Decoding Profitability Metrics
Profitability metrics are a set of measures that law firms use to track their financial health and performance. These metrics go beyond the traditional bottom line numbers and provide insights into various areas of a law firm’s operations. Law firms use these metrics to make smart business decisions, understand their financial strengths and weaknesses, and assess their performance against key performance indicators (KPIs).
The list of KPIs for law firms likely includes some familiar basics, such as revenue growth and client growth, but typically also includes some more sophisticated metrics, like detailed expense allocation and data about how well an individual lawyer is performing in a variety of areas (e.g., billing efficiency, underscoring value in a way that encourages prompt payments, etc.). However, the most important KPI is often profitability per equity partner because it takes into account the firm’s leverage ratio.
Law firm profitability is generally driven by user-level data about individual users’ profitability , collections, and non-billable time. Law firm profitability metrics are driven by user-level information, so to manage (and improve) profitability, a firm must use reports that provide this level of detail.
These metrics can reveal a lot about the firm at both macro and micro levels. Law firm profitability by department can show the success of a particular practice area, while law firm profitability by user can identify tasks completed by each individual lawyer. Implementing a law firm profitability measurement system provides greater insight into which departments or individuals can improve revenue, which can cut costs, and how pricing could be adjusted for services.
Law firms that utilize profitability metrics are 22% more likely to have a process in place to grow that profitability by end of year than firms that don’t. They are also 13% more likely to know with certainty if the firm will make its profit plan.
Must-Have Financial Metrics
When it comes to law firm profitability analysis, there are a number of different financial metrics that are extremely important. These include Revenue Per Lawyer (RPL), Profit Margin, Profit Per Equity Partner (PPP), Compensation Per Equity Partner (CPPL), Utilization Rates, and Realizations.
Revenue Per Lawyer. What is Revenue Per Lawyer? This is the amount of each attorney’s revenue averaged across all of the attorneys in the firm. For example, if the firm has 100 attorneys and the firm’s total revenue is $40 million, then the RPL would be $400,000. It is important to understand that RPL is not revenue per equity partner (RPEP). RPEP is total revenue divided by the number of equity partners only, while RPL is total revenue divided by total firm headcount. Recent studies have shown that across the board in law firms, those with RPLs definitely over $1 million are more profitable than those with less than $1 million RPLs. So, RPL is yet another area where you can compare your firm against the rest of the industry to see if you are in fact getting the most out of your lawyers.
Profit Margin. Profit margin is expressed as a percentage and measures how efficiently a firm is generating its profits before the deduction of income taxes, interest, and nonrecurring items. Again, to calculate profit margin, divide net profit by total sales. You can use any measure of sales, such as gross sales or net sales. Profit margin is important because it represents the portion of the revenue that the law firm can ultimately spend on its stakeholders. As an example, if the firm had $20 million in revenue and a net income of $3.5 million its profit margin would be 17.5 percent. The average law firm profit margin is around 18-20 percent, depending on the number of employees, revenue, and firm structure.
Profit Per Equity Partner (PPW). A law firm’s Profits Per Equity Partner (PPW) can be calculated by dividing its net profits by the number of equity partners, which will provide a basic starting point. Equity partners are generally defined as partners who own an equity stake in the firm. This type of partner holds a governing interest in the firm and is typically entitled to a share of the firm’s profits or losses. Equity partners will distribute the available firm profits among its members and themselves. The most basic formula for establishing a law firm’s PPW is: net income of the firm/equity partner total.
Compensation Per Equit Partner. Compensation Per Equity Partner (CPPL) measures the average, total direct compensation paid to each equity partner in the firm. It measures the overall financial well-being of a law firm’s business by dividing the total firm income, after paying associated costs, by the number of equity partners. CPPL is not the same as WPP, which is the compensation paid to an individual partner.
Utilization Rate. Utilization Rate is simply the ratio of the time a lawyer spends doing billable work to the time they are working. A high utilization rate may mean a healthy allocation of a lawyer’s time to revenue-generating activity. The law firm profession is very competitive, so if your lawyers have low or declining utilization rates then your firm will be at a disadvantage. Law firms can still be profitable with low or declining utilization rates, but only if their realization and collection rates are high.
Realizations. Realization measures how much of what is charged to a client is actually collected. Realization can be affected by discounts, write-offs, and bad debt. High realization rates are a positive indicator and show that a firm is charging a reasonable hourly rate commensurate with their level of expertise accumulated over the years. Realization rates commonly range from 85% to 95%. Low realization rates could indicate a general dissatisfaction with the service being provided by the firm.
Operational Efficiency Signs
When you strip away all of the fancy-sounding terminology of law firm financial management, you are really talking about how much is going into the firm, and how much is going out.
