May 27, 2008

Partner Cost and Client Profitability (Part V)

12:00 am

This is the fifth in a series on and client profitability written by Ron Paquette, consultant with Redwood , now part of .  The first article, titled Client Profitability: What Is The Cost Of Partner Time?, was an introduction to the concept of allocating partner cost in calculating client profitability.  The second article, titled Partner Cost And Client Profitability, (Part II), is focused on pitfalls of some firms' methodology in allocating costs to partners.  The third article, titled  Partner Cost And Client Profitability, (Part III), is focused on basing a partner's direct cost on a "minimum margin percentage".  The fourth article, titled Partner Cost and Client Profitability (Part IV), is focused on basing a partner's direct cost on a "minimum margin dollar amount".  This article is focused on allocating a partner's direct cost using a variation of both the "minimum margin percentage" and "minimum margin dollar amount" based on different partner "ranks" using a sliding scale. 

Over the last 4 weeks, we have been discussing in some detail the topic of as a direct cost in profit modeling. Specifically we are answering the question: “How much of a partner’s compensation should the firm consider when calculating the cost rate allocated to each he/she works?” We have evaluated several methodologies that create unfavorable results and 2 that Redwood recommends. While we will discuss another methodology today (or variations of previous strategies), it is important to remember that there is not one right answer that will work for all firms. Instead, it depends on the current state of affairs of the firm, the long and short term goals of the firm, the relative level of , and maybe most importantly, how the firm thinks about client profitability.
Sliding Scale (for minimum margin % or $):
The final methodology we will explore in this series is a variation on the previously recommended approaches. In this variation, firms have the flexibility to use different minimum margins for different partner “ranks”.   We do not suggest moving to complete customization (where each partner has a different threshold) but we do recognize that the minimum margin for a senior partner may differ from that of a mid-level partner and a junior partner. In other words, it has been argued by several partners we know that the relative portion of compensation paid to a partner for performing billable work decreases with seniority. Since most firms have some form of partner ‘shares’ , ‘points’ or other credits, we recommend using this as the basis (see fig 1 below), but standard rate or tenure could work as well. In this example, we have split the partnership into 3 buckets to determine the minimum margin %, the firm is free to choose any number of buckets. It should be kept in mind that too many can unnecessarily increase complexity and open the door for disagreement for both start/end points for the ranges and the minimum thresholds
Minimum Shares
Maximum Shares
Minimum Margin %
1
50
40%
51
100
30%
101
150
20%
 
 
 
 
 
 Figure 1
 
Alternatively, instead of using a handful, a firm could create a continuum to represent the changing minimum that would eliminate the abrupt change in partner profit that would be experienced as they progressed from one bucket to the next (see fig 2 below). In this example, a partner with 150 shares would have a 20% minimum margin while a partner with 100 shares would have a 30% minimum.
Figure 2
In the examples below, we see the three familiar partners from our previous blog entries with the minimum % applied from the table shown in figure one. Once again, the Jr. Partner is not affected by the minimum because his fully loaded margin exceeds the threshold. Unlike the minimum margin % methodology though, this approach differentiates the Rainmaker and the Dept. Manager (instead of both having 40%). Keep in mind that while we have illustrated this methodology using the minimum margin % approach, we can also apply this to the minimum margin $ approach.

 

Role
Comp
Std
Rate
Shares
Minimum Margin %
Cost
Rate*
Actual Margin
Rainmaker
$1MM
$250
125
20%
($200)
20%
Dept.
Manager
$500M
$200
75
30%
($140)
30%
Jr. Partner
$150M
$150
25
40%
($83)
44%
*         Assumes 1800 standard billable hours expectation
Advantages of the methodology:
  • It ensures that every partner has a positive margin associated with his/her hours when valued at standard rate. While one may purposely choose to lose money on specific matters through discounting, there should be margin on every hour of time when valued at published rate.
  • It is based on the partner’s published rate. While total compensation can rise and fall with firm profits, this relative cost will not fluctuate and this method is in line with thinking about compensation for a partner’s work effort.
  • If executed properly, a leverage model will be supported by forcing the highly compensated partners to a lower margin % than lower compensated partners.
  • It supports a firm with a closed compensation system since actual compensation will not be revealed through profit model.
We have to address the weaknesses of this approach as well:
  • Higher complexity. With either bucketing (fig. 1) or the margin curve (fig. 2) the firm will still have more decisions in this methodology than in either minimum margin approach. More decisions open the door to more disagreements and dissenters.

Like the other Redwood recommendations, the weaknesses are overshadowed by the strengths in the model. And, if the firm can build agreement around the (semi-arbitrary) decisions necessary for this methodology, Redwood believes this creates the most robust model of all those explored, allowing the firm to assess relative client profitability without having to exclude a client due to high/low partner costs. In the last entry of this series, we will detail the list of criteria we have developed to better understand the strengths and weaknesses of a new methodology that we may encounter. 

While this series documents every methodology (some with slight variations) that we have come across in our years of working with firms, we do realize that it is not necessarily exhaustive.   Have you used, seen, or thought about a methodology that we have missed?  Do you have any other feedback?  I’d love to hear from you: rpaquette@redwoodanalytics.com

 

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