Originally published in The Legal Intelligencer

The manner in which law firm leaders measure profitability has the potential to have a profound impact on behavior and motivation, particularly as more firms integrate this metric into their operational management and compensation systems. Yet the nuance involved in establishing profitability metrics opens the door for even the most well-intentioned to encourage and incentivize the wrong behaviors. In a competitive market, firms chasing the false profits of production will quickly be left behind. As law firms continue to embrace and deploy profit metrics, it is essential lawyer leaders – and not just their business advisors – truly understand the implications and risks involved in their decisions, every step of the way.

Pricing pressures open the door

Law firms are early in their trajectory of understanding and applying profitability metrics. The relentless pressure from clients is forcing law firm leaders to better understand underlying performance. Client requirements for greater efficiency, flexible pricing options and reliable quality metrics (perhaps alongside tepid demand growth) have provided the initial impetus for exploring profitability, most often at the matter level. For the most part, this stage is where most law firms remain. Matter profitability and, relatedly, the improvement of matter management tools and techniques are today’s most common profit-measuring activity. We estimate fewer than a third of AmLaw 200 firms are actively, systematically measuring and using matter profitability firmwide.

Matter profitability measures alone do not a profitable firm make, just as aggregate firm profitability measures don’t guarantee timekeeper or matter profitability. Improvements at the matter level, depending on how profits are measured, may or may not have a positive impact on the firm’s bottom line. As with so many concepts, to borrow a well-worn phrase, the devil is in the detail. To become increasingly effective, law firm leaders must not only embrace multiple approaches to measuring profit, but also rely on different measures for different business purposes. One size most certainly does not fit all.

Unintended consequences

The utility of a profitability metric, and the behaviors it fosters, are heavily influenced by the underlying assumptions. For example, the seemingly straightforward approach of allocating higher lease costs to partners in more expensive cities may make these partners less desirable to those looking to staff a matter profitably. Similarly, highly utilized lawyers may appear to have a lower cost per hour than less busy colleagues. Accordingly, busy lawyers might attract even more work while others fight an uphill battle to secure enough work to break even. Focusing on the wrong profit metric may lead to underutilization of high-cost resources, lost opportunities to engage talent and staffing decisions at odds with what, ultimately, may be best for the client. If the most knowledgeable lawyer on a specific topic is deemed a poor choice for the bottom line and she’s overlooked in favor a less experienced, yet less expensive option, quality will suffer.

Herein lies the conundrum: for virtually every assumption made for the purposes of developing a profit metric there are advantages and drawbacks. What may seem to an untrained eye to be a simple, logical choice can have unintended consequences. Multiply those consequences by a dozen – or more – assumptions that go into the creation of a profitability measure and it becomes clear why law firms have defaulted to simple, aggregate measures of profit. It’s time to embrace wholeheartedly the necessary profitability metrics inherent to highly effective business models and enhanced performance.

Garbage in, garbage out

Law firm leaders have long enjoyed the luxury of high demand, which has stifled interest in more precise profit measures. For more than a generation, so long as the aggregate pie of equity partner distributions grew every year, leaders have been content to avoid tough conversations about individual or group performance. Even more troubling, during the occasional economic downturn when law firm leaders felt emboldened to address under-performance, they were as likely to target profitable growth engines that didn’t enjoy favorable traditional metrics. The rainmaker with a $4 million book of business might have received compensation guarantees and the partner with a $2 million book might have been starved of resources, even if the cost to deliver their work resulted in equal profit contributions. Low rate practices that might generate significant profits from practice re-engineering might be overlooked in favor of high rate practices, irrespective of the cost of service delivery.

As the market shifts to alternative, non-hourly billing, pricing is the new frontier. Understandably, law firms want to price in a way that boosts the bottom line, and high billing rates coupled with high billable hours have long been the solution. However, this combination is not sustainable. The data to monitor costs of service delivery – essential to accurately evaluate profitability – is far from perfect; and without it, law firms are at a disadvantage. A typical law firm lacks the ability to sift through and analyze years and years of data to determine the implications of various inputs and assumptions into profitability. They simply have not captured the information required to make critical decisions. In many respects, thus, we are starting from scratch, as an industry. Still, what a law firm charged in the past and how it delivered a specific service has declining relevance to current client demand, so all is not lost.

What’s good for the goose…

Law firms are not the same. Different markets, different clients, different offerings call for different business strategies. What one firm seeks to accomplish may cause its leaders to adopt different assumptions from another in how to measure profits. Over the past year, we have engaged in discussions with dozens of law firm leaders to better understand how they are informing profitability decisions. One truth has become self-evident: there is no single model that suits every firm.

Consider the above examples. For a law firm encouraging a “one firm” approach to staffing matters and servicing clients the allocation of dollars on an office-specific (or even practice- or department-specific) basis will contradict their intent. This firm may, therefore, choose a more equitable allocation method. For another firm wishing to prioritize the use of local resources to service local needs, the opposite may be true. A firm with a high volume of low-rate matters might prioritize investments in technology or process improvement to boost profits rather than force higher rates on an unrelenting market. Another firm with a premium practice might seek to secure its long-term health by prioritizing repeat engagements and cross-selling over one-time matter profitability. Different business objectives will mean different profit measures and different incentives.

Where to Start

The modern law firm has all the complexities and nuances of any multi-line business, often compounded by a multi-national footprint and a wide variety of client types operating across a spectrum of business cycles. Consequently, identifying the appropriate measures of profit requires more than one simple, catch-all solution, despite the intoxicating simplicity of the olden days. Identifying and adopting more precise measures of profit, and then linking incentives to the lawyer behaviors that drives these measures of profit, is a nuanced exercise, to be sure, but not beyond the grasp of law firm leaders and the business professionals who support them.

Profit measures are, at heart, an indication of how well the firm’s capabilities and strategy are addressing evolving market demands. Getting it right will take time, in-depth analysis, and a change management mindset, but law firm leaders who embrace profit as an essential measure of a lawyer’s contribution, and over time incorporate these measures to drive and reward the behaviors consistent with the firm’s strategy, will enhance their firms’ staying power. Let other firms pray at the altar of false profits, resisting client demand and pursuing outdated production metrics. Come judgment day, all will be made clear.