How Firms Should Be Measuring the Profitability of Matters
Matter profitability matters. Yet most firms struggle to measure it in a manner that is accurate, focused on the levers partners control, and inclines partners to take action. Using margin per partner Hour (MPH) to measure profitability delivers on these objectives.
The MPH measure enables assessment of profitability on matters with widely varying realization and leverage in a directly comparable way. It also allows you compare profitability consistently across clients, practice groups, and partners. But, from discussing the measure with law firm leaders, I know that the reasons the measure works aren’t intuitive, so let me start with some principles and then turn to the particulars of MPH.
A first principle: in management, you should align accountability with control; holding people accountable for elements they don’t control yields frustration and demotivates. Thus, as we look to partners to manage matters profitably, we should only include in how we measure profitability the things partners directly control: the realized revenues and the amount of time that lawyers of different seniority dedicate to executing the matter. As partners managing a matter don’t control things like an associate’s overall level of activity, office rent, etc., these should not be included. In management accounting, the term “margin” is used for profit measures like this that account for some, but not all, costs. Hence the result of subtracting the cost of the executing lawyers’ time from the realized revenue of a matter is termed “matter margin.”
A second principle is that profitability measures should focus on how much we get out of using a particular, scarce, resource. For example, investors don’t look at the appreciation of a stock price in isolation; rather they look at appreciation as a percent of the original share price—if the share price of Stocks A and B both rose $10, and their original prices were $5 and $20, respectively, then stock A was the more profitable investment; supermarket managers look at the margin generated per unit length of shelf space—shelf space is the scarce resource; it’s the thing managers want to get the most out of. For law firms, the scarce resource is partner time—there is only so much of it that can be deployed; we want to be sure we get the most out of it. Hence, it makes sense to look at matter profitability relative to the amount of partner time involved.
Bringing the above two principles together suggests matter profitability is appropriately measured by looking at matter ‘margin’ on a ‘per partner hour’ basis—hence margin per partner hour, or MPH for short. It is noteworthy that MPH mirrors the ubiquitous profit per partner (PPP) measure of overall performance—MPH is in essence the matter-level counterpart of the summary PPP metric.
A third principle comes into play in the particulars of how MPH is calculated and applied: the generation of profit should be looked at separately from the distribution of profit. In a sense, this is a corollary of the first principle of aligning accountability and control: client service partners control the generation of profit; a firm’s compensation committee controls the distribution of profit. If we don’t follow this principle, we obscure the important issue of where and how profit is generated by inclusion of how profit is distributed. This is not to say that we shouldn’t look at how profit generation and distribution align; indeed, it’s critical that we do. Rather, it is to say that it is better to look at them separately as this identifies more readily how to address any misalignment, i.e. how much can and should be done through improved profit generation versus through changed compensation allocation.
How MPH Works
Consider two idealized matters. Matter A is a year-long counseling arrangement. It’s relatively low leverage—1.5 associate hours per partner hour, but the client pays full billing rates. Matter B is a litigation matter that settles before going to trial. It’s relatively high leverage—4.1 associate hours per partner hour, but the client is getting a 15 percent discount so realization is only 85 percent.
Table 1 below shows the calculations of the matters’ MPH. Gross revenues are determined simply as hours multiplied by billing rate, (the examples use the same average partner and associate hourly billing rates of $1,000 and $650, respectively). For ease of comparison, gross revenues are $1M for both matters. The matters’ realization is applied to gross revenues to determine net revenues from which associate cost—approximated as one quarter of the associate billing rate (discussed more later)—is subtracted to determine margin. Margin is then divided by partner hours to provide MPH.
The final line of the calculation presents the matter’s MPH as a percent of firm target, typically the MPH level implicit in the firm’s financial plan, (every annual plan has such a metric in it ). There are a number of reasons to look at MPH in this way. One is that, because the MPH metric is new, partners don’t have a feel for what constitutes a “good” level of MPH in the way that they do for, say, an individual’s billed hours; comparison to a target level makes it easy to assess. Another is that comparing a matter’s MPH with a target brings into the assessment of profitability how well the matter is contributing to covering the firm’s fixed costs and to meeting the firm’s profit expectation. Finally, as billing rates increase year by year, the level that constitutes a good MPH also rises; looking at MPH as a percent of firm target allows the assessment of what constitutes a strong MPH to rise naturally over time.
