A common metric for measuring financial success of a matter in large and medium-size law firms is realization rate (the percentage of standard rate fees actually collected, after discounts and write-offs). Profitability of the matter is a far better metric, and in some cases, may work better as an incentive linked to partner compensation than realization (aka origination credits) and realization rate.
Realization rate vs. profitability—what’s the better metric at the matter level?
Keith Mayfield, chairman of an AmLaw 200 firm, is debating with his management committee the pros and cons of introducing to his firm’s partners the metric of profitability of a matter rather than realization rate, the metric currently used.
Reasons to focus on profitability
Keith believes realization rate of a matter shows only part of the picture and does not permit comparisons across practice groups. A tax advisory matter billed and collected at standard rates, involving mostly partner time, could produce lower profitability than a routine bank-loan matter billed at a 10 percent discount and utilizing two associate hours for each partner hour.
In other words, realization rate measures only the revenue side, while profitability also takes into account expenses attributable to the matter, driven principally by the lawyer resources used.
Concerns about using profitability as a metric
After pressing these points, Keith gets pushback from several management committee members:
- “Our partners won’t understand the profitability metric,” says one member.
- “Using profitability will be divisive,” says another. “Even if we give profitability information about a matter only to the billing partner for the matter, our partners will quickly start comparing their profitability.”
- “I think I get what realization rate means,” says a highly productive partner on the committee who has a large book of business, “but what exactly do you mean by ‘profitability’ of a matter?”
- “I rest my case,” says the first committee member. “This is too hard for our partners to understand.”
In response, Keith reviews how each of the two metrics is calculated. [The management committee debate resumes below after this explanation.]
What we mean by realization rate and profitability
Fortunately, the firm has software that can readily perform these calculations and present them to any partner in a dashboard format. For now, Keith is proposing that the firm’s partners be able to see the profitability only of the matters for which they have billing responsibility.
Realization rate for a matter is actual collections (realization) divided by fees at standard billing rates, expressed as a percentage. It reflects agreed-upon discounts from standard rates, write-downs (fee reductions taken before sending the bill) and write-offs (fee reductions after sending the bill).
Realization rate can be computed for an individual matter or for the firm as a whole. The sum of realizations for all matters equals the firm’s revenues.
While the firm’s partners tend to think of “profitability” as profitability of the firm as a whole, it can also be computed at the matter level. To compare profitability across matters, profitability should be expressed as profits per notional equity partner working on the matter.
The computation involves allocating direct and indirect expenses of the firm to each matter, using allocation methods appropriate for each type of expense. Those matter expenses are subtracted from fees collected (realization), to obtain profits for the matter. Divide those profits by the number of notional equity partners working on the matter to obtain profits per notional equity partner for the matter.
The number of notional equity partners is partner hours worked on the matter at standard billing rates as a percentage of total partner work for the firm, times the number of equity partners. The sum of profits per equity partner for all matters equals the firm’s profits per equity partner.
How these metrics fit into the law firm economic model
Profitability at the matter level can also be expressed in terms of the law firm hourly billing model, in which profits equal the product of realization rate, average standard billing rate, leverage, margin and utilization.
The law firm model takes four additional variables beyond realization rate in measuring profits per partner. The main practical difference, though, between realization rate and profitability is due to the leverage variable. Margin and utilization probably will not vary nearly as much across matters as leverage will.
In practical terms, this means that if matter A and matter B involve the same number of timekeeper hours, same billing rates and same realization rates, but matter A uses more associates in the mix than matter B, matter A will be more profitable. Matter A also will produce slightly lower fees for the client, because of the associates’ lower billing rates. Leverage is the secret sauce.
The debate resumes
After Keith’s summary of the realization rate and profits per partner metrics at the matter level, the management committee debate becomes even livelier.
They won’t understand the law firm hourly billing model
”There’s no way our partners will understand the law firm hourly billing model,” says the committee member who questioned partners’ ability to understand matter profitability. “I admit, I barely understand it! Using that model to explain why leverage improves profitability won’t fly.”
Any metric is better than no metric
“I think we need to start really simple—with realization rate,” says the committee member who raised concerns about divisiveness when partners compare profitability of matters. “We haven’t done enough to educate partners even about realization rate, so we have no metric. They forget that we measure the collected percentage against our full billing rates, so a standing discount to the client reduces realization rate even before they negotiate a discount for the matter. Any metric is better than no metric.”
“We need to proactively report realization rate to them on every matter, and show where they stand in relation to the firm average and firm goal,” agrees another committee member. “Until they fully understand realization rate, they’re not ready for profitability.”
