Partner Cost and Client Profitability (Part II)

This is the second in a series on partner compensation and client profitability written by Ron Paquette, consultant with Redwood Analytics, now part of LexisNexis.  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.  This article is focused on pitfalls of some firms' methodology in allocating costs to partners.

Some firms have chosen to exclude costs all together from billable hours worked by partners.  Generally it has been requested for one of two reasons: the firm would like to keep actual partner compensation out of the profitability model (a closed compensation system), or the firm is thinking about a P&L model where partner compensation is simply a distribution of firm profits.  While this methodology does accomplish those goals, from a client profitability perspective, it introduces its own set of issues.   

What results is a model where client profitability is maximized by only using partners to perform the billable time.  In the example below, there is a timekeeper with a 66% profit margin and two partners, both with 100% margins.  Any hour that the Associate performs for a client will in essence drag down that client’s profitability and a matter manager might be tempted to use a Partner where an Associate would suffice in an effort to ‘game’ his clients profitability.  This is contrary to the proper use of leverage and economic theory which would have the partners working on tasks for which lower level timekeepers are not qualified such as originations and the management of matters and attorneys.  For this reason alone, there needs to be some cost associated with each billable hour of a Partner’s time, if not for any other purpose than to represent the opportunity cost of them not performing these other tasks.  Besides, every firm that we have encountered expects their partners to perform a certain quantity of billable hours for their clients which would imply that some of their compensation should in fact be allocated to the client.

Role	Compensation	Std Rate	Cost Rate	Profit Margin
Rainmaker	$1MM	$250	$0	100%
Dept. Manager	$500M	$200	$0	100%
Associate	$80M	$100	($44)	66%

 

 

 

 

 

 

 

 

 

Another methodology that has been requested in an effort to support a closed compensation is what we call a fixed (or capped) partner cost.  In this scenario, every partner is given the same direct costs.  Aside from the privacy of actual compensation, firms make their case by stating that above a certain point, all partner compensation is for contributions besides the billable hour.   However, since billable rates vary significantly even in the upper echelons of partners, it is hard to justify those hours having the same cost rate.  Regardless, like the methodologies we have already examined, this too creates some unfortunate outcomes. 

The biggest concern with this methodology is the reversed leverage that it creates (similar to having no costs at all).  In the example illustrated below, we see a firm that has chosen $270,000 as the partner direct costs.  Any partner whose compensation exceeds this threshold has their compensation limited and as a result, all have a $150 cost rate for their time.  The result is that the highest rate timekeepers have the highest profit margin, 40% in the case of the Rainmaker, while those with lower compensation, like the Jr. Partner, have minimal (or zero) profit margin for their work.  Certainly, the cost to the firm for these 3 timekeepers is not the same.

The alternate version (and preferable to the former) is to use the dollar amount as a limit to partner compensation and not a flat amount for every partner.  In the example below, we see the Jr. Partner whose actual compensation is below the $270,000 mark.  In the fixed methodology his profit margin is 0% but if it were capped, his direct costs would be his actual compensation and therefore would have a more favorable profit margin of 44%. This still does not relieve the cost similarity between the Dept. Manager and the Rainmaker but it is a slight improvement over having all partners at one cost rate.  Of course this methodology does not meet the requirements of a closed compensation system (unless the firm is primarily interested in the privacy of Sr. Partner compensation).

 

Role	Compensation	Std Rate	Fixed Cost	Cost Rate	Profit Margin
Rainmaker	$1MM	$250	$270M	($150)	40%
Dept. Manager	$500M	$200	$270M	($150)	25%
Jr. Partner  (Fixed)	$150M	$150	$270M	($150)	0%
Jr. Partner  (Capped)	$150M	$150	$270M	($83)	44%

 

 

 

 

 

 

 

 

 

 

 

 

The next installment will focus on better ways to calculate partner cost in measuring client profitability.

 

Related posts

• Partner Cost And Client Profitability, (Part III)
• Client Profitability: What Is The Cost Of Partner Time?
• Why Law Partners Hoard Work?
• What Corporate Clients Read Into Law Firm Bills
• Measuring Your Law Firm's Billing Cycle