The calculations show that the high-leverage, low-realization Matter B has the higher MPH—111 vs. 80 percent of firm target. That is to say, each partner hour on Matter B is contributing significantly more to coverage of the firm’s fixed costs and generation of its partner profit pool.
Comparison With Current Measures
The most popular measures of matter profitability used today focus on matter margin percent, calculated by subtracting allocated costs from a matter’s gross revenue and then diving the result by gross revenue. The allocated costs typically include fully-loaded associate costs, office costs, and a nominal cost of partner time.
There is much to commend this view of profitability. It certainly allows for a quick and intuitive comparison across matters. However, it has a number of practical and conceptual limitations. For me, the most concerning limitation is the effect on this profit measure of increasing the amount of partner time dedicated to a matter. Because of the dual profit-and-cost nature of partner compensation, most implementations of this approach include a relatively modest cost for partner time. As a result, the margin percent on partner time is typically quite high, higher than on the other lawyer cohorts deployed on the matter. In the same way that accumulating class grades that are higher than an existing grade point average (GPA) raises that GPA, adding more high-margin partner time to a matter improves the matter margin. This is counter to the economic reality—adding partner time reduces leverage and hence profitability—and is thus the opposite of how a profitability measure should move.
Another benefit of MPH relative to margin percent is that MPH focuses attention on the profitability drivers that client service partners actually control and expresses them in practical, accessible, terms: realization and leverage. More conceptually perhaps, but more powerfully, MPH has the benefit of focusing on the output achieved from the scare resource of partner time, rather than on the narrower issue of the efficiency with which an unconstrained gross revenue quantity is converted to margin. Table 2 outlines a summary comparison.
When partners first discuss the MPH metric, they identify quickly a number of subtleties implicit in its use.
One is: MPH rewards a partner for forgoing doing work and having an associate do it instead; doesn’t this assume that the partner has something else to do with their time? The answer is yes. More fully: the MPH metric embodies the notion that work should be done by the lowest cost resource capable of doing it. Pushing work to associates is a triple-word score: lower cost to the client, better experience for the associate, and more time for the partner to do other things. If what the partner does with the newly freed-up time isn’t other billable work then the time can be deployed on client relationship building and business development so that, in the medium term, the partner does indeed have other billable work to which to turn.
Another issue: how should associate cost be calculated? There are many different ways to do it. I incline toward simplicity and thus estimating a lawyer’s hourly cost as their billing rate divided by the typical “multiplier” for the lawyer’s cohort (e.g. associate class year in a particular geography) where the “multiplier” is the number of times a lawyer’s hourly billing rate multiplied by their anticipated annual billed hours exceeds their annual base, bonus, and benefits cost. Note that this multiplier will vary by country, reflecting both differences in anticipated billed hours and associate salary levels. It doesn’t really make sense to adjust the multiplier for an individual lawyer’s actual number of hours or supplementary bonus as these are not under the control of the partner managing the matter.
Shouldn’t the cost of the partner’s time be included in determining margin? In a two-tier partnership, the cost of nonequity partner time absolutely should be included. For equity partner time, a purist would incline not to include such a cost element as the compensation of equity partners is a distribution of profit and not a cost item. In a similar vein, if you want to be able to combine matter profitability with office and other costs and tie out to overall firm profit, you can’t do so if you include a cost for equity partners. In practice, I have found that enthusiasm for including a charge for partner time often moderates when partners understand that, all else equal, adding a cost of partner time makes high-leverage matters look even more profitable than their low-leverage counterparts. That said, if you are more comfortable including a putative cost for partner time, you should do so. You should avoid using costs that derive from a partner’s compensation as so doing violates the third principle of profit measurement outlined earlier. A better way is to use the same multiplier approach as above, applying the multiplier for the most senior cohort of associates to the individual partner’s billing rate.
