I received an email earlier this week from a reader who corrected an error I made when discussing the effects of inflation within the post How Law Firms Can Increase Income By $100k Per Partner In 1 Year.  Rather than re-working the example in the original post(where few would notice it), I decided to dedicate a post to the effects of inflation on your bottom line and clarify the point, which was not in error.  Considering the overwhelming negativity flowing through the minds of many regarding our current economy, a discussion on inflation's affect on profitability appears ripe anyway.

During the 1990's inflation increased an average of 3% per year.  In fact, many of us have become accustomed to using the standard of 3% when adjusting any cost by the rate of inflation.  From 2000-2006, inflation was even a little better, increasing on average of only 2.85% per year. 

 

Source:  www.inflationdata.com

In 2007, the average rate of inflation was still only 2.85%.  However, in the last 2 months of 2007, a trend began that is continuing this year.  From November, 2007 until January, 2008, inflation has exceeded 4%.  On March 14, the February inflation percentage will be released.  It will be interesting to see if this trend continues [MARCH 14 UPDATE:  Core inflation was unchanged in February - news that, while perhaps temporary, opens the door to another interest rate cut by the Federal Reserve.].  Regardless, January's inflation was highest in the month of January since 1991.

 

Source:  www.inflationdata.com

Inflation has actually has been moving up since 2000, except for an interruption after the impact of Hurricane Katrina caused inflation to first spike just after the storm, then drop to under 2% in late 2006.  It wasn't until late 2007 that rates returned to the 6 year trend, according to the below chart.

 

Source:  www.inflationdata.com

Whether inflation is going to stay at plus 4% in 2008 remains to be seen, but let's just consider the effect of inflation based on the average from 2000-2007 (2.85%).   In the following example, annual revenues are $1 million (for simplicity).  To determine the effect of inflation on your bottom line, the scenario I am using utilizes fixed margin percentages of 10%, 11%, 15%, 20%, 30%, 40% and 50%.  (Using these percentages alone make business owners of other industries indignant, as many can't imagine pulling margins of 50% - though the best performing law firms in the 2007 Law Firm Economic Survey were doing just that)  As well as factoring inflation, I also factor in a 6.5% increase in revenue (based on predicted rate increases from firms in the 2007 Survey).  Will this offset inflation?

Not hardly.  In fact, at low margins, inflation is deadly.  If margin is 10%, even with a rate increase of 6.5%, income purchase power is reduced by 22%.  Even at 15% margin, your purchase power is reduced 13%.  It is not hard to see how small businesses with low margins struggle to survive even moderate inflation.

With margins up to 40%, you are still losing money when revenue increases 6.5% and inflation is as low as 2.85%.    However, at least when margins are 40% you are close to offsetting inflation - so long as revenue increases more than double the rate of inflation.

The above model takes into consideration a rise of expenses that includes both inflation and the revenue increase.  The assumption is, as Parkinson's Second Law states, that "expenses rise to meet income".  When you increase revenue, it is likely due to an investment, whether that investment is additional staff, timekeepers, technology, pay increases, etc.  The numbers above change if you only apply inflation to expenses, but that would assume that you are not investing in the above to increase revenue.  One way to accomplish increased revenue without  additional cost is through increasing productivity, at least in the short term (for those who increase productivity will soon seek financial reward).

In the above, you can see the drastic difference taking "revenue cost" out of the equation.  If you can increase revenue without adding cost, inflation is suddenly no longer a threat - all you must do is keep up with the rate of inflation and inflation is abated.  In the above, you actually see a higher percentage increase with lower margin.  In any event, income across the board goes up.  The above, however, is accurate only in the short-term, as costs inevitably increase with revenue.

What can be concluded from this?

• Rate increases must be much higher than the rate of inflation to offset its effects (ie, rate alone isn't a path to increasing income);
• The higher your margin, the less inflation affects income;
• Higher productivity with higher rates can substantially increase income in the short term and minimize its effects in the long run.

For subscribers of the blog, I have attached a spreadsheet with both formulas for you to use to plug in your own numbers and forecast how inflation will affect your profits in both the short run (if you budget for higher revenue without additional cost - such as increasing productivity) and the long run.  To download, click here.  If you haven't already subscribed, registration is free.  Thanks to Joe Dwyer for his time and thoughts.

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Measurement improves performance.  If you measure the following 5 key performance indicators, your profits per equity partner will increase.  These drivers are:

• Leverage
• Rate
• Realization
• Productivity
• Margin

Leverage in the above model is based on head count leverage.  Head count leverage is the ratio of equity partners to non-equity fee earners. 

Rate in the above model is based on the effective billable rate for all fee earners.  You get this by adding all fee earner rates and dividing the sum by the number of fee earners.

Realization in the above model is based on the amount of fees billed against what was worked.  You get this from dividing the sum of all fee earner hours billed by the sum of all fee earner hours worked.

Productivity in the above model is the sum of all fee earner billable hours divided by the total number of fee earners.