Most law firm financial reports are focused on revenue generation, since that is the main focus of every firm. The more a firm can expand its revenue, the greater the profit.
There are numerous metrics to analyze in order to determine how a firm is efficiently managing its Costs of Goods Sold (COGS). For example, Your Total Compensation Cost as a Percentage of Total Revenue (i.e., the compensation of partners, associates, paralegals, legal secretaries, etc.) can shed some light on the Cost of Goods Sold for your portfolio of services. Other Cost of Goods Sold category metrics might be Your Total Non-Compensation Cost as a Percentage of Total Revenue, or Your Total Compensation and Non-Compensation Expenses as a Percentage of Total Revenue.
While these are important metrics for assessing how efficient your firm is in generating revenue, profit per equity partner is a more meaningful measurement of profitability. It is a measurement of the firm’s pre-tax profitability. Profit per Equity Partner is a simple calculation based on this formula: Total Firm Profit / # of equity Partners. Of course, overhead percentages and Compensation to Partner calculations are, obviously, also important measurements of profitability.
The biggest drivers of profit for a law firm are operational efficiency metrics, such as billable hours, realization rates and leverage. These are the metrics that will directly impact profitability.
Billable hours is such a core tenet of law firm operations that I should probably dispense with an explanation – but where would the fun be in that? Generally regarded as the most important metric within a law firm, the simple breakdown of billable hours is very basic: This is the number of hours a lawyer bills to the client. A the vast amount of legal fees charged to clients of large firms are based on an hourly rate, while a small group of firms offer alternative fee structures, the hours billed usually directly affect the fees collected by the law firm.
Realization Rate measures how efficiently lawyers’ time is captured through billed and collected amounts. Mathematically, you arrive at the realization rate by dividing the total of these two amounts by the total amount of time a lawyer has worked on the matter. A realization rate of 100% indicates that the firm charged effectively for all lawyers’ time and that all of the amounts billed have been collected.
Leverage is the relationship of "leverageable" lawyers to partners at the firm. Highly leveraged firms are those that for every one partner, they have multiple associates. A firm that has larger-sized associate classes and manages them well, has high leverage. As the leverage goes up, usually the revenues per partner go up as well, because a larger combined work effort is applied to a fixed amount of client work. However, highly leveraged firms can be exposed if there is a lack of business acumen among the associate ranks – or if partners are unable to delegate. In these instances, the firm can quickly lose its competitive edge to less leveraged firms. Even though those firms may be less efficient than their highly leveraged competitors, the services provided may simply boil down to better quality and better customer service, which trumps efficiency.
Generally, expanding leverage will lead to higher realization and profitability. Improving leverage can yield significant profits for the firm. Leveraging up increases profitability but also increases risk to the firm. An ideal law firm model will consist of a balance between less leveraged, higher realization and highly leveraged, lower realization.
It is vital for law firms to understand and act on the primary drivers of profitability. Otherwise, they may be losing out on profits that rightfully belong to them.
Demystifying Client Profitability
A critical area of focus in managing profits is a law firm’s profitability on a client by client basis. A firm can’t be wildly profitable and then have its profits as a whole dragged down by a handful of clients, and for partners and practice areas to prosper, they need to have healthy clients. And the answer is not merely knowing which clients are, and are not, likely to contribute to the bottom line, but managing those clients and practices in a way to get them to a more profitable place.
So how do you analyze and identify clients that are providing, and are likely to provide, a contribution to profits and those clients that are a drain on resources? How can you run a more profitable practice? How do you manage a less profitable client to a more advantageous position?
This white paper tackles these questions and offers practical steps for firm leaders to take.
Tech Effects on Profitability
Adopting legal technology has a significant impact on profitability. The use of technology tools and the structure of a firm’s knowledge management, time entry, billing, collections, and even new business development can make the difference in success. Tools such as document automation and assembly software to reduce the time spent drafting documents, WorkFlow and Legal Project Management technology to increase productivity, and even enterprise search tools to identify and share existing documents , all enhance productivity. At the same time, the use of analytics and data visualization tools to track expenses and revenues-or at the most granular level, track the input from individual matters or clients-helps firms understand the financial impact of changing their behaviors. For example, how would profitability be impacted if we spent 10% less on research? What are/would be the changes to profitability if we were to end the practice of writing off time?
Revenue vs Cost
The quest for profitability in a law firm is an exercise in balancing cost with revenue. The range of cost items in a law firm is broad and everything from paper clips to cars can come under the microscope. But, the most significant line items are on the human side. Those items that deal with the compensation and benefits of the most important assets of any law firm – its people.
