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February 21, 2007

METRICS! WE DON’T NEED NO STINKIN’ METRICS (PART II)

Wow!  Just when I thought it was safe to go back into the water – I read an article this morning at Law.com in which a law firm consultant was quoted as saying:

The key determining factors in large law firm profitability are getting billing rates to the highest price the market will bear and getting the realization rate as high as possible.

Guess I better send a blast communiqué to every business school in the country – the schools obviously just don’t get it.  Their curriculum just got much shorter and much simpler:  no longer do businesses have to worry about such operating concerns as increasing the rate at which the business generates money through sales, lowering inventory, or lowering operation costs, much less worry about any strategic or marketing concerns such as delivering value to clients.  Just jack up those rates!

The above quote provides a great lead-in to today’s posting.  Two postings ago, I began looking at legal industry metrics and their significance.  I illustrated the metrics and the importance of examining them over time with public information from 2 real firms, which I called “Firm A” and “Firm B.”  Today, I’ve put a link to a *.pdf version of the illustration, with a few additions, in the upper right hand margin of this blog under the category heading “Posting Attachments.”  Return on assets (ROA) has been added to the illustration, as has “cost per lawyer.”  And, finally, to make the first “what if” example clearer where the key element being managed is the growth rate in lawyers, the heading above that example has been changed to “Lawyer Growth” from “Leverage.”

At the end of that earlier posting, I started focusing on the power of return on equity (ROE) metrics not only to answer “What happened?” but also both to address “Why did it happen?” and to show the way to manage for better performance.  To recap, the illustration shows Firm B narrowed the ROE (profit per partner) gap between Firm A and itself from 1991 to 1996, primarily on the strength of improving its margin.  But from 1996 to 2005 Firm A’s financial performance left Firm B in the figurative dust even though Firm B’s revenue grew at a higher compounded annual growth rate (CAGR) than, and its financial leverage grew to exceed, Firm A’s.  By “drilling down” into the ROE components, some of the reasons for this disparity in relative financial performance start to surface, including Firm B’s faster lawyer (or asset) growth rate (contributing to Firm B’s slower growth in asset turnover) and deteriorating margin.  The illustration’s “what if” examples show that if Firm B had managed its growth in lawyers to be at the same CAGR as Firm A, while still achieving the financial leverage that it actually did, the improvement in its asset turnover would’ve led to an ROE that was $122,825 better than it achieved; or that if Firm B had managed its margin so that its actual decline had been only to the average margin it experienced from 1991 to 1996, it would’ve led to an ROE that was $104,527 better than achieved.  I want to continue drilling down into the illustration’s metrics in today’s posting.

ROA is a simple equation:  ROA = net income ÷ assets.  To put it in the context of its principal components, it’s:  ROA = profit margin x asset turnover.  Remember the algebra:  ROA = (net income ÷ sales) x (sales ÷ assets).  For the legal industry, with terminology changes ROA = profit ÷ lawyers; or, ROA = margin x asset turnover, with the algebra being:  ROA = (profit ÷ revenues) x (revenues ÷ lawyers).  ROA is a good measure of the efficiency with which a business allocates its resources, as it eliminates the effects of financial leverage on operating results.  Just as with ROE, Firm B narrowed the ROA gap between Firm A and it from 1991 to 1996, as its ROA, fueled by its margin improvement, grew at a CAGR of 7.64% to Firm A’s 5.77%.  But by 2005 Firm A’s ROA again had left Firm B in the figurative dust.  Firm A’s profit growth and its asset turnover growth both exceeded Firm B’s CAGR.  As a result, Firm A’s ROA grew at a 6.34% CAGR from 1996 to 2005, while Firm B’s ROA grew at an anemic 1.86% CAGR for the same period.  Firm A’s ROA grew from 1.4232 times that of Firm B in 1996 to 2.0957 times in 2005.  The relative disparity between the firms’ 2005 ROE (2.0192) was slightly less than that of the firms’ 2005 ROA due to Firm B’s relative financial leverage improvement.

