We use cookies to collect and analyse information on site performance and usage to improve and customise your experience, where applicable. Click OK to use our website.

The profit motive

The profit motive

Only measure controllable factors when determining a partner’s profitability

Hugh A Simons



Getting profitability right is hugely important, but it isn’t easy. However, there are certain approaches that can ensure the linkage between compensation and profitability is accurate, and that matters are managed effectively for improved profitability.

An important principle in determining the profitability of a partner’s practice is that one should include in the measurement only those factors that partners control.

If you do otherwise, then partners simply get frustrated and disregard the result, thereby undermining the reason to measure profitability in the first place – namely, to guide partners on how to improve it.

The profit motive

The profit motive

There are only three profitability drivers that partners truly control:

  • Revenues realised from a client for a particular matter,
  • Time of lawyers of different seniorities deployed in delivering on the matter, and
  • At firms where partners have specific lawyers dedicated to their practices, how busy they keep their dedicated lawyers.

Note that, because client-serving partners do not control overhead expenses, such as rent and administrative compensation, these should not be included in the measurement.

Theory and praxis

Table 1 shows how this principle applies to three examples of partner practice profiles. It starts with partner hours (line 1) and leverage (that is, associate hours per partner hour, line 2); together these define associate hours (line 3). Multiplying these hours by ‘rate card’ billing rates (assumed in this example to average €480/hour and €240/hour for partners and associates respectively) yields the gross revenue (line 4).

TABLE 1: PARTNER PROFITABILITY

EXAMPLE CALCULATIONS OF PARTNER CONTRIBUTION MARGINS

 

NO

 

LINE ITEM

 

PARTNER A

 

PARTNER B

 

PARTNER C

1

Partner hours

1,600

1,400

1,200

2

Partner leverage

1.0

2.2

4.2

3

Associate hours

1,600

3,080

5,040

 

 

 

 

 

4

Gross revenue, €K

€ 1,152

€ 1,411

€ 1,786

5

Realisation, %

95%

85%

75%

6

Net revenue, €K

€ 1,094

€ 1,200

€ 1,339

 

 

 

 

 

7

Associate cost, €K

€ 115

€ 222

€ 363

8

Partner contribution margin, €K

€ 979

€ 978

€ 976

 

 

 

 

 

9

Firm target, €K

€ 1,000

€ 1,000

€ 1,000

10

Percent of firm target

98%

98%

98%

 

Most firms have reasonably robust ways of assigning revenues by partner. That said, it’s not without issues. The sharing of revenues between partners who source and execute (that is, ‘finders’ and ‘minders’) can be controversial.

'Profitability measures should focus on how much we get from using a particular limited resource

I’ve seen firms leave this to negotiation between individual partners, while others lay out guidelines (for example, origination receives a percentage that declines over time), and yet others allow partners who collaborate to bring in business to share credit for more than the actual revenue generated.

One thing I’d discourage is giving credit in perpetuity for beginning a client relationship: it dissuades partners with the necessary skills for this critical activity from continuing to establish new relationships.

The next step is to apply a realisation rate (line 5) to these gross revenues to get to net revenues or cash receipts (line 6).

There is a timing challenge with this, as cash receipts lag the recording of hours by some months.

Most firms find using a 12-month trailing average to be an effective workaround.

Following the principle above, we subtract only the compensation cost associated with the lawyer time that generated these revenues (line 7) to arrive at partner contribution (line 8). In traditional accounting, these compensation costs are referred to as ‘direct costs’ (as they directly relate to the revenues), and partner contribution is referred to as ‘contribution margin’, as this is the amount these revenues ‘contribute’ to coverage of the firm’s overhead costs and, thereafter, to creation of the firm’s profit pool.

The lawyer time encompasses that of all lawyers and other timekeepers, except for equity partners.

Billed hour times

The lawyer cost is determined as the sum (for all lawyers involved) of their billed hours times their annual compensation cost (base and bonus), converted to an equivalent cost per hour.

For partners who staff their matters from a dedicated pool of lawyers, the cost-per-hour should be based on the individual lawyer’s billing history; this is because, in this circumstance, partners have control over the lawyer’s hours and hence their hourly cost.

For partners who can exert no such control (for example, where staffing is done centrally from a large pool), then a standard cost-per-hour by lawyer cohort (such as by associate year) should be used. In the example calculations, the hourly compensation cost is approximated as one-third the billing rate.

The difference principle

This approach diverges from many in use today in two areas. First, it’s common to subtract an allocation of overhead to get to partner profitability. Firms are drawn to doing this so they have a full accounting of all their costs.