Follow the money
“If we introduce a new metric that we want partners to follow,” says the high producing committee member who asked for profitability to be explained, “we’ll ultimately need to make that an incentive in our compensation system. Whether or not they fully understand the metric, they’ll work towards it if that affects their comp. And they’ll ignore it if it doesn’t.”
That seems to put a halt to the discussion. Everyone knows he is right. They also know changing the comp system would take time and effort.
The leader pursues a phased approach
Being a good leader, Keith knows he cannot push his profitability metric without a consensus. Keith is generally prepared for the objections he receives, though, and before the meeting has made a plan.
“Here’s what I hear you saying,” Keith responds, presenting his plan as a response, so committee members will feel it is their plan and give it their strong support.
“First, we need to accompany the introduction of the new profitability metric with an education program for partners, to gain buy-in. We should include further education on realization rate, which covers only the revenue side, as well as on the profitability metric, which also takes expenses into account.”
“Second, we should introduce the profitability metric on an information-only basis, as a supplement to the realization rate and other information currently reported.”
“Third, after a year or two of education and reporting using the new profitability metric, if the metric has gained credibility and acceptance, we could begin considering whether and how to use it in partner compensation.”
Most of the committee members nod in agreement, though the few inevitable skeptics remain. After finalizing the plan at the next committee meeting, Keith plans to introduce the new metric at the upcoming annual partners’ meeting.
Expense allocations in calculating profitability—Achilles’ heel or manageable issue?
As he prepares to introduce profitability of matters as a new metric at the upcoming annual meeting, Keith worries about the judgments required to make the crucial expense allocations, which can significantly affect the profitability calculation.
Why worry about expense allocation?
Matter profitability is computed as fees collected (revenues) for the matter minus attributable expenses. Calculating fees collected for the matter is straightforward. Attributing expenses is a more subjective – and sometimes arbitrary—exercise.
Keith’s partners tend to be skeptical and change-averse, like most lawyers. He worries they may question the allocations used in computing matter profitability to such an extent that they refuse to accept the new metric. Some of them struggle with the concept of realization rate. To them, matter profitability may seem like smoke and mirrors.
Keith decides to approach the whole issue with transparency. The presentation materials for the partner meeting introducing the new profitability metric will acknowledge the allocation judgments being made in key areas, describe alternatives and state the approach the firm has chosen to take. He’ll also include numerical examples to illustrate how different allocation approaches can produce different profitability for a matter. He hopes to gain his partners’ trust by being transparent, and gain their buy-in by inviting and addressing their input.
Major allocation issues
Keith’s presentation will address the following allocation issues. His firm’s software will perform the required complicated calculations once the allocation rules are established.
Imputed equity partner salaries
Technically, equity partners receive no compensation, but instead only their distributions of firm profits. Treating these partners as having zero compensation, though, distorts profitability when comparing matters with varying degrees of equity partner involvement. Keith’s firm does not want to create incentives for equity partners to deleverage their matters.
This problem is addressed by breaking an equity partner’s distribution into a notional salary component and a profit distribution component. The simplest approach is to use the same fixed dollar amount for each equity partner. Other alternatives include using a handful of seniority-driven salary bands or calculating imputed salary as a multiple of an equity partner’s standard billing rate.
Keith’s firm has decided to use the first method. Imputed salary for equity partners will equal two-thirds of the average annual equity partner distribution for the previous three years.
An associate’s annual salary and benefits are allocated to a matter based on the percentage of the associate’s full-year billable hours worked on the matter. Rather than using the associate’s actual hours worked, Keith’s firm has decided to use the firm’s billable hours target. If actual hours were used, partners would have the perverse incentive to assign the busiest associates to their matters, because the expense allocation percentage of those associates will be lower than that of associates working fewer hours in a year.
Lawyer occupancy expense
Keith’s firm has decided to allocate occupancy expense of its lawyers and other timekeepers differently than occupancy expense of administrative personnel, which is treated as general overhead (see below).
The cost of each lawyer’s office will be allocated to the lawyer based on relative square footage used by the lawyer and his or her administrative assistant. This approach puts more of the occupancy cost on partners and takes into account the differing occupancy costs of the firm’s offices.
Keith’s firm has decided to exclude from revenue and expense calculations all disbursements that are true pass-throughs of expenses paid to third parties, such as travel expenses, the costs of contract attorneys and charges by e-discovery vendors. Doing so maintains focus on how the lawyers and other timekeepers are assigned and managed.
