From the early 2000’s a number of performance trends have gathered strength in the legal profession. Benchmarking data from the FMRC Legal Business Monitor (www.legalbenchmarking.com.au) shows a continuation of performance polarisation and a heavy reliance on price to grow (or maintain) gross fees. These internal issues are compounded by external pressures such as further commoditisation of legal services and increased competition, particularly among smaller practices.
Whilst the operating environment is similar for most firms there is a huge variance in profitability. The benchmark data showed that successful practices are building on their success, while struggling practices are continuing to see the rewards for their efforts diminish. To stay ahead of the game firms need to understand and manage a number of lead and lag indicators of performance.
Most firms have a practice structure that does not match their service offerings. Common misalignment includes:
•Excess capacity –where there are more personnel than the work flow requires
•Top heavy firms –where the there are too many senior lawyers given the commoditised nature of the work
•Hour glass –firms with lots of seniors and juniors and no mid level lawyers.
In most cases firms are not willing or able to do much about these capacity issues. Worse, cultural norms have crept into practices that exacerbate the problems. The following measures highlight capacity and alignment issues.
The number of employed fee earners per equity principal is commonly referred to as leverage. Leverage is a straightforward economic model. If one is in the business of selling time the greatest impediment to financial success is the availability of ones own time. It is beneficial to acquire additional units of time beyond those available to the principal and on sell them at a profit. The more you sell, the more you make. The only impediment to success now becomes the supply of appropriately talented labour. Not surprisingly talent attraction and retention along with client attraction and delegation skill are becoming the must have skills of partnership.
In addition to the more obvious benefits of quantum, leverage also provides compelling cost advantages as many of the fixed costs of practice can now be allocated across a greater number of chargeable hours. In short, a fully utilised leveraged practice has a lower cost of production than a non leveraged practice.
Leverage ratios need to be considered in the context of the legal services offered. For example a practice that specialises in complex tax matters will find it difficult to leverage beyond two or three fee earners per equity principal, whereas a high volume conveyancing practice may have leverage of greater than eight.
Most practices consider leverage in terms of the number of fee earners per equity principal. Given that leverage is only successful when each of the fee earners are fully utilised this measure of leverage only tells part of the story.
A better measure is to assess leverage as a ratio of employee chargeable hours to partner chargeable hours. Ideally hours leverage would be higher than headcount leverage as this indicates work is not beinghoarded by those at the top.
Our experience has been that by measuring 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; or where time is being written off.
Author dollars billed per equity principal dollars billed
Author dollars billed per equity principal dollars billed is a measure of the effectiveness of leverage. We would expect this ratio to be lower than the headcount leverage given the variances in hourly rates between principals and other solicitors.
There are a few issues in the delivery of legal services that have gained as much media attention as the pricing of legal services.
There has been little uniformity in the Australian legal profession when determining and setting hourly rates. In most instances it is driven by the ability of the partners to sell value irrespective of an hourly rate. This introduces a personal nature to hourly rate pricing. As a result we have seen principals in country towns charging $400 per hour without discounting whilst some of their peers in mid size CBD practices are agonising over their capacity to get close to this.
When it comes to the mechanic of price, lawyers have several options. Time based pricing is relatively straightforward, fixed fee pricing and value billing more complex. Given the importance of price in profitability, successful firms are at the leading edge in terms of rates – hourly and fixed fee.
Cost of production
In successful firms the cost of production underpins all pricing decisions be they hourly rate or fixed fee. These firms know that each practice group 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.
It is important to understand that cost of production attaches itself to an individual not an activity. In an increasingly cost conscious market there are significant gains to be made by structuring your practice and staffing your matters so as to reduce the overall cost of production.
A critical element component in determining cost of production is time recording. The cost of delivering legal services is hourly driven, regardless of how those services are then priced. It is not surprising that the best performing practices are diligent about time recording – as a management tool and a pricing methodology where appropriate.
Realisation involves turning activity into cash and refers to the percentage of work-in-progress on matters that is invoiced to clients. Recent benchmarking showed that the realisation for many firms was decreasing and WIP write offs were in the rise. Some firms had partners and solicitors writing off more than 25% of their WIP for a realisation of only 75%. High performing firms usually have realisation in the range of 89% to 93%.
In a busy practice one would not expect reduced realisation – quite the opposite. Our benchmarks indicate poor realisation in busy and slow firms alike. Low realisation is usually a combination of:
•poor pricing for fixed fee matters
•inappropriate structure of practice groups
•firms submitting lowball pricing to secure tenders
•poor training of juniors
•junior lawyers doing work that cannot be charged
•failing to set and meet client expectation
These factors can contribute to what may become a ‘culture of write downs’ where principals unthinkingly write off significant amounts of WIP to meet their perception of value.
In more profitable practices fee earners are capable of doing significantly more chargeable work than their contemporaries in other firms. It is not unusual for employed lawyers to average 900 effective chargeable hours a year, better performers are capable of 1200 chargeable hours a year some achieving 1400 in the Australian and New Zealand markets.
Maximising productivity involves adherence to policies and systems as well as effective delegation and supervision. Where lawyers fail to achieve performance benchmarks supervising partners should work with them to determine the root cause.
The old maxim ‘if you measure performance, performance improves’ holds true with chargeable hours. If your pricing mechanic and cost of production rely on chargeable hours it is essential to capture all activity.
Return per dollar of salary
A false rule of thumb is to assume that all lawyers should be generating three times their salary. The reality is that return on salary is largely a function of experience. Lawyers with less than two years experience will struggle to generate more than $2.30 for every dollar paid in salary. Those lawyers with between three and six years experience will often be capable of returning 3.5 to 4.5 times their salary.
For more experienced lawyers –i.e. those with seven and more years experience – this return drops back toward $2.25 for each dollar of salary. The loss of return for these senior lawyers is due to salaries increasing and their roles within the firm expanding to include more client and staff management.
Our benchmarking has shown some firms are struggling to generate a $3 return on salary for their lawyers, whilst senior associates and salaried partners can be as low as $1.50. At these levels the firm is providing charity.
Performance relative to budget
There is enormous variation within firms as to lawyer’s capacity to meet budget. Whilst the aim is to achieve at least 100% of budget it is worth noting that lawyers who manage busy general practices seldom record the quantum of chargeable time that highly specialised lawyers who only work on a couple of files at once manage to record.
One should also remain aware of the reality of available work. Underutilised lawyers never achieved benchmark performance.
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.
As a benchmarking exercise, 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.
Whilst thrift has its place in the successful management of any business, you cannot save your way to success in the law. Most firms have a reasonable cost base with many of these costs are fixed, or partially fixed such as salaries. Therefore the best way to improve profit margin and ultimately net profit per principal is to focus on the drivers that increase gross fees.
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 improve your profitability visit www.legalbenchmarking.com.au
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