By David Favor
President, Strategic Thinker
Many law firms just measure revenue as an indicator of performance. That metric by itself does not tell you the full story. I once visited a law firm that was celebrating a million dollar settlement. I had to say, that was impressive, but I also had to ask how much was spent to get that million. This put a damper on their celebration, but it is still a valid question. The next day we discussed performance metrics with numbers like return-on-investment, overhead, and burden rates.
Return on investment is the “return” or financial benefit from an action, divided by the cost of that action. The “ROI” for a law firm is not so obvious. My first thought was that it would be the total revenue generated minus the total expenses divided by the expenses. One problem with most law firms is, they make the lawyer’s earnings equal to any leftover profit. This makes the expenses equal to the revenue. My next idea was to assume a zero cost for the lawyer, and that gave me a false view of the true cost. The compromise I came up with was to assign a base salary and make leftover revenue after expenses a bonus. This provided an ROI I could use for trending.
I have found that the number, by itself, is not very meaningful. I can play with the numbers and create any result I want. The best we can do is create a trend using an ROI measure and see if we are doing better. So, is it a good metric or not? I think the trend can be a good indicator. By “trend”, I mean calculating the ROI every month or quarter to see if it is going up or down. As long as the definition of the numbers is consistent you can develop a trend. I like to use a rolling average over a span of two years. When we first look at a law firm, we generally use 30% as a good return on investment. That is a good starting point anyway.
I could see a problem developing. It is relatively easy to discover the revenue, but how do we calculate the dollar amount of the investment that created that revenue? One idea for getting the expense number is to eliminate any expense that did not directly contribute to generating the revenue. The term overhead or burden is usually used to group expenses that are necessary to the continued functioning of the business but cannot be immediately associated with the products/services being offered. Another way to look at this is, any expenses present even if no products or services are sold would be overhead. Expenses like rent, electricity, computer hardware, or licenses. Does that mean it is part of the investment or not? This can quickly turn into an interesting discussion.
Then there are production expenses. For a law firm, we define the salary of the lawyers as production cost. We generally also include the cost of medical records, accident reports, investigators, and depositions. This is an arbitrary decision, so other costs may be bundled into production. For example, you may determine that the cost of the case management system is production cost. It does not affect the measurement much as long as you remain consistent over time because it is the trend that is important.
The burden rate is a ratio or burden cost to production cost. Generally, a burden of greater than 50% will be a red flag, and we will look at expenses to see if we can lower the burden. You would want to keep this low and make sure that the trend is not going up. The tricky part is to agree on what you consider to be overhead. As long as you keep your definitions consistent, you can create a good trend for this number.
Return on Investment, burden rates, and process times can be used to measure internal performance. Eventually, you will develop a well-balanced scorecard tailored to your law firm that can be used to track your performance in several areas. I generally look for 3 to 5 different areas. Client service is usually always there. Internal process measures are often forgotten, and we add them in. So, with the financial metric that completes the three basic measures. Now we can add metrics for staff (retention, development, happiness, etc.), community service, reputation, etc. With a more comprehensive measure of how your business is performing, you can track progress better and prevent surprises.
One of the keys to all of this is a good financial system that can keep track of expense and revenue categories. Once you have that you can drop those numbers into a “bucket,” like overhead. I pull numbers from the financial system into an Excel spreadsheet and calculate any of the metrics I want. What metrics do you like?
Did you find some neat ideas in this blog? What are the exciting ideas you came up with, and how are you implementing them? Let me know by contacting me at dwfavor@catalystgroupinc.com.
For more information on creating a strategic plan that works, contact cheryl@catalystgroupinc.com.
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