June 3, 2008

Partner Cost and Client Profitability (Part VI)

12:00 am

This is the last in a 6-part 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".  The fifth article, titled Partner Cost and Client Profitability (Part V), 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.  This final article compares the different methodologies to help a firm decide which one to utilize in their environment.

Over the past several weeks, I have explored a number of methodologies for determining the appropriate amount of to consider direct cost and allocate to clients for purposes of evaluating client and matter profitability. Since a partner is compensated for a multitude of contributions to the firm (, originations, matter & client management, attorney management & development, and for firm ownership), the issue is complex. Through my last five postings, I have evaluated half a dozen methodologies, all of which are used by at least one firm Redwood has worked with, but not all are recommended. 

The first step Redwood took as we set out to answer this question was to determine what we were trying to accomplish with an allocation methodology. From there, we developed a list of five criteria to evaluate each methodology against. As I wrote about in the prior entries, the advantages and weaknesses are all based on this list:
  • Simplicity. If the methodology is not easy to understand with a minimal number of decisions, it will prove difficult to build partner buy-in.
  • Positive margin. There is value associated with every hour of partner time at standard rates. While discounting may be a planned strategy to acquire a client or matter, at full rates, every hour should have some margin.
  • Rate based. Compensation can be affected by a large number of factors including discretionary bonuses and overall firm performance in a year (cash received from a litigation case). As a result, it is possible for compensation to decrease from one year to the next.   Since we are trying to assign costs to the client for the only, it is important to ignore these effects. Instead, direct costs should be based on partner’s standard rate,
  • Leverage. While not the only measure, leverage is extremely to increasing firm profitability. Any methodology should (through the resulting ) encourage the use of lower cost timekeepers over higher cost (and highly compensated) partners.
  • Closed Compensation system. If this is a concern for your firm, it can generally be accomplished by using a rate-based methodology and leaving out any actual compensation figures.
In our journey through this process, we gathered various approaches from our clients and from industry experts. The list of criteria above is a solid place to begin evaluation to determine if the resulting model is providing the desired outcome.  In the figure below, you will see the six methodologies that we evaluated and the degree to which they meet the criteria above (solid circle indicating criteria met, half circle indication partial, and blank indicating criteria not met). As you can see, the three methodologies that we recommend to our clients, Minimum Margin %, Minimum Margin $ and Sliding Scale, meet almost all six of the criteria we have laid out here.
If you use or know of another methodology, we would be interested to hear about it and may be able to provide some guidance on its performance against the list of criteria. Please send an email to rpaquette@redwoodanalytics.com with any suggestions, questions, or additional methodologies that we have not yet seen.

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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 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 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 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 , 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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May 20, 2008

Partner Cost And Client Profitability, (Part IV)

12:00 am

 This is the fourth 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".  This article is focused on a related methodology:  using a "minimum margin dollar amount" to allocate partner direct cost.

Thus far, we have evaluated a number of methods of allocating partner direct costs (compensation) to a client. Since firms have differing long and short term goals, levels of , and thought processes about client profitability, we have concluded that there is not one perfect solution for this question, but instead a handful of recommended options.
Minimum Margin $ (or fixed margin $ for firms with closed compensation):
Very similar to the Minimum Margin %, this methodology differs only in that the threshold is set as a dollar value instead of a % of standard rate. Some firms we interviewed think about partner profitability in dollars, stating as an example that each partner should have an annual margin (standard revenue less direct costs) of $100M on their bRate MinimumMargin Minimumillable time (hourly margin is an option as well).  
In the example, again we have the same partners but now each is given a minimum annual margin of $100M (or $56 per hour based on 1800 std hours). Since the Rainmaker and the Dept. Manager have fully loaded much less than this amount, they are set to the minimum while the Jr. Partner remains at his full compensation level. Notice that with this methodology, while both the Rainmaker and the Dept. Manager are at the minimum threshold, they have different Direct Margin %. While the dollar margin is the same, the higher rate timekeeper has a lower margin %, thus encouraging a billing attorney to use the more junior (or lower cost lawyers) on their matters.
Role
Comp
Std
Rate
Minimum
Yearly
Margin
Minimum
Hourly
Margin*
Cost
Rate*
Direct Margin
Rainmaker
$1MM
$250
$100M
$56
($194)
22%
Dept.
Manager
$500M
$200
$100M
$56
($144)
28%
Jr. Partner
$150M
$150
$100M
$56
($83)
44%
 
