Masterclass: financial measurement

Tying financial measurement into long-term strategy

As an accountant, I trained for my professional qualification with financial measurement very much a backward-looking exercise. Historic cost reporting was the standard when preparing financial statements on behalf of clients (note one was and still is: “The accounts have been prepared under the historic cost convention”) and the figures that you reported were usually between six and ten months out of date.
These days, greater emphasis is being placed on the use of financial measurement as a forward-looking tool, particularly in the strategic-planning and implementation processes. The rapid advance of software capability has put an array of analytical tools at the disposal of the finance director and management team, enabling them to use financial measurements proactively in terms of outcomes analysis, but also as a sophisticated predictive planner.
As part of the recent Ark Group conference, ‘Driving law firm profitability through financial measurement’, this theme was explored from four perspectives:

Using financial measurement proactively as a strategy driver – using outcomes to identify areas for growth and investment;
Driving change with financial measurement as your supporting evidence;
Using financial measurement reactively – identifying and managing worrying trends or dips in performance;
Focusing on problem areas and areas for action in what you report to the management team.

Using financial measurement proactively as a strategy driver
If we take a look at the traditional model of strategic planning, implementation and monitoring, we can see how financial measurements play a proactive part throughout the process and, most importantly, on an iterative basis.
Once the organisation’s purpose (or mission) has been defined, the translation into specific goals will usually involve a financial definition. For law firms, the current emphasis on profitability and, in particular, profit per equity partner (PEP), drives the need to clarify financial objectives (which may include global reach or practice area). How often have you seen the external benchmark of law-firm success measured by a client-satisfaction ranking or staff-contentment survey result? Many law firms actively identify their staff-satisfaction objectives or corporate-social-responsibility credentials in their mission statements. Sadly, the reporting of these laudable, non-financial achievements is secondary to the potentially misleading PEP benchmark.
As figure one shows, the translation of objectives into an implementation plan, or a set of actions, is encapsulated within the traditional SWOT (strengths, weaknesses, opportunities and threats) analysis. This requires a review of the organisation and its internal capabilities, together with an analysis of the external environment in which it operates. During this process, financial measurements can be used proactively in a number of ways such as:

Internal analysis – any internal review of an organisation will include an analysis of current performance and, in particular, financial condition. Using specific outcomes such as profitability analysis, the current relative performance strengths of each practice area can be assessed, but with a view to predicted future performance when coupled with trend analysis. With the ‘slice and dice’ functionality afforded by business-intelligence packages, it is therefore possible to review overall resource allocation, using sensitivity analysis to identify a range of possible outcomes. The resulting data should enable management to make informed decisions, such as whether to invest additional resource to improve underperforming areas or focus on alternative growth opportunities;
External analysis – inevitably for a law firm, a key part of the external SWOT analysis relates to clients and, in particular, at what level to set charge rates and ultimately income objectives. How often have you seen a firm’s annual turnover budget derived from the traditional capacity-based model of hours times charge rate of existing fee earners, plus some anticipated expansion? While useful at identifying a possible turnover figure, this approach can be limiting in defining strategic scope, focusing on internal rather than external capacity. As the marketplace becomes ever more competitive (particularly as the Legal Services Bill begins to change the operating landscape), firms need to look at the scope of the market as their turnover driver, not what resources they already have. For example, different practice areas are prone to economy fluctuations to a greater extent than others and, in the past, the recruitment of additional staff at busy times has resulted in over-staffing when the economy slows. Planning should therefore take on a wider analysis and review of how the firm is positioned – not only in the current landscape but also at which stage of the economic cycle the firm is (the current credit crunch is a timely reminder of how quickly things can change).

Driving change with financial measurement as your supporting evidence
Any planning process for an existing business will identify areas where change is needed. It is typically human to be resistant to change and require a degree of persuasion to take on board new practices or working methods and, here, financial measurement can also be used proactively. For example, the perennial issue of efficient time capture and billing can be aided by increased fee-earner education and understanding of how firm-wide profitability is affected, thereby removing the disconnect between time and profit that often exists. Previous experience has shown that, by demonstrating to partners and fee earners how small changes or improvements in the process can lead to additional profit, the motivation to record and bill time more efficiently is significantly increased. Similarly, and by using a simple on-screen sensitivity model, it is possible to show, say, a head of department, how changes in structure (for example, better fee-earner spread) can lead to greater efficiency and ultimately improved departmental performance (comparison to other departments’ results also creates an element of healthy competition). The key is to show instantly the effect of a change on the financial result (that is, in partner terms, the individual’s own remuneration); but simplicity is vital and graphics and dashboards, as we shall see, play a major part.