'For law firms, the resource we are trying to get the most from is partner time. Hence, we should measure profitability relative to the amount of partner time involved

I’d propose that, rather than allocate overhead, which always begets a battle, firms instead compare the partner contribution margin (line 8) with a target amount that covers overhead and the desired profit pool.

This can be determined as revenues, less lawyer comp, per partner from the firm’s financial plan for the year. This target amount is assumed in this example to be €1 million (line 9); each partner’s margin is then translated to a percentage of this target (line 10).

The second divergence is that many firms include as a ‘cost’ the compensation of equity partners. They do this to capture any disconnects between the economics of a partner’s practice and their compensation.

This is problematic primarily because partner compensation is profit, not cost. It’s also tricky because it muddles together two very distinct things: how much a partner contributes to the profit pool through their practice, and how much they are allocated from the profit pool, as decided upon by the compensation committee.

A better way to get at how well the economics of a partner’s practice align with their compensation is to compare two numbers: each partner’s contribution margin as a percent of the sum of contribution margin for all partners, and each partner’s compensation as a percent of the total compensation of all partners.

If the former exceeds the latter, the partner is being undercompensated relative to their economic contribution.

Note that the examples shown yield the same level of partner practice profitability, despite the wide variation in partner hours and realisation rate. This is to highlight an important point: high leverage practices can be very profitable even with low realisation and modest partner hours. It’s a strength of this approach that it consistently captures the profitability of such varying practices.

Possessive individualism

To extend this approach to assessing the profitability of individual matters, another principle comes into play. That is, that profitability measures should focus on how much we get from using a particular limited resource.

For example, investors don’t look at the appreciation of an asset as an absolute amount; rather, they look at it as a percent of the capital invested.

For law firms, the resource we are trying to get the most from is partner time. Hence, we should measure profitability relative to the amount of partner time involved.

'Getting partner profitability right is hugely important, but it isn’t easy

Integrating this principle and the contribution margin approach leads to measuring matter profitability on a margin-per-partner-hour (MPH) basis. It is noteworthy that MPH is the matter-level counterpart of the ubiquitous profit-per-partner (PPP) measure of overall firm performance.

To see how this works, consider two idealised matters: matter A is low leverage, and the client pays full billing rates; matter B is relatively high leverage, but the client gets a 20% discount.

Table 2 shows the calculations of the matters’ MPH, with lines 1 to 8 determined as in Table 1. Matter contribution margin (line 8) is divided by partner hours (line 1) to yield MPH (line 9), which is then converted to a percent of target MPH (line 11).

 

TABLE 2: MATTER PROFITABILITY

 

EXAMPLE CALCULATIONS OF MARGIN PER PARTNER HOUR

 

Line

 

 

Matter A

 

Matter B

 

1

Partner hours

 

500

 

275

 

2

Associate hours

 

500

 

825

 

3

Leverage

 

1.0

 

3.0

 

 

 

 

 

 

 

 

4

Gross revenue, €K

 

 €360

 

 €330

 

5

Realisation, %

 

100%

 

80%

 

6

Net revenue, €K

 

 €360

 

 €264

 

 

 

 

 

 

 

 

7

Associate cost, €

 

 €36

 

 €59

 

8

Matter contribution margin, €

 

 €324

 

 €205

 

 

 

 

 

 

 

 

9

Margin per partner hour (MPH), €

 

€648

 

€744

 

10

Target MPH, €

 

 €625

 

 €625

 

11

MPH as percent of target, %

 

104%

 

119%

 

There are a number of reasons to look at MPH as a percent of target rather than as an absolute number. It indicates directly how well the matter is contributing to covering the firm’s fixed costs and to meeting the firm’s profit expectation, making it easy to assess if a given level is ‘good’ or not.

Inflation

Another is that it allows what constitutes a strong MPH to rise naturally over time with inflation and increased firm expectations. Note that the examples shown again indicate the power of leverage – the high-leverage, high-discount matter has the stronger profitability.

Getting partner profitability right is hugely important, but it isn’t easy. The above approaches can ensure that the linkage between compensation and profitability is accurate, and that matters are managed effectively for improved profitability.

 

At a glance

  • An important principle in determining the profitability of a partner’s practice is that one should include in the measurement only those factors that partners control
  • There are only three profitability drivers that partners truly control: revenues realised from a client for a particular matter; the time lawyers of different seniorities deploy in delivering on the matter; and, at firms where partners have specific lawyers dedicated to their practices, how busy they keep their dedicated lawyers.