April 29, 2008

Client Profitability: What Is The Cost Of Partner Time?

12:00 am

The following is the first in a series of posts on compensation written by Ron Paquette, an analyst with Redwood Analytics, now part of LexisNexis. Ron is a new contributor to the blog who we hope will write regularly.

Most law firms want to evaluate client and matter profitability. When deploying profitability models, one of the most common questions Redwood receives has to do with determining the cost of partner time on billable work. Since most matters in the legal industry today are billed on an hourly rate, the most effective means of allocating costs is on an hourly cost basis. There are two components to costs, direct and indirect (overhead) – the focus of this discussion is on the direct component, e.g. partner compensation. And since most firms set billable hours expectations for their partners, the question becomes: How much of a partner’s compensation should the firm consider when calculating this “hourly cost rate” allocated to each billable hour he/she works?

Partners are compensated for a number of contributions to their firm. Some include:

Billable hours;
Originations;
Matter & client management;
Attorney management & development; and
Their status as a co-owner of the firm.

Since no firm (that we have encountered) determines a partner’s compensation by measuring each contribution and summing them, our goal with every firm is to come up with a proxy that is reasonable and creates a means of evaluating client/matter profitability that is truly usable.

You might be wondering why this is such a big deal. After all, you know how much a partner is compensated – why not allocate all of that compensation across his/her clients? It’s important to distinguish between a partner’s profitability and his/her clients’ profitability to the firm. Should a client or matter look less profitable solely because a highly compensated partner performed some of the work? What if most of his/her compensation was a reflection of his value to the firm as a rainmaker? What if there were two partners with similar legal skills and similar billing rates, but Partner A is a heavy originator while Partner B is primarily a service partner? Should the client appear less profitable simply because Partner A was staffed to the matter instead of Partner B?

If, as we’ve seen some firms do, you choose to include all partner compensation in this hourly cost rate, clients could end up being allocated costs like in the figure below.

Role	Compensation	Std Rate	Cost Rate	Profit Margin
Rainmaker	$1MM	$250	($556)	-122%
Dept. Manager	$500M	$200	($278)	-39%
Jr. Partner	$150M	$150	($83)	44%

In this example, the Rainmaker and the Dept. Manager are both compensated more than their billable hours alone would bring in as revenue (calculations assume 1800 standard or budgeted hours). For every one hour the Rainmaker works on a matter, it would take 4.5 hours of Jr. Partner time for the client to have a 0% profit margin (and all this without considering overhead). Therefore, EVERY HOUR for which the Rainmaker or Dept. Manager billed time would appear unprofitable. Granted, it may be desirable that the firm should be leveraging a more junior person to the matter, and the Rainmaker and Dept. Manager should have a relatively lower profit margin for their work, it makes no sense that their contribution to a matter is unprofitable.

We’ve discussed the concept of the cost of partner time with many leaders of law firms over the years. What we know for sure is that there is not a one size fits all solution. What has become clearer, however, is that there are key criteria that every solution should strive to meet. Over the course of a series of entries, we’ll be exploring the pros and cons of various options. We welcome your feedback and reactions.

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April 29, 2008