What happened with Firm B?  Let’s look at revenues, cost per lawyer, and business base requirements.  Revenues generally grow from price increases, volume increases, or a combination of both.  They are a product of the rate achieved (price) and the units produced and sold (volume).  For a law firm, this concept is:  total revenues equal a firm’s realized billing rate times the hours billed.  Drilling down into asset turnover can help us understand revenue changes.  Asset turnover = revenues ÷ lawyers (or revenue per lawyer).  Another way to look at asset turnover is:  asset turnover = price (sales ÷ billable hours) x volume (billable hours ÷ lawyers).  We don’t have any information about Firm B’s billing rate or its billable hours, so let’s use an example.  Assume that in 1996 Firm B’s lawyers billed an average of 2,160 hours per year.  As a firm, the aggregate hours billed would have been 375,840.  Using Firm B’s 1996 revenues, its realized billing rate would have been $152.9906 per hour.  (Just for grins, multiply 2,160 hours/year x $152.9906/hour.  The answer is $330,460 – just what the illustration shows for Firm B’s 1996 asset turnover – the asset drill-down math works!)  Now, let’s assume that all of Firm B’s revenue growth from 1996 to 2005 was the result of rate increases (let’s get the highest rate possible!) – although in the real world that’s not likely to happen.  At Firm B’s actual 10.65% CAGR for its revenues from 1996 to 2005, it’s realized billing rate in 2005 would’ve been $380.4811 (a price increase).  If that’s the case, its 2005 aggregate billable hours would’ve remained constant (no volume increase) but the billable hours per lawyer would’ve decreased to 1,361.7391 as the firm’s number of lawyers grew at a CAGR of 5.26%.  Or, if the billable hours remained at 2,160 per lawyer in 2005, then the total billable hours would’ve had to increase by a 5.26% CAGR (volume increase) due to the increase in the number of lawyers and the realized billable rate would’ve increased by a 5.12% CAGR (price increase) in order for Firm B to achieve its actual 2005 revenues.

The actual line item costs for Firm B aren’t public, so we have to do some simple extrapolation to get to cost per lawyer.  In 1996, Firm B’s revenues were $57,500,000 and its profits were $26,600,000.  That leaves $30,900,000 as costs for 174 lawyers or $177,586 per lawyer.  In 2005, Firm B’s costs per lawyer were $337,609 – a 7.40% CAGR.  Think about that - Firm B’s revenues from 1996 to 2005 grew at a 10.65% CAGR; but its asset turnover (revenue per lawyer) grew only at a 5.12% CAGR. Its costs per lawyer grew at a 7.40% CAGR.  The business result was an anemic 1.86% ROA CAGR.  By comparison, Firm A’s revenues grew at a 9.18% CAGR and its asset turnover grew at a 6.16% CAGR, while its cost per lawyer had a 5.99% CAGR.  The business result was its 6.34% ROA CAGR. Holy Cow, Batman!  I think that if your costs per lawyer grow at a faster rate than your revenue per lawyer, you’re not efficient in the way you allocate and manage your resources and your returns aren’t going to be very good.

We don’t know the requirements necessary to adequately service Firm B’s business base.  But, law firms must match their assets (lawyers) with the requirements of their business.  As lawyer-tasks become more standardized and require less complex problem-solving, the experience level and pricing for the lawyers in the firm must be managed to match these changing business requirements.  If you have a real estate project that can be handled by a $300/hour lawyer but you only have $500/hour lawyers to do the project, today’s client is more apt to push back – either bill it at $300/hour or lose the business.  My best guess – what it took to service Firm B’s business did become much more standardized and did take less complex problem solving.  But, instead of managing its mix of assets and pricing to reflect that change, Firm B focused on raising its rates as high as it could.  It probably lost business as a result, while at the same time growing its number of lawyers.  It likely got lulled into a false sense of security because its revenue and profit both grew; it didn’t actively manage its business through the ROE component operating levers; and it didn’t realize that its costs per lawyer were growing at a faster rate than its revenue per lawyer or that its ROA was anemic. It didn’t, and probably doesn’t still, understand that business is competition – and by comparison to at least one competitor, Firm A, it’s not even in the game.

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