 
 
 
 
 
 
  *Assumes 1800 standard 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 simple. Firm leaders need only to decide on one variable that can be based on firm and for other titles (e.g. income partners or senior associates).
  • It is based on the partner’s published rate. While total compensation can rise and fall with firm , this relative cost will not fluctuate and this method is in line with thinking about compensation for a partner’s work effort.
  • The most highly compensated partners will be forced to the minimum margin ensuring they appear less profitable than junior partners, therefore supporting a leverage model.
  • Multiple partners hitting the minimum margin level will have different margin % if they have different standard rates, further promoting a positive leverage model.
We have to address the weaknesses of this approach as well:
  •  A firm will need to decide on the minimum margin. While strong arguments can be made for a certain threshold, there may still be dissenters. 
  • Each partner who is affected by the minimum threshold will have the same margin (in dollars), leaving discounting as the only differentiator of profit on

Like the Minimum Margin %, the strengths of this methodology prevail over the weaknesses and many firms have found this option easy to implement and easy to gain support for (due to minimal arbitrary decisions). In the final two entries, we will discuss some variations on the two minimum margin methodologies (% and $) and discuss a set of criteria to help a firm determine the pros and cons of each.

 

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May 13, 2008

Partner Cost And Client Profitability, (Part III)

12:00 am

This is the third 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.  This article is focused on basing a partner's direct cost on a "minimum margin percentage".

 When it comes to allocating partner direct costs (compensation) to a client the answer, unfortunately, is not a simple one.  After exploring options with various law firm leaders at a number of firms, we heard on one key point — that “it depends.”   “Depends on what?” you might ask. Well, 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. As a result, we have developed a handful of options to address the analytic needs while considering firm goals and philosophy. In my next several entries, I’ll explain some of those options, and their pros and cons. Today’s option is basing a partner’s direct cost on a minimum margin percentage for each partner.

Minimum Margin % (or fixed margin % for firms with closed compensation):
In this methodology, (Std Rate less Direct Cost Rate as a % of Std Rate) are kept at or above a minimum threshold (or equal to the threshold for firms with closed compensation cultures). In the example below, we have the same three timekeepers from previous examples, with the Rainmaker and Dept. Manager having compensation that exceeds their revenue. With the minimum margin % methodology, these two timekeepers’ direct costs are set so that the margin % is 40% (this variable is set by the firm) while the Jr. Partner maintains the 44% margin occurring ‘naturally.’

Role
Compensation
Std
Rate*
Cost
Rate*
Direct
Margin
%
Rainmaker
$1MM
$250
($150)
40%
Dept. Manager
$500M
$200
($120)
40%
Jr. Partner
$150M
$150
($83)
44%

 
 
 
 
 
 
 
*Assumes 1800 standard expectation
Advantages of this 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 simple. Firm leaders need only to decide on one variable that can be based on firm and for other titles (e.g. income partners or senior associates).
  • It is based on the partner’s published rate. While total compensation can rise and fall with firm , this relative cost will not fluctuate and this method is in line with thinking about compensation for a partner’s work effort.
  • The most highly compensated partners will be forced to the minimum margin ensuring they appear less profitable than junior partners, therefore supporting a leverage model.
There are some weaknesses to this approach:
  • A firm will need to decide on the minimum margin percentage. While strong arguments can be made for a certain threshold, there still may be dissenters. 
  • For those who have the minimum margin %, the only profitability differentiator relative to how they  affect client profitability is the on the hours worked. If too many partners are at the minimum, there is virtually no difference in leverage within the partner ranks.
Overall, the strengths of this methodology far outweigh its drawbacks.  With this method, client profitability can be evaluated objectively with minimal explanation about the handling of . In subsequent entries we will be evaluating additional methodologies vetted by Redwood and providing a checklist of criteria that your firm can use to select a methodology.

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May 6, 2008

Partner Cost and Client Profitability (Part II)

12:00 am

This is the second 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.  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 worked by partners.  Generally it has been requested for one of two reasons: the firm would like to keep actual out of the profitability model (a closed compensation system), or the firm is thinking about a P&L model where is simply a distribution of firm .  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 .  In the example below, there is a timekeeper with a 66% profit margin and two partners, both with 100% .  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 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 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 is for contributions besides the .   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 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. ).

 

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.

 

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