Margin is net income divided by total fee revenue.

Here is the scenario.  Your firm has 29 fee earners.  Eleven equity partners, eleven associates/non-equity partners/of counsel, and seven paralegals.  You have a total of 50 employees including equity partners.  Your effective billing rate is $275, your average fee earner productivity is 1,690 per year, your firm writes down or discounts an average of 10% of work performed (90% realization) and your cost per head is $140,903.   

Based on the above, profits per equity partner would be $462,255.  

 

 Now, let's play with the numbers.  First, we'll look at rate.  If we increase rate by 6.5% (which was the average rate increase predicted by respondents of the 2007 Law Firm Economic Survey by LexisNexis), factor in cost inflation (currently around 4.25%), total PEPP increases to $486,314, an change of $24,059.

Factoring inflation, the increase in income is not substantial.  However, it underlies the importance of increasing rates annually to avoid devaluing your rate due to inflation.  The secret to beating inflation, though, isn't rate;  It is productivity.  High productivity creates the gap (margin) between cost (which includes inflation) and revenue.  The higher your margin, the less inflation hurts you.  The lower your margin, the more inflation works against you.

So let's consider productivity.  If you increase billable production by 100 hours per fee earner per year (a meager 24 minutes per day based on a 50 week year), PEPP increases to $527,505, a change of $65,250 per partner!

 

This is one way to make a substantial increase in income with very little change in your workload.  In fact, you can likely make up the 24 minutes per day by just entering your time as you are doing the work.  Tools such as MyJuris Mobility take advantage of mobile devices such as Blackberry devices to recover nearly an hour per day of productive time. 

Finally, we'll consider leverage.  If you add two non-equity fee earners (assuming you have the business to necessitate such growth), PEPP increases to $512,686; a change of $50,431 per partner. 

Best performing firms, however, do well in several indicators.  If you were to combine the above, the results would be striking.  If you increased rate 6.5%, added 24 minutes a day to each fee earner's billable goal, and added two associates, you would increase income from $462,255 to $609,677, a change of $147,422 per partner.  The effect of compounding factors works to increase the effect of each indicator on income more than you would by increasing any of the indicators alone.

Even if you only increased rate and productivity, you would increase PEPP by $90,733.  Click here to download a sample spreadsheet (you must be registered to this site to access the downloads page) and work the numbers yourself.  Use it to forecast your increases and measure your performance to reach your financial goals.  

Morepartnerincome.com is sponsored by Juris®.  For information about Juris products and services for increasing law firm performance and partner income contact Juris National Sales Center:

 877/377-3740, e-mail info@juris.com or go to www.Juris.com.

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The 5 key performance indicators all law firms should measure are:

• Rate
• Realization
• Utilization/ Productivity
• Leverage
• Margin

This week each day I will focus on one of the above. Today the focus is on margin.

Margin is partners' profits divided by firm revenues. It is the percentage of revenue left after all operating expenses have been paid (not including partner salaries and distributions). For previous posts on margin, look here, here, here, here, and here.

There's no secret to increasing margin. Do a good job, be fair to clients, focus on client development, bill what you are worth, never devalue your time, and make sure costs rise proportionately to revenue. You don't increase margin over the long term by cutting costs. Reducing expenses is either done to correct a past mistake in investment or to replace lost revenues. Neither are positive causes. If you want to grow, you have to spend.

The point is made in the 2007 Law Firm Economic Survey from LexisNexis as well. The firms who had the highest per partner income spent the most. The firms with the highest margins spent the most.

The firms with the highest per partner income are represented in the Q1 column. The operating margin is at nearly 51% and their expenses per head are nearly $100,000. Compare that to the lowest performing firms. In the Q4 column, margin is a paltry 29% but they saved money - only $84,000 per head cost. You can't grow with a constrictive operating budget. Note that both the best performing and worst performing firms also spent a nearly identical percentage of their budgets on technology. This could mean that technology isn't being utilized properly in the poor performing firms (due no doubt to a lack of services if experience tells me anything) or that poor performing firms are attempting to utilize technology to manage their practice. I am encouraged to think the latter and am curious as to whether those firms are improving their practice as a result. There are so many variables to successful implementation of a process, but looking at these firms in 5 years might be a good follow up.

 

The way to improve margins may be different for each firm depending on where they start, but there are still two constants: cutting costs do not equate to long-term increases in per partner income and measurement improves results. With any action geared to improve the financial performance of your firm, you must measure it and adjust when you get off track.

 

Morepartnerincome.com is sponsored by Juris®. For information about Juris products and services for increasing law firm performance and partner income contact Juris National Sales Center:

877/377-3740, e-mail info@juris.com or go to www.Juris.com.

Related posts

• Law Firm Business Model - Leverage
• Law Firm Business Model - Measuring Rate
• Law Firm Business Model - Realization
• Measurement Improves Law Firm Performance
• What Margin Should Your Law Firm Generate?