But what about all the other costs, how can you just ignore them? Well, obviously, you can’t. So, two things: first, as described above, MPH should be compared with a target level because the target will bring into the assessment of profitability the firm’s other costs and profit expectation. Second, profitability management doesn’t stop with matter profitability; rather, matter profitability should be integrated with other profitability views.
Integrating MPH With Other Profitability Views
The MPH view of matter profitability is just one element of a broader approach to firm profitability management. In this broader approach, a firm’s P&L is divided into tranches defined by accountable party and the profitability of each tranche is looked at relative to the partner resources involved.
For example, for a firm that is managed by office, the tranches, accountable parties, and metrics would be as outlined in Table 3 below. The top tranche, from revenue to margin on matters, is the purview of all client service partners and is best looked at using MPH.
The middle tranche, from margin on matters to office margin, is the purview of office managing partners. Office margin is best looked at on a per-partner basis (using the number of full time equivalent (FTE) partners resident in the office) as this quantifies the average ‘output’ per partner to coverage of firm-wide fixed costs and to generation of the firm’s profit pool. One particular: as office managing partners are typically responsible for having the right level of lawyer resources be available for partners to deploy, the cost of any unused associate capacity is included in office costs, (the cost of the ‘used’ portion of associate capacity is already captured in matter profitability).
The final tranche incorporates firm-wide costs into the P&L. It is firm leaders who are accountable for this final step of conversion of office margin to bottom line firm profit. Consistent with the other two tranches, and as is common across law firms today, this bottom line profit is best viewed on a per-partner basis—i.e. profit per partner (PPP). It is not just happenstance that the common PPP formulation mirrors the ‘per partner resources deployed’ profitability metrics recommended for the two higher tranches; rather, it’s an affirmation of the rationale and value of looking at the different levels of profitability relative to the partner resources involved.
MPH has numerous applications in a firm’s day-to-day operations. These include pricing analysis, client profitability and performance monitoring.
While pricing decisions involve consideration of many factors, understanding their profitability implications is especially important. MPH affords such understanding while also making pricing discussions with partners action oriented. In the typical situation, a client puts pressure on billing rates; partners, eager to secure the work, come forward to a pricing committee with a proposal to accede. Introducing MPH into these discussions with partners shifts the focus of the discussion from a thumbs-up-or-down on a proposed discount to the development of a plan for increasing leverage so as to be able to yield on price without undermining profitability. In particular, MPH allows an accurate quantification of the tradeoff between realization and leverage, as shown for an example matter in the graph below. All points along the curve have the same MPH; thus, a partner looking to discount can see (per the example) that 100 percent price realization at 2.5 leverage yields the same profitability as 85 percent realization and 3.5 leverage, etc. A proposed discount can be translated to a leverage target which can then guide how the partner staffs the matter and set the parameters used in legal project management.
Another high-value application of MPH is in client profitability analysis. Such analysis guides client teams and partners on how to optimize the allocation of their time across and within client relationships to improve profitability. To quantify a client’s profitability, one simply looks at the sum of the profitability elements across all matters for the client. This is typically very informative. Many firms have an intuitive understanding that some large clients, often major public companies and banks, are challenging to serve profitably. Looking at the MPH of such clients can quantify both any profit shortfall and the benefits from various initiatives that client teams and individual partners can take to shore up profitability.
MPH finds valuable application too in routine financial reporting. Looking at MPH enables firm leaders to identify partners struggling with price realization or leverage and get them appropriate coaching or legal project management support while there is still opportunity to improve the outcomes on active matters.
As the aphorism goes: what gets measured gets managed, and what gets managed improves. Measuring matter profitability using MPH is thus a critical cornerstone of profitability improvement in an increasingly challenging business environment for law firms.
Hugh A. Simons is a strategist and veteran professional services firm leader. He is a former senior partner, executive committee member and chief financial officer at The Boston Consulting Group and the former chief operating officer at Ropes & Gray.
The views in this article are expressly those of Hugh A. Simons.