What the more profitable firms are getting right

In last month’s Journal we discussed the “headline” profitability of firms of various size and in different locations across Scotland.  This indicated a wide range in profitability of firms of similar size – as measured by the number of profit-sharing partners – in the same location.  This article looks in more detail at some of the factors that can contribute to this variability, and at the financial structures of the more profitable firms.

It can of course be a mistake to assume that high, or even above average, profit levels are a key goal or driving force for all partners.  There are many, especially in rural practice, who are prepared to forego high profitability for a better work/life balance.  They would hope to earn a “reasonable” income that reflected the hours they put in and the responsibility and risk that they carry, but money is not a prime driver. For other partners, perhaps the majority, profitability is important and indeed is a key factor as to why they are in practice.  The problem is that in many areas of work it is becoming ever harder to achieve:

" We are busier than ever, but costs rise inexorably, and margins are cut by competition and Government's unwillingness to allow a fair hourly rate for Legal Aid. It’s tough out there!"

Managing partner 10+ partner Edinburgh firm

Many of the factors that determine the profitability of a firm are outwith the control of the partners in that firm.  These would include the rates of pay for legally aided work, competition from other firms and overall activity levels in the economy.  

Traditionally, firms have combated these external factors, and have maintained or increased their profitability by requiring partners and other fee earners to work ever harder, to work ever longer hours, and to keep as tight a control on expenditure as possible.  This is still a good starting point, and many firms go no further, but there may be better ways to increase profitability.  For many firms there comes a point when they take stock and realise that better results could be obtained by looking more carefully at the firm’s financial structure and fee-earner working methods, in particular:  

• The firm’s Gearing – the ratio of fee-earners who are not profit-sharing partners to profit-sharing partners;
• Their fees per profit-sharing partner – which is, in effect, another gearing ratio;
• Their salaries (including a notional salary for each profit-sharing partner) relative to fee income;
• Their non-salary overheads relative to fee income.

Chart 1 (and the other charts in this article) groups firms according to whether their profit per profit-sharing partner is:

• In the bottom quarter - below the 25% point;
• Above the 25% point but below the mid-point;
• Above the mid-point but below the 75% point;
• In the top quarter - above the 75% point.

Chart 1 - Gearing

Chart 1 indicates that the most profitable firms generally have higher levels of gearing.  For example, the most profitable two to four partner firms had at least one other fee-earner in addition to each profit-sharing partner.  The least profitable firms had under one-half.  In the larger firms, the more profitable firms had gearing of greater than three other fee-earners in addition to each profit-sharing partner.  

“Gearing” allows work to be delegated and frees up partner time to concentrate on more complex cases.  It requires a different role of the profit-sharing partners, who will, or certainly should, spend part of their time supervising the fee-earners. It implies that they become managers – not just fee-earners, something many find hard to adjust to.  

The achievement of improved gearing may take some time – quite possibly several years – and may be related to partner retirements and the recruitment and training of new fee-earners – qualified or perhaps unqualified.  It is normally a gradual process, and the introduction of more formalised systems of file management and supervision, along the lines set out in the Law Society’s “Better Client Care” guide is often a pre-requisite.

This concept is demonstrated even more clearly in Chart 2, which illustrates fees per profit-sharing partner. (total fees of firm divided by number of profit - sharing partners). The least profitable firms with under five partners achieved fees per profit-sharing partner of under £95,000. These are likely to be firms where there are few fee-earners other than the profit-sharing partners and with fees at this level, once staff salaries and overheads are deducted, the eventual profit shares cannot be high.

The most profitable of these firms, by contrast, achieved fees per profit-sharing partner in excess of £237,000.  At this level there is far more scope for better partner profits.  The higher figures may be due to the higher personal fees of the partners but are more likely to reflect better gearing.

Some of the more successful firms are starting to abandon individual fee targets because they can easily be counterproductive.  They have moved on instead to looking at team targets, either for fees or more usefully for profitability.  Within each team they may look at chargeable hours or other performance measures.  Too much emphasis on individual figures can result in partners and other fee-earners hanging on to work, not passing it to more suitably qualified colleagues or to more junior fee-earners. It is difficult to fully reap the benefits of gearing whilst focusing too much on individual fee targets – especially if they are related to bonus schemes.  

Chart 2 – Fees per profit-sharing partner

Moving beyond fees, Chart 3 examines the relationship between salaries and fee income and, in effect, measures the “gross profitability” of a firm.  We have included a notional salary for each profit-sharing partner in this calculation so as to reflect their cost as a fee-earner. The chart indicates that the most profitable firms achieve a figure of around 50% – or less.  In other words, if the firm’s fees are £1m, its payroll, including the notional salaries is under £500,000.

Chart 3 - All salaries as a % of total fee income

For firms that wish to improve their profitability, this ratio is worth spending some time on.  More so than overheads, which are often relatively fixed, any improvements to this percentage are likely to result in increased bottom line profits.

The important point to remember is that this is not about cutting salary costs – it is concerned with the relationship between fee income and

the basic cost of producing that income – the cost of the people in your firm. In many cases improvements in this measure result from paying higher salaries – and attracting better quality staff – and by careful re-assessments of what people actually do. Firms may also need to consider reductions in people who are never going to make the standard you expect – staff and partners.

This article seeks to provide some insights into some of the factors that influence profitability.  Most firms would probably find it useful to compare their own accounts with these charts and see how they compare. They may well identify areas they need to explore further, areas where they appear to be out of line with other firms.

All participating firms receive a free copy of “The 2002 Survey of Law Firms in Scotland”, the detailed report upon which this article is based.  Other firms can purchase a copy of the full report which contains a wide range of useful statistics and performance indicators.  Priced at £80, this is available from Lisa Hamilton at the Society on 0131 476 8164.

In April the President will be writing to all firms inviting them to participate in the 2003 survey.  Participation is free and carries a two hour CPD credit as well as a copy of the survey report.  In recent years there has also been a prize draw.  This year the prize of a theatre break in London was won by Pamela Gray of Lefevre Litigation in Aberdeen.  The Society is again grateful to Alex Quinn for sponsoring the prize in 2002.

Andrew Otterburn is a management consultant and for many years has run practice management seminars on behalf of the Society.  He has helped in the development of the Cost of Time Survey since 1999, working initially with Professor John McCutcheon and now with Dr John Pollock.  His new book, Profitability and Law Firm Management, is published by the Law Society in London.

Dr John Pollock, a consulting actuary, was responsible for the administration and statistical aspects of the Cost of Time survey in 2002 having taken the place of Professor John McCutcheon on the Law Society of Scotland Remuneration Committee last year.  John is well known to personal injury, employment and family law solicitors in Scotland through his expert witness work at Pollock & Galbraith Consulting Actuaries.