Using financial measurement reactively: Identifying and managing worrying trends or dips in performance
Returning to the strategic-planning process, the next stage is to identify performance expectations and to constantly monitor and control progress. Traditionally, the vehicle to achieve this objective would be the monthly management accounts and the annual year-end financial statements. As discussed at the outset of this article, we can effectively discount the annual statements as a true controller of performance as they are produced and finalised long after the event. Similarly, management accounts can be limited on the basis that they represent a snapshot view, and are usually accompanied by substantial tabular data in which worrying performance trends or dips in performance can be hard to spot. Take, for example, the common scenario of a hidden build up of time on a particular matter, which we have all seen happen. Work in progress is accumulating fast but is hidden on 'page 10' of the client partner’s monthly report, which no one else sees at this stage. Suddenly, the amount has reached a level substantially over that quoted to the client and, despite the work being good, billable time, the embarrassment factor creates a spiral of inactivity and ultimately a large write off, simply because the client was not informed in time. What is required is a system that is effectively an early warning of issues, before they become problems. Event-driven reporting (EDR) is just such a tool. Using an alert system of e-mails and reports, EDR works by scanning the practice-management-system database for key events (that is, by comparison to pre-defined standards) and notifying the appropriate authority that action is required. Using the earlier example an e-mail would have been automatically generated and sent to both the client and client partner when the work in progress reached 75 per cent of the pre-set limit. If unaddressed (perhaps by an interim bill), a second e-mail would be generated but copied to the head of department, when 85 per cent of limit is reached. In this way, a system of escalation is created so that a potential problem is identified and dealt with long before any damage is done. Not only is the issue flagged internally but, more importantly, the client is kept informed without the unpleasant surprise of a large bill. The essence of this system is that it is entirely automatic once the parameters of performance have been defined and is separate from the standard key performance data routinely circulated.

Focusing on problem areas and areas for action in what you report to the management team
The above system highlights a constant challenge for finance directors: that of ensuring the appropriate mix of standard and exception data. Management need to be able to see the bigger picture, while being able to identify any areas for action. Traditionally, the management-accounts package has consisted of substantial tabular data; figures that are entirely transparent to the trained eye, but to the lawyer on the management team, with a busy caseload, completely unfathomable.
Again, thanks to both simple and complex technology, and by using colour, graphics and dashboards, it is possible to quickly identify problem areas and provide the overview at the same time. I have set out in figure two a table of fictitious data, relating to common key performance indicators for a particular department of 20 fee earners. The head of department needs to be able to review the figures and identify problem areas quickly from 180 numbers! If we look at just one column in figure two – chargeable hours – it would be possible, with enough time, to identify departures from target.
However, using simple Microsoft Excel conditional formatting it is possible to colour code the actual chargeable hours recorded to identify performance variations. If we were to apply a percentage colour rule to the chargeable hours column in figure two, the head of department would instantly see which fee earners have recorded below-expected hours (perhaps coloured red), and those that have recorded lower than average hours (perhaps coloured amber).
Such a simple traffic-light effect is immensely powerful in quickly directing attention to areas requiring further action.
The focus has, so far, however, been on just one column relating to hours. A further simplification of the table can be used using standard Microsoft Excel charts. Here, the chargeable-hours column, with target, has been converted into a simple bar graph (bottom right, figure three) with expected performance shown as a transparent bar against which the actual performance in blue is shown. Not only can variation from target be seen instantly but also the graph is ordered from left to right by absolute hours, thereby providing greater comparison between fee earners.
Similarly, other key-performance data is shown graphically in figure three to provide an instant identifier of any problem areas such as the combination of work in progress (WIP) and debtors by fee earner. These are relatively simple examples of how specific performance data and exceptions can be reported, but what of the global picture? Management must be kept appraised of the up-to-date firm-wide picture, as well as the detail. The same distribution software that can be used for the event-driven reporting, can also be used to generate and issue a standard firm-wide update report to management, such as shown in figure four. The important aspect is that the report can be prepared and distributed to management daily without any input other than the initial set-up. The combination of colour, graphics, arrows and figures provides all the data necessary to quickly understand the current position.
Naturally, further data will be prepared and distributed to provide more detail and back up. It is the combination of real-time exception reporting (EDR), up-to-date overview information and understandable performance reports that will keep management focused on the priority of proactively maintaining the firm’s strategic direction, through timely control. This theme can be taken further with a host of dashboard products available on the market but, whatever the format, the common features are clarity, simplicity, relevance and, above all, timeliness.
Numerous studies have shown that measure-managed companies perform better than others in establishing position, communicating direction, monitoring progress and taking timely action. But the process is constant and the strategic-planning process iterative, with financial measurement as a key driver.

Edward Gordon-Hall is finance director at Lewis Silkin. He can be contacted at edward.gordon-hall@lewissilkin.com