Financial analysis: Measuring the true profitability of legal work

The dynamic of the marketplace for legal firms has changed dramatically over recent years and this is going to continue. Many law firms are facing downward pressure on their pricing combined with significant upward pressure on remuneration to ensure that they are attracting the best staff. Many firms are also being taken out of the comfort zone of hourly-based time and materials arrangements by the continuing rise in popularity of conditional fees, fixed prices and other non-traditional arrangements. All of this is putting adverse pressure on profitability; but how many firms truly understand the profitability of a client, a work type, a department or even the firm as a whole? It is more critical than ever before that we actively manage our profitability.
The traditional approach has been to assess profitability by looking at realisation: the ratio of the value at which hours are billed on a case, to the value of those hours at standard hourly rates. This ratio is usually easily calculated, but how accurate is it as a measure of profitability? The realisation ratio relies on standard hourly rates being a reasonably accurate proxy for the cost of providing an hour of chargeable time. But is that really true? Typically, a partner’s rate might be twice that of a newly qualified solicitor, but that may not reflect the true measure of their cost, particularly in view of how much each is paid. Also, the realisation ratio takes no account of variation within the firm in fee-earner utilisation rates or gearing ratios.
Many firms in their day-to-day management adopt a team structure based on either discipline or partner. It is possible to calculate the profit or loss generated by that team activity by comparing fees billed with the cost of the team, including a share of relevant overheads and, in effect, creating a mini profit & loss account. Although revenue figures are readily available from the practice-management system (PMS), quantifying cost is a more complex issue. But a careful review of the nature of a typical law firm’s expenses suggests that there are ways round this problem. Remuneration cost can be allocated directly to each member of the team and typically some 60 per cent of fee income is absorbed by the remuneration of partners and fee earners. That leaves a balance of 40 per cent of costs where the allocation of expense to individual earners is arguably more subjective. It is possible to develop models of great detail and complexity to allocate central overheads but these are generally unhelpful – they are time consuming and therefore expensive to develop and maintain, and their complexity encourages, rather than otherwise, debates and dissent about the detailed assumptions adopted.
The simplest approach is, perhaps, to allocate overheads broadly into those that are incurred equally by all fee earners, irrespective of their position in the firm and those that tend to increase with seniority. The former can be allocated on an equal ‘per head’ basis, while the latter can be allocated pro rata to remuneration, which can be considered as a proxy for seniority. Although this in itself can lead to debates about the accuracy of the cost allocation, it is likely – given that whatever model chosen will give a broad rather than precise measure of profitability – that any sensitivity analysis looking at the impact of changes in assumptions about cost allocation may not change significantly the conclusions generated by the model.
This more developed strategy is straightforward to apply in the evaluation of the profitability of teams, but is less helpful when looking at clients, work types or individual partners, where there might not be a consistent team but instead different fee earners who have come together at different times to handle different types of cases. For these, another approach can be considered.
This involves using standard costing. This is simply expressing an hourly cost rate for each fee earner that includes the fee earner’s remuneration, plus an allocation of the overhead costs described earlier. The hourly cost rate is calculated by dividing the total remuneration and overhead cost by the expected number of chargeable hours per annum for the firm, department or grade of fee earner. Again, the basis of developing hourly cost rates should be kept simple. Fee earners, for example, are usually grouped into bands for hourly charge rates, and it is probably useful to associate each charge-rate band with a single cost rate.
What are the benefits of standard costing? Theoretically, the hourly cost rate should express the cost of delivering an hour of service to a client. Even if the hours may not ultimately be billed, or are billed at a discounted rate, there is still a cost associated with delivering that hour and that cost can be compared with the revenue generated. Now we can start to get a feel for how much it is costing to service a client or a particular matter.
You can choose to look at clients or specific instructions, which can be particularly useful where those instructions span a number of years. Chargeable hours worked in one year may not be billed until later, by which time pressures on costs (both salary and non-salary) could mean that the firm may be operating in a different cost environment from that when the work was actually undertaken. By matching the hour worked with the prevailing standard cost in the year in which it was worked (rather than billed), a true lifecycle picture begins to emerge.
Many law firms are facing the ongoing challenge of contingent fee work (or no win no fee). These matters by definition often afford no billing until they have reached a conclusion. Valuing work in progress on these matters using a cost rate rather than a sales rate certainly puts them in a different light (particularly when you consider that the majority of the cost base is to a great extent fixed and cannot be flexed when revenue volumes fall). It may also radically alter many a managing partner’s view on the likelihood of success.
So, we now have a view of profitability at a micro level but there are pitfalls. Any standard rate is only as good as the key assumptions made regarding expected chargeable hours, levels of cost and cost allocation, and the relative stability of the firm’s cost base in the year. Ultimately, all cost-allocation processes are arbitrary to a certain extent and it may be that they have to be ‘tweaked’ during the course of a year, if you become aware that circumstances change to the extent that assumptions become fundamentally flawed. Perhaps the real challenge will lie in explaining the conclusions to your partnership.
Planning and financially modelling will also help assess likely profitability of impending work, particularly fixed or contingent-fee instructions. A simple planning tool (in Excel, for example), which uses both expected or agreed billing rates, or fees and standard cost rates, should enable those involved in business development to model the potential outcome of an instruction and quickly make an informed price decision. Where fees are not hourly based, this will involve preparing a budget for the work, which may assist in identifying and understanding the implicit assumptions about the nature and extent of the tasks that need to be fulfilled to complete the job. Of course the ‘answer’ is only as good as the assumptions used in generating it, but allowing fee earners to see the impact of giving a ten-per-cent discount is an important step in helping them understand the profit impact of client relationships.
Perhaps more important, though, is ensuring that post mortems are undertaken once the instruction is complete so that assumptions made are continually tested and refreshed. This is of particular importance where making accurate assessments of time and resource used are vital in delivering a profit. If these reviews are not undertaken, then the planning tool is rendered largely meaningless.
One often overlooked discipline is simple change management. Extra work is often undertaken at the twelfth hour or close to a deadline, without any reference to the prevailing contractual arrangement. Phrases like ‘client goodwill’ are often used to mask a lack of willingness to approach the client for extra funds and, inevitably, when the dust has settled, the ensuing negotiation will involve some kind of discount.
Understanding what drives your client profitability is absolutely critical to the survival and growth of many firms. Only once we have begun to understand our profitability can we then begin to manage it.

Ian McAndrew is finance director and Matthew Kelsall is a divisional operations finance manager at Clyde & Co LLP. They can be contacted at ian.mcandrew@clydeco.com and matthew.kelsall@clydeco.com respectively.