Pulling the right financial levers

One of the links I provided in my last post was to a Financial Times report from six months ago, “Professional services at heart of UK productivity problem”, which suggests that depressed productivity is a particular problem for services sectors:

Lawyers, accountants and management consultants lie at the heart of the UK’s productivity problem, explaining almost a quarter of a shortfall since 2008.

