can control. The focus must be on improving the realisation rate, coupled with an effective pricing structure, as even small changes up or down in rates can have a significant impact upon profitability.

 

Cost management

A firm’s cost base matters and people and property make up a big chunk of a law firm’s cost base – avoiding the big numbers here could make a huge difference to long-term profitability.

The only way to maximise the bottom line will come down to cost management and reviewing overheads. Cost controls cannot be ignored in improving the bottom line, but it is best left to management at finance and other support levels. It should not require the significant involvement of fee-earner time.

Cost control should be a phased approach by identifying and prioritising short, medium and long-terms savings. Larger organisations must have commitment from all areas of the business to reduce costs (within reason), as directed by senior management.

There are many areas which appear to be easy wins in terms of cost savings, but can result in sacrificing the long-term goals of the firm. Typical businesses across all sectors look to staff remuneration as the biggest potential for savings. Unfortunately, staff cuts are often the biggest area where mistakes can and often are made.

The level at which costs should be reduced needs to be considered. Although easier to reduce at the more junior level, this can prove futile in the medium to long term. Furthermore, it does not help leverage or subsequently delivering services to clients at the right price. It will certainly hinder succession planning, which can put some firms at risk in the long term if talent is lost to other firms.

Key performance indicators and balance scorecards when appraising staff should be used to make decisions about staffing levels across all practice areas.

Other expense categories may provide some opportunity for savings, but firms should be more creative. Devising strict procurements policies and renegotiating major contracts will certainly help to keep costs at bay. Reviewing expensive photocopying and printing contracts can be make a difference to the bottom line, along with reviewing paper usage and maximising how much is billed out to clients.

It’s also important to take a good look at each of the firm’s marketing expenditures, from the perspective of return on investment. It is not about necessarily cutting marketing costs, but measuring the return on marketing activities and ensuring they are tied into the overall strategies of the firm.

A firm must implement a strategy to track where its business comes from. And it must attempt to find a way to measure the efficacy of each of the expensive marketing strategies. Those which don’t produce results within a reasonable time limit should be eliminated.

Finally, establishment costs should be reviewed, as this is one of the biggest fixed overheads which can result in long-term changes to profitability. Does the firm use all of its available space to generate revenue? Is the space the right place at the right price for the firm for the next five to ten years?

There are many ways to structure leases and their incentives in the current market, which puts the lessee in a much stronger position than before the downturn.

 

Measuring profitability

Even if you achieve effective pricing, realisation and a steady cost base, these can prove ineffectual if you don’t measure them accurately and on a timely basis. Many accountants spend too much time focusing on historic numbers and doing reams of analysis of past performance, and spend less time on reviewing forecasting and proactive measurement.

It’s essential for firms to measure not only the all-important top line but also the middle (gross margin) and bottom lines.

A useful measure when considering the gross margin is the cost multiple, which is essentially sales divided by the direct costs of the individuals driving the sales, i.e. the ratio of sales to costs.

This is a useful short-term indicator of how to track the profitability (and highlight problems in leverage) of a client, individual or practice area. Measurement of this and changes to the cost multiple can have the biggest effect on profitability and can be the easiest indicator for a team to control within the firm.

Client profitability models have also begun to emerge as useful strategic tools among law firms of all sizes. They can be used to make medium to long term decisions about the clients, pricing, leverage and overall strategy of the firm. They can encompass all of the key drivers noted above and really get to the heart of measuring the true profitability of clients.

A basic profitability model takes into account standard cost rates for different levels of fee earners by attributing direct costs and apportioning indirect overheads.

Many questions will arise when devising cost rates which may take some thought before presenting the results to fee earners. Do you use budget or actual figures? Do you include partner notional costs? What is the best mechanism to apportion overheads?

The key point to emphasise is that this is a strategic tool which should provoke thought and trend analysis, not absolute figures in profitability.

 

Focus on strategy

Financial measurement should be used as a strategic driver, with clear firm objectives set out from the start of the year. The legal sector outlook is changing and firms have to react to that change by moving away from traditional chargeable hours indicators. Business plans should be the link between a firm’s strategy and management accounts.

There are many drivers to a ensure profitability in the short to long term, all of which can have differing effects to law firms. Each firm is unique, but the best path to sustained profitability is the one that focuses on the basics, meets the expectations of the firm’s clients, measures and reacts to information quickly and ensures alignment with the long-term strategy.