People and profits: How HR programmes can increase firm profits

20 Apr 2012News

HR director Simon Nash of Carey Olsen looks at the impact of HR programmes on firm profitability

Three things you will learn from this Masterclass:

The effect of solely focusing on margins and utilisation
How to achieve long-term improvements in profitability through a balanced focus on rate and leverage
The impact of learning and development on service pricing

Law firms are retailers of talent. They rent talent wholesale in the form of employment contracts and lease it out retail to clients in the form of billable hours. The practise of law can therefore be analysed using some tried and tested analytical tools such as value chain analysis and enterprise return on investment formulae. This is not to say '¨that the practise of law might not consist of more than these rather clinical calculations, but it should not be regarded as anything less.

Keen observers of the legal market will be familiar with the enigma that law firms are packed full of the most intellectual people, dealing on a day-to-day basis '¨with legal problems of immense complexity and sophistication, and yet often they approach the task of enterprise management with a toolkit and mindset that are quite simply outdated in comparison to many of their clients.

David Maister’s professional services firm (PSF) profitability model is a good place to start. He updates the classic DuPont model for return on investment as shown in the formula above in Figure 1. The four principle elements on the right hand side of the equation are better known by the jargon of margin, rate, utilisation and leverage. So, they might be expressed instead as the formula below in Figure 1.

Figure 1: Professional services firm profitability model

This shows both the simplicity and also the inherent limits of the PSF model. Each numerator is also a denominator. This means that, as soon as you increase one variable, you automatically run the risk of decreasing another.

Many firms have sought to ‘grow’ their way out of this conundrum and, while that does deliver some economies of scale and enable them to work on large multijurisdictional transactions, growth alone will never deliver a radically different financial outcome in terms of profits '¨per partner.

Maister went on to distinguish the short-term hygiene factors of margin and utilisation, from the longer-term health factors of rate and leverage. In his own inimitable style, he said “if you are not increasing either rate or leverage you are either cruising or losing”.

Why is this? Let us in each case take the denominator as constant and look at the effect of increasing the numerator.

Effect of increasing margins

If you try to drive up margins by increasing the amount of profits you take out of a constant level of fees, the only way to do that is by cutting costs. Cost cutting in law firms is notoriously difficult to get right.

Making innovative changes to product or service lines that make clients happier and cost less to deliver are obviously great synergistic ways to reduce costs, but law firms are not typically nimble innovators and therefore find the cost benefits of innovation slow to materialise.

Of course, the biggest line of operating expenditure in a firm is staff costs, including salaries, benefits and bonuses. While there is always a sound business case for prudent restraint of future increases in the pay bill, I would caution firms to think twice before making knee jerk cost-cutting measures, including bonus restructuring, pay freezes and across-the-board redundancies in key areas of practice.

Too many firms have ended up paying a steep price for these savings by means of increased attrition, typically of their best people, and costly re-recruitment when the economic recovery comes faster than expected.

Naturally, in cases of poor performance or exiting service lines that are not core to your client profile, these are not merely cost-driven decisions and a quite different approach is called for.

Effect of increasing utilisation

The other seemingly quick easy fix is to try to drive up the billable hours, while keeping the fee-earner headcount constant. Yes, if you crack the whip you’ll indubitably see more work in progress (WIP) on the accounts. But, the problems with this approach are obvious.

Everyone can do a little more from time to time and there are some fee earners who really need to buck up their act to stay in the game. But, as we have all seen from time to time, some firms attempt to promulgate an across-the-board increase in permanent billable hours targets, without a corresponding innovative change in working practices.

Such efforts are rarely thought through. These regimes often lead to a number of adverse symptoms, such as: '¨

cheating on time recording; '¨
unhealthy rivalry between lawyers scrapping over work credit; '¨
diminishing teamwork; '¨
reduced ad hoc helping out; '¨
reduced know-how work, training or supervision; and '¨
a general distrust of the motives and understanding of the firm’s management.

'¨What’s more, for all of those side effects, there is often little more than a short-lived blip in the ‘hours recorded’ figures. It bears repeating that there are always certain issues to be addressed at an individual fee-earner level and, in a healthy firm, a contextual message to ‘go over the top’ for a short time can be well received.

But a continuous and senseless ramping up of hours targets breeds hostility and erodes respect. One '¨should also not forget to consider the '¨very real health and wellbeing issues '¨that arise from overwork that can affect your best fee earners when you most '¨need them.

Effect of increasing rate

The next area to look at is increasing the level of fees over constant hours, to improve the effective rate. This is the critical area of service pricing and, more pertinently, the issue of price increases.

You can often hear participants in the profession bemoaning the price sensitivity of their sector, particularly at the moment, or about the necessity of price gouging to win work. What’s more, the continuing impulse towards the commoditisation of routine work and the arrival of new market entrants exerts a downward pressure on price like the turning of a vice.