Staffing is the first major expense in most firms. Staff costs include salary, bonuses, benefits and employment taxes. The staffing metrics that are most used include revenue per full time equivalent (FTE), which is derived by dividing total revenue of the firm by total FTEs times 1,000. However, for many firms the best metric is revenue per staff, which is derived by dividing total revenue by total staff. Although revenue per FTE provides some insight, every firm has some FTEs that do not produce revenue (such as librarians), so law firms also use revenue per staff. Either way, the message is clear – if a firm wishes to increase profits it must increase revenue without increasing costs of staffing and benefitting.
Often the first step is to develop a staffing model that seeks to identify those areas where the firm has opportunity to eliminate cost without eroding revenue per FTE.
Next on the list is overhead. The rubric is simple – cut costs without eliminating revenue. Law firms have come under pressure to cut costs. The best firms continually analyze cost items to determine where efficiencies can be gained. The most recent opportunities involve cyber security expenditures and cloud computing.
Future-Proofing Profitability Metrics
Future trends in Law Firm Profitability Metrics
We are already seeing change in law firms’ profitability metrics and how law firm executives are discussing them. Many firms have or are working to automate the firms’ data so that the data is more visible and actionable on an ongoing basis rather than in infrequent summarized reports. Not only are there now more frequent updates, but there is more and more tailored delivery to the audiences. Law firm leaders have different priorities than practice leaders, as do practice leaders in comparison to department and office leaders. The older CEO, COO, CMO and CFO roles are being replaced by the roles AIO (administrator officer), ROO (revenue officer), IRO (innovation revenue officer) and CMO (chief management officer). Law firms are increasing the responsibility and accountability of partners through additional compensation incentives, more transparency and more detailed metrics.
The traditional economic impacts of profit per equity partner and profit share for partners, fixed and contingent compensation for non-partners, realization and collection rates, leverage, marketing and business development expense efficiency compared with revenue, and new business generation per partner and per matter remain in use. Non-traditional economic profitability metrics are also gaining ground. These include data on attrition, expanding relationships, and value-add efficiency. In addition, revenues are segmented so that practice, industry, and service lines can be evaluated more distinctly than before.
The impact of AI on profitability metrics includes being able to codify best practices to assess and improve work process efficiency and create more consistent client delivery, as well as providing predictive analytics about many matters so that law firms can manage their resources more effectively. Given this data, firms are more efficiently using AI and other technology to deal with compliance, security, and liability issues. Analytics enables law firms to actually engage in risk assessment, gain insights to manage client relationships, and understand their revenue and new business better.
The move to remote and hybrid work impacts profitability metrics, as firms find that various office spaces, office equipment and supplies, parking, and travel overhead can be either eliminated or reduced significantly. Time and billing, implementation and execution for administrative functions such as billing and collections, and personal time spent for matters are also being assessed.
These metrics and the ability to measure them empower law firms to expand into consulting services, alternative fee structures, and subscription and contingency fee arrangements, all of which bring demands for different profitability metrics. To be successful with these non-traditional services, law firms must be competent to establish and manage multiple workforces and service delivery models, which too require different profitability metrics and processes.
Conclusion: Boosting Your Firm’s Profit
A law firm that does not track its profitability by client, practice, and industry, is like a ship navigating without a compass; most of the time they seem to just be all over the place. Those firms that invest in this area of performance management almost always end up with a much higher Return on Investment (ROI) on their investments than those that do not. The ROI isn’t always cash, it can also be human capital or intellectual capital.
Utilizing the metrics and setting goals discussed above can enhance your ability to serve your clients well, providing for improved service, repeat business, and referrals from your present clients. Investments in people, processes, and technology that are focused on the right clients and the right services that you provide to them will improve your ROI.
Many law firms are concerned about sharing financial information with their staff. They are often worried that it will create animosity, or that some people may leave for greener pastures if they find out that someone else with years of service is making more than they are. In many cases knowing the overall financial state of the firm by the staff can create the kind of teamwork and camaraderie that will result in improved profitability.
Providing the individuals within your firm with the knowledge of how their actions directly impact profitability can produce results that are beyond any expectations that may have existed for those individuals . It enables everyone within the firm to contribute to the bottom line.
Remember, a partner-level review of final billables does not replace a comprehensive performance evaluation process that is based on values and competencies. Rather it is a supplement that is shared with each professional in the firm when helps them understand how they are doing against the goals contemplated in the compensation system. While there may be those that are resistant to receiving this information, most individuals see how the metrics support the performance evaluation process and this results in many positive benefits.
By using the metrics discussed in this article, you can turn your law firm from a legal services firm into a Business Law Firm. A Business Law Firm is not just focused on the law; it is focused on the marketplace, a client’s profit, the professionals that comprise the firm, and the way you do business. You will no longer merely practice law, rather you will be a business person who practices law. There is a real difference between practicing law and being a business person who practices law. The former implies a relatively low impact on the real world while the latter indicates an individual who represents himself and his profession as the best solution to real world issues. Which position would you prefer?