Law Firm Profit Margin: Assessing Partner Profitability

Increasing Law Firm Profit Margin: Partner Profitability
THE NEWSLETTER FOR LEGAL OFFICE MANAGERS
LAW OFFICE ADMINISTRATOR
Volume XIV / Number 11 NOVEMBER 2005
(Reprinted with permission of Ardmore Publishing Company)

Counting Partner Dollars: How To Tell A Partner To Do A Better Job
Last month, LOA told how to calculate the dollar loss from unrealized accounts. (See, “Calculate the cost of the firm’s unbilled, unpaid hours.”)

Here’s a look at another side of the financial pic­ture: how to calculate the partner profitability. And how to approach the poor performers.
One of the best indicators of where and how to improve the firm’s profit margin is the indi­vidual partner profitability.

Knowing whether the partners are performing at par lets the firm know if and how it can improve its financial picture. The same numbers tell the firm which partners are damaging the profit margin and by how much.

Here Robert Henderson of RJH Consulting, a legal practice management firm tells how to put the numbers together and also how to present them to the underperformers.

Partner Profitability: A Very Simple Equation
A partner’s profitability is a simple calculation. It’s the percentage of collections the partner is taking out.

To get it, start with the partner’s net profit, which is the partner’s collections minus his or her with­drawals.

He points out that the withdrawals include only the things that actually go into the partner’s pocket such as draws, benefits, profit share contributions, and bonuses. They don’t include apportioned overhead items such as rent.

Divide the net profit by the partner’s collections, and the outcome is the percentage of collections that partner is taking out.
Thus, if Partner A has brought in $250,000 in col­lections and has taken out $125,000 in withdrawals, his net profit is $125,000 and he’s withdrawing 50% of his collections.

On the other hand, if Partner B has brought in $250,000 but has taken out $150,000 in withdrawals, her net profit is only $100,000, and he/she is withdrawing 60%of his/her collections.

Where’s The Good Mark?
“Accepted wisdom” is a withdrawal percentage of no more than 50%, Henderson says. In other words, no partner should be taking out more than half of what he or she is bringing in.

Holding to that simple approach keeps the payouts fair. The partners who produce more take out more, and those who produce less take out less.

Henderson admits that with operational costs increasing continuously and competition for clients strong, a 50% ratio may not be achievable all the time. But it’s a good guide to follow. If a partner consistent­ly withdraws more than 50% of what he or she col­lects, “that’s something to be concerned about.”

Profit Margin: Handling The Underperformers
What if the firm finds that one or two partners are far behind the others?

Now comes the task of addressing their poor show­ings, and Henderson’s advice is don’t confront them individually.

“A partnership is like a marriage,” he says. Sensi­tivity is high. “Haul someone before the meeting” and announce that performance is inadequate. The per­ception is going to be that it’s not business but a per­sonal attack because “Partner So-and-So never liked me and now I’m being picked on.”

Far better is to sidle into the issue.

Present the profitability findings to the managing partner or management committee and recommend that they address the issue.

If that doesn’t work, present the results at the next full partnership meeting and hope the under-producing partners get the message.

If that doesn’t work, bring in a consultant to evalu­ate the firm’s profitability and let that person address the issue with the under producers. Getting the word from someone “who doesn’t have an agenda” makes the criticism less personal and more palatable. But the best approach of all is prevention, he says. Spell out the billable hour standards and collection benchmarks in the partnership agreement. When the agreement says every partner is required to bill 1,600 hours a year, it’s easy to approach the partner who’s billing only 1,200 hours.

He emphasizes, however, that when a partner is consistently under producing, the situation has to be confronted some way. “That’s a function of manage­ment.”

Or Count The Money Collectively
It’s also possible to calculate partner profitability collectively, Henderson continued. That way, the firm can see the average partner performance and identify its outliers.

The process is much the same.

Just subtract the overall withdrawals from the rev­enues. That’s the overall net profit (and hence, the profit margin).

Then once again, divide the net profit by the col­lections, and the result is the collection percentage the firm is seeing.

So suppose it’s a five-partner firm with annual rev­enues of $2 million and withdrawals of $1 million.

Collectively, the partners are withdrawing 50% of what they are collecting.

Divide the profit by the five partners, and the aver­age net profit per partner is $200,000.

If the overall percentage looks good, the firm may stop its calculations there and not go to individual results. But if it looks bad, “it’s time to find out if what the individuals are withdrawing is justified by what they are producing.”

When there’s no one partner at fault, the firm has to make improvements via overall changes.

Doing that, Henderson says, the concern is not is where to start but where not to start.

Don’t Just Cut The Outgoing Expenses
Don’t start by trying to cut down on the outgo. That’s because outgoing expenses are made up almost entirely of overhead – rent plus associate and staff salaries – and the reduction options are for the most part not viable: moving, renegotiating the lease, or layoffs.

Attack instead of the income side of the picture. “Find more ways to generate revenue.”

The obvious starting point is to look at the number of hours the partners are billing. If the average is low or if there’s great disparity from partner to partner, the firm needs to set – and enforce – billable hour stan­dards for the partners.

If the billable hours are okay, the firm may be able to better its financial picture by putting limits on the number of write-offs each partner can take. That shouldn’t meet much opposition, he says, because the partners have been practicing law long enough to know how to avoid situations where they have to write off large blocks of time.

Still another approach is to bill faster because the longer the stretch of time between service and bill, the less likely the client is to pay.

Also, address the accounts receivable that are more than 90 days old. When a partner has high balances that old and more, there’s a strong possibility that the firm has not established collection guidelines or the partner isn’t billing the clients on time or the clients aren’t satisfied with that partner’s services.

A Bad Idea In Good Times
Oddly enough, it’s not always a good idea to mea­sure partner profitability for overall profit margin, Henderson adds.

He recommends against it in the times of satisfac­tion -—when the firm is performing well, the partners are satisfied with the returns, “and everyone feels like everyone else is making an equal effort to pull on the oars.”

Don’t rock that boat. At that point, the only thing profitability measures will produce is “finger-pointing where it’s not really necessary.

Worse, announcing to a group of satisfied partners that “Partner A is a leach” can be neither productive nor helpful. All it can do is create unnecessary con­flict.

Profitability measures aren’t necessary either in a firm that operates under “an eat-what-you-kill com­pensation formula” where the nonproductive attorneys simply get less of the profit margin.

The time to measure the profits, he says, is when there’s dissatisfaction about how the profits are being distributed or when the partners are saying the firm is not producing the profit margin as it should be.

At that point, there’s invariably a problem, and most of the time it’s a partner “who’s been consistent­ly underproducing for a number of years.”

Follow RJH Consulting blog for more tips on law firm consulting.