Not all revenue is created equal
In 2003 American film maker Morgan Spurlock only consumed McDonalds food for 30 consecutive days. As a result, the then-32-year-old, Spurlock gained 11.1 kilograms, a 13% body mass increase, increased his cholesterol to 6.0 mmol/L, and experienced mood swings, sexual dysfunction, and fat accumulation in his liver. He produced a now famous and award winning documentary ‘Super Size Me’ that follows his experiment from day to day.
A 58 grams Mars bar contains 260 Kcal, which is just as much as a 150 grams bowl of Bircher Muesli. Despite having the same number of calories, their nutritional value could not be more different.
High revenue does not mean high contribution to the firm's success
In law firms, partners are measured by the amount of revenue they create. But like calories, revenue does not mean much. It is the quality of the revenue that counts. It is not unusual that partners who accumulate the highest revenue have a special status within the firm. Such partners weigh in heavy on discussions and partnerships try to keep them happy so that they do not leave. All this however might be misguided. So, let me explain why the partner who makes 20% less in revenue, could be 20% more profitable. Have a look at the graph:
In order to understand the economics, it is important to start with the notion of ‘fixed costs’. Unlike most other business, in law firms the costs do not vary with the level of production. We distinguish between direct costs i.e. the salaries of the lawyers and indirect cost, which are the costs for housing, IT, marketing and so on. On an annual basis all these costs are more or less fixed and can not be influenced. Law firms do not fire lawyers if business happens to be slow for a few weeks as it will be near impossible to recruit talent if business picks up again. The same goes for support staff compensation, occupancy and IT. Also, these costs are basically inflexible and on the short term not influenced by the production level.
When we take all annual costs of a firm and divide this by the total number of budgeted hours, we can calculate the costs per hour. To keep things simple, we do not take into account the differences per level of experience and just calculate the blended hourly costs for the firm. In the example shown in the graph, the fixed cost per billable hour is 161. Regardless what, every billable hour comes with 161 in costs that need to be recovered before there is a profit. The profit then is the margin between the actual realized blended rate and the blended costs.
Focus on profit contribution rather than revenue
In the example the first partner has billed 1.000.000 against a blended rate of 220. With a base cost of 161, the margin/profit per hour is only 59. Out of a total revenue of 1.000.000 this partner therefor contributes 267.273 in profit.
The second partner has only billed 800.000, which is 20% less than the first partner. The blended rate however in this case was not 220 but 270. As there are no additional costs, this immediately increases the profit margin to 109. As a consequence, despite producing 20% less in revenue, the second partner contributes in absolute numbers 20% more in profit. We encourage our clients not to focus on revenue but on profit contribution instead. Obviously in order to do so, you need to know your bottom line.
Revenue from smaller files hurts the reputation
Besides the fact that revenue does not equal profit, there is another reason why not all revenue is created equal. That is reputation building. Typically the mandates that help a firm and a partner build a strong reputation in the market are not the small matters. For building a reputation there is a huge difference between 5.000.000 in revenue coming from 10 matters with an average file size of 500.000 and the same 5.000.000 in revenue but coming from 200 matters with an average file size of 25.000. The 500.000 euro/dollar/pound matters will significantly help build the reputation of the partner and the firm, as where the 25.000 euro/dollar/pound matters will not be noticed by the market at all.
There you have it. Two reasons why not all revenue is created equal and why the fixation of most law firms on partner revenue might be a bit short sighted. We would encourage you to from now on also carefully look at the quality of the practice before some partners are elevated to the level of untouchable and super important to the firm. Maybe number two is actually doing much better than number one.