Leaving aside the rhetoric of pricing, the principal driver in terms of rate is '¨that clients will pay premium fees for premium service. The way to premium service is not merely in the little extras of good service (although those will help the client to come back for more). The key sustainable way to premium service is through the learning and development (L&D) of your principal fee-generating assets – your partners '¨and associates.

So many firms treat L&D as a cost sink – a necessary evil of being in the business of law or a kind of pay-to-play fee. The point is that good L&D programmes – whether they are qualifications, short courses, books or coaching – can make your fee earners more valuable to the market and justify premium pricing.

There is a phenomenal correlation between L&D spend per lawyer and average charge rate within firms that have a reputation for quality. The L&D needs to be well chosen, well managed and well measured, and, if you have improved a lawyer’s marketable skills, you also need to change the price tag.

It is amazing how few firms work this element of the equation. Part of the problem seems to be that pricing and L&D are handled by two different parts of the firm, which are insufficiently engaged in each other’s agendas.

Effect of increasing leverage

Leverage was the defining advantage of the capitalist system in both its preindustrial form and supremely important in industrial mass employment. Quite simply, leverage enables one person to break free from the constraints of only having 24 hours in a day to being able to deploy many more hours '¨to clients.

Of course, leverage is not an infinite advantage. As soon as you have new people working for you, you need to train them, lead them, guide them, check them, praise them and reprimand them – the whole host of management responsibilities.

Management requires various styles and systems, some of which work (by delivering a greater return on performance than the effort invested in them) and some of which sadly do not.

Levers of profits

So, in summary, we have two levers of profits in the system that are hygiene factors. These will cost you if you get them wrong, but they cannot deliver ever-increasing improvements to profit.

The first of these, margin, suffers diminishing returns and potentially adverse side effects. The other, utilisation, typically creates gaming, burnout and the adverse effect of a leadership credibility gap.

On the other hand, there are also two health factors. These potentially create a virtuous spiral which, although not without limits, can deliver sustainable long-term increases in profitability.

The first of these is improving the rate by increasing the economic value of your work producers through good L&D. The second is enhancing leverage through managing teams in such a way that volume, quality and self-sufficiency are all increased, and so building for the future.

Hygiene factors

Don’t get these wrong, but they won’t deliver the paradigm shift to higher sustainable profits:

Maintain costs control on salaries, benefits and bonus pools
Carefully scrutinise the need for recruitment
Have a rolling review of recurring cost lines, not a panicked ‘fire sale’
Work hard to partner with the best suppliers you can find and stick with them
Exit business lines that are not core to your client profile
Retain good people through the economic cycle
Make good use of atypical patterns of working hours
Take timely and decisive action with underperformers
Analyse trends and contexts in work levels
Communicate to everyone how the firm is doing financially and their part in it

Health factors

Make sure you get these right to really grow your profits:

Become the most expert provider within your core specialism/sector
Be consistent in the delivery of client services
Invest in training on the issues that are important to clients
Price in the premium added by superior learning and development
Build effective teams to deliver more capacity
Recruit the very best people you can
Utilise psychologically sophisticated recruitment and selection techniques
Acquire superior delegation and supervision skills to maintain quality
Implement on-the-job coaching throughout the firm
Invest leadership time in superior employee communications

Rethinking strategies

The operational aspects of the strategic management of law firms tend to be dominated by two factors: '¨

inertia: doing what we’ve always '¨done; and
imitation: doing what everybody else is doing. '¨

These two tendencies make for a market in which service is undifferentiated '¨and therefore very prone to a price-'¨driven descent into lower profitability. '¨An overemphasis on the elements of margin (costs) and utilisation in the profitability model exacerbates '¨this effect.

Firms that want to achieve sustainably higher profits must do so by providing something of uniquely differentiated '¨value to their client base, which means '¨an emphasis on developing market-'¨leading expertise and delivering it with consistently superior levels of service.

Such a switch in emphasis '¨has profound implications for the management of IT, marketing, '¨finance and HR in law firms, as well '¨as for the day-to-day management of '¨fee earners.

In a professional services firm, the biggest drivers of cost and income are the people in the business. The greatest determinants of profitability therefore '¨come from the HR agenda, including the reward, recruitment, development, management, communications and retention of people.

Law firm strategy is typically a matter of emphasis, and a firm that emphasises rate and leverage can expect a journey towards significantly higher profitability on a sustained basis than one that habitually reaches for the quick-fix levers of margin and utilisation.

The role of people in profitability

Profitability is made up of margin, utilisation, rate and leverage. Increasing the first two can only deliver short-term hits to the bottom line, whereas building the second two delivers longer term sustainable increases in performance.
People are the greatest drivers of both cost and income, and therefore people factors play the greatest part in determining long-term profitability.
To truly contribute added value, the firm’s strategies for HR, marketing, finance and IT need to be rooted in the profitability model.
Profitable firms need to integrate the people agenda of leverage, performance management, learning, employee engagement and reward with the client agenda of service, pricing and differentiation, as both are interdependent.
Law firm professionals in these disciplines need to be able to work their functional plans up from the firm’s own plans for sustained increases in profitability.

simon.nash@careyolsen.com