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February 13, 2007

METRICS! WE DON’T NEED NO STINKIN’ METRICS

During a recent speech, Cisco General Counsel Mark Chandler said, “The legal department in Cisco is as metrics-driven as manufacturing, HR or sales.”  (Emphasis added.)

I imagine most (if not all) lawyers are thinking, “So what.  We practice law.  Metrics!  We don’t need no stinkin’ metrics.”

Let’s start with a simple truth – eloquently stated in The Goal - the goal of a business is to make money.  Every thing else, from producing quality products to hiring good people, is essential to running the business successfully; but each is a means to make money and is worthless if the business isn’t making money.  For those who argue that practicing law is different – it serves a “higher purpose” – I direct you to the mission and vision statements of companies like Microsoft, Federal Express, Southwest, General Electric, Johnson & Johnson, and Starbucks.  Each expresses a lofty purpose and helps generate what Gary Hamel and C.K. Pralahad in Competing for the Future call the fuel for the journey to the future – “the emotional and intellectual energy of every employee.”  But if the business doesn’t make money, the higher purposes will be for naught.  The Goal sets out 3 basic financial metrics – net profit, return on investment, and cash flow - that are central to knowing if you are achieving “the goal.”  It also lays out 3 basic operations metrics – throughput, inventory, and operational expense – that facilitate managing operations to achieve the goal.  I’ll spare you a recitation of what they mean for now.  Instead, I just highly recommend the book.

The importance of metrics was underscored in a November 27, 2006 article in Fortune, “Private equity, private lives.”  Authors Geoffrey Colvin and Ram Sharan said of private equity fund-owned companies:

More than others, they insist on identifying the measurements that are most important. Many companies call them key performance indicators, or KPIs.

At AZ Electronic Materials . . . CEO von Krannichfeldt uses about 80 of them, covering all the critical areas - finances, growth, productivity, quality, safety, market position.

In Analysis for Financial Management (another excellent book), Robert Higgins says the most popular financial performance metric among investors and senior managers is return on equity (net income ÷ shareholders’ equity).  ROE is the product of, and can be viewed through, its 3 principal components:  profit margin (net income ÷ sales), asset turnover (sales ÷ assets), and financial leverage (assets ÷ shareholders’ equity).  ROE = profit margin x asset turnover x financial leverage.  If you remember your high school algebra, this necessarily is true, as like numerators and like denominators each cancel out the other:  ROE = (net income ÷ sales) x (sales ÷ assets) x (assets ÷ shareholders’ equity).  The ROE components have a close correspondence with the financial statements of the business - profit margin summarizes the income statement, while asset turnover and financial leverage do the same for the left side and the right side of the balance sheet, respectively. But, to look at them simply at a given point in time is interesting but not very helpful. They can tell you what happened at that point in time, but not why it happened.  Their importance is in examining them over time.  ROE looks at the business as a whole; how did ROE change over time?  And, what happened in the 3 components that contributed to the change?  Finally, you can drill down into the components to find what led to their changes; e.g., was a revenue increase the result of increased volume, increased pricing, or both?  As Higgins notes, ROE and its components give management the ability to manage financial performance through its operating decisions affecting the components and to facilitate analysis of the business and its competition.   

Interesting – but what does this have to do with the business of practicing law?  With a few terminology adjustments, the same methodology exists to manage law firm performance and to analyze a firm’s business and its competition.  “Assets” become “lawyers”; “shareholders’ equity” becomes “partners” (equity partners only); and, “net income” or profit is what’s left after sales (revenues) are used to pay all costs, but with no money having been paid to the partners.  ROE = Profit ÷ Partners.  ROE = profit margin (profit ÷ revenue) x asset turnover (revenue ÷ lawyers) x financial leverage (lawyers ÷ partners).  Algebraically, it works:  ROE = (profit ÷ revenue) x (revenue ÷ lawyers) x (lawyers ÷ partners).

Actively managing by ROE (profits per partner) isn’t a new idea – David Maister pointed it out in his 1993 book Managing the Professional Service Firm – but the legal industry seems to have ignored it.  Even The American Lawyer, a great source of industry information, presents ROE as disparate, rather than linked, information points and only gives an annual snapshot, not a “panoramic” view.

Let me illustrate what this means.  Below is information for 2 firms, Firm A and Firm B.  They are real firms, and the information as to lawyers, partners, revenue, and profit is from in The American Lawyer and The Texas Lawyer for 1991 and 1996 and in The American Lawyer for 2005.


By 1996, Firm B had closed the comparative ROE gap.  Its margin improved from 36.92% to 46.26%, and its profit grew at a 7.89% compounded annual growth rate.  By 2005, Firm A’s ROE was nearly out of sight even though Firm B’s revenue had a higher CAGR (10.65%) and its leverage passed Firm A’s.  What happened?  Firm B’s lawyer growth rate exceeded Firm A’s, so its asset turnover had a slower growth rate.  Its margin fell to 34.84%.  Why?  Without drill-down information (e.g., cost per lawyer), we can’t tell. Firm B could; but I bet this information would shock Firm B.  Two “what ifs.”  If Firm B had managed just its growth in lawyers to be the same rate as Firm A, but still achieved its leverage gain, its asset turnover would’ve improved and its ROE would’ve been $122,825 better despite its margin decline.  Or, if Firm B had managed just its margin so its decline was only to the average margin it had from 1991 to 1996, its profit would’ve improved by nearly $10 million and its ROE would’ve been $104,527 better.

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