Valuing KM: some hard figures

In general, I am not keen to get bogged down in debates about the financial value of knowledge management, or the RoI of particular activities. To an extent this is because I am not well-versed in financial management, and I suspect that those who are sometimes use their expertise as a black art in a way that constrains experimentation and innovation. Also, for knowledge-intensive businesses (like law firms) it should actually be difficult to argue against effective management of knowledge activities — they are a basic health requirement, not a luxury. However, a couple of recent blog posts (together with an old memory and a conference presentation) have brought the value question to the fore for me.

Some time ago, I attended a two-day workshop on knowledge management in law firms (probably the only formal KM training I have had). One of the principles that stuck with me was that KM value can be judged by how well it supports the core elements of law firm profitability. Memorably, this comes with an acronym: RULES.

  • Realization of billing rates;
  • Utilization of attorneys;
  • Leverage of lawyers;
  • Expense control; and
  • Speed of billings and collections.

KM can help improve all of these in one way or another, and it is always useful to take time to contemplate whether we are doing our best in each of these areas. As usual, it is also important to distinguish the knowledge component from other areas of management. KM is not about improvements in time recording, for example — that may be a joint effort between IT (building a system to automate timesheets), HR (designing processes to help partners recognise good practice and manage poor time-keepers), Finance (communicating the impact of good time-keeping, billing, etc), and BD (collating feedback from clients on good and bad practice). However, along with these functions, KM people will have a part to play — perhaps by unpacking what lawyers actually do when they work and exposing where the pinch-points are, or developing clear checklists and guidance to ensure that there are as few obstacles as possible to doing all the important elements of the job.

One of the interesting points in profitability is leverage. As Toby Brown makes clear in his 3 Geeks… post today, many partners fail to understand the financial importance of driving work down to the lowest effective level.

Yet most firms don’t get this. Primarily because comp systems reward a different behavior. They’re not designed to reward profits – they reward hours and revenue. This is the case since these compensation systems were designed under a different model. This was a cost-plus business model, where profit was built into prices (a.k.a. rates). So partners have not focused on the metric of profitability in this fashion.

Once partners understand this, then it becomes quite natural to shift work to its lowest cost, effective labor source. Ron Baker will likely appreciate this statement: Tasks should be performed at their cheapest, most effective, level of timekeeper. This behavior will lead to improved profitability for law firms. But more importantly, this same behavior will lead to lower costs of service for clients. On a simple, illustrative level this means partners should not be performing tasks associates or paralegals can perform sufficiently well. Doing so undermines profits and raises costs for clients.

That point about clients is important. One of the discredited arguments against law firm KM was to claim that “KM is about saving time, and we don’t need to do that because we charge our clients for our time and so saving it undermines our income stream.”

That was always a poor argument (and to be honest is a bit of a straw man), but now we know how much the economy has affected our clients and most firms, if not all, profess to understand their clients. However much lawyers try to empathise, many of them will miss the impact of overruns on legal fees. For me it was brought home by Tony Williams in the keynote I referred to in my last post. He pointed out that in addition to delivering commercial legal solutions for their companies, General Counsel will be under pressure from their Finance Directors to manage costs to a pre-determined budget. Any overrun on that budget will require a many-fold increase in turnover to cover the cost.

For example, take Tesco, which appears to have a net profit margin of about 4% at present. (I know nothing of that business, apart from being an occasional user of its retail services (usually under duress). All information replicated here is taken at face value from public sources.) In rough terms, this means for every £100,000 of revenue, Tesco spends £96,000, and only makes £4,000 profit. Any cost overrun eats directly into the profit (it can’t come from anywhere else), and so has to be matched with a significantly greater increase in sales. A law firm acting for Tesco that allows costs on a given transaction to increase by just £12,000 (maybe three associates taking a day and a half longer than they should have done on the job) will require the supermarket to make £300,000 more in sales just to maintain its margin. Which partner wants to tell their client that because of the firm’s shoddy KM, the client needs to find an additional £300,000 revenue? Maybe the RoI on KM needs to be measured by reference to a reduction in the number of difficult conversations partners have with clients?

The other point about valuing KM was made very forcefully by Nick Milton, developing a point made by Larry Prusak.

When I was at the KMRussia conference with Larry last week, he asked a question which made me really think hard, and its an interesting question for anyone concerned with KM metrics.

He asked “What percentage of a company’s non-capital spend, is spent on knowledge”?

Now I would be thinking in terms of 3% maybe – perhaps the training budget, or perhaps the budget spent on conferences, but Larry suggested that would be quite wrong.

His answer was – 60%

60% of an organisations non-capital spend, is spent on knowledge.

The 60% figure is difficult to pin down — it depends on what other non-capital costs a business has. (For a law firm, rent may be a higher cost than for many other businesses.) The basic equation is simple enough, though:

Take the company wages bill, take away what this bill would be if everyone was paid as a new graduate, and that’s the investment in knowledge. After all, if knowledge was not valuable, you could staff the company with smart young graduates at a fraction of the cost. The only reason you don’t, is because knowledge is valuable.

Nick’s post got me thinking. How much do law firms value knowledge and, more interestingly, what return do they get on it? That latter point was not part of Nick’s argument, but it is one that can be explored quite easily for a business (like a law firm) that charges directly for the use of its knowledge. Just as one can get a figure for the value of knowledge by totting up a notional wages bill as if everyone was a raw recruit, one can do the same for the return on this value by calculating notional fee income for these raw recruits and comparing that figure with the actual fee income.

I have postulated an imaginary law firm: with 1060 staff and partners, a total of 120 partners in three grades, 500 other qualified fee-earners (in four bands), plus 75 trainees. The 365 support staff are grouped into five bands. Unfortunately, it is not possible to embed Google spreadsheets here, but this link will go to the full set of data.

Using some rough data for salaries (I have given the partners a salary for the purposes of the calculation, even though they would usually see a share of profit), fee rates, and so on, I have arrived at the following figures.

  • Actual salary bill: £56,350,000
  • Actual revenue: £178,887,500
  • Notional salaries: £25,750,000
  • Notional revenue: £93,200,000

Please take a look at the figures in the spreadsheet and suggest amendments n the comments — I don’t claim that this is a perfect model. However, it does suggest that this firm pays its people a knowledge premium of £30,600,000 annually, in return for which it recoups additional income of £85,687,500. This looks like a pretty spectacular return on investment to me.

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