General overhead includes book and electronic library subscriptions, technology infrastructure costs, malpractice insurance premiums, compensation and benefits for most administrative staff, and occupancy costs for administrative staff.
For expenses that truly relate to the entire firm, such as technology infrastructure costs, Keith’s firm will allocate the expense in proportion to a matter’s share of all expenses (allocated as previously described) other than general overhead.
The cost of an item that is used only by one of the firm’s office locations, such as occupancy cost for administrative staff in that location, will be allocated only to lawyers in that location. To the extent usage of a subscription service overseen by the library is reliably recorded to matters (regardless of whether charged to the client), the cost of that service will be allocated to a matter based on the matter’s share of total usage.
Keith views partner acceptance of the matter profitability metric as essential to steering their behavior in the right direction. He is deliberately proceeding at a slow pace, to improve the chances his partners will embrace this new approach.
Should matter profitability be a factor in partner compensation?
Several years later, Keith has succeeded in getting his firm to use matter profitability as an analytical tool to drive decisions about what matters to pursue or take on. He is now weighing the pros and cons of using matter profitability as a key compensation metric for partners.
The firm’s current system is based on a subjective mix of factors, with the only objective factors in the mix being realization (origination credits), realization rate and billable hours. Partner behavior is driven mostly by the objective factors, because those factors are clear. Whether or not compensation is in fact mostly determined by realization and billable hours, that is what the partners believe.
Pros and cons of tying partner comp to profitability
Changing partner compensation is disruptive and potentially destabilizing. Any change to the partner compensation system can be disruptive. If that disruption is severe, major damage may be done to the fabric of the firm and to partner relationships before adjustments can be made.
The metric may come under attack. Once partner pay depends on profitability, partners may start to question and reject the various allocation assumptions in the model, such as the way general firm overhead is allocated. The result may be a rejection of matter profitability not only in the context of the compensation system but also for purposes as a diagnostic tool.
Partners may game the profitability model. Lawyers, being smart and rule-driven, may find a way to game the system. The more complicated the model, the more opportunity for distortion, and profitability is more complicated than realization and billable hours.
For example, setting all equity partners’ imputed salaries at the same level creates an incentive for senior partners to avoid staffing expensive junior equity partners on their matters and instead to use of counsel or non-equity partners. To address this, the firm could instead use broad seniority-based bands of imputed salaries.
The profitability model doesn’t take into account important synergies. Lawyers in a particular office, or who do certain types of work for a particular client, may have low matter profitability, but are not being recognized for highly profitable work performed by other lawyers that comes to the firm only because of the low-profit office or low-profit work for the client. Synergy issues will be present, though, in any metrics-based compensation system and should be handled in the subjective part of the compensation decision.
Changing compensation systems is possible. Short-term pain may be justified by long-term gain. The challenges of transition can be managed by properly socializing the change with the partners to get their buy-in, reporting on the new metric years before compensation is tied to it, making adjustments during that phase and then increasing the weight of the metric in compensation gradually over several years.
A firm should, of course, defer a compensation system overhaul if it needs to address more pressing issues, such as mapping out a new strategic direction.
Partners will perform according to the way they are compensated. Even law firm partners are generally rational beings. They will do what they are financially rewarded to do. If they are paid based on realization and billable hours, those are the metrics they will pursue. It has been said that a firm’s partner compensation system is the firm’s strategy. In the pursuit of realization, partners may pursue unprofitable work, placing more pressure on the new intake gatekeepers. If done right, using matter profitability as a compensation metric will lead to greater profitability for the firm.
The decision whether to link compensation to profitability
Whether to mess around with a firm’s partner compensation system is a very serious decision. A firm that believes its compensation system is broken may have an easier time making the leap than a firm that would be trading stability for several years of distraction or, in the worst case, internal strife.
In a firm where individual partner business plans are the norm, with both subjective and objective compensation goals that vary based on the partner’s individual situation, it may also be an easy decision to employ the matter profitability metric as an element of some of the partners’ plans.
On the other hand, a firm where all partners are rewarded formulaically based on the same metrics may be more hesitant to change systems, especially if the existing metrics are simple, such as realization and billable hours. Chances are, though, the partners in that firm are already gaming the system. Assuming the firm cannot change to the individualized partner compensation system described above, it may be better off realigning its metrics to incentivize profit-producing behavior, despite the effort that will require.
There is no one-size-fits-all when it comes to partner compensation plans, but as a diagnostic and planning tool, matter profitability can be a great advance over simpler metrics such as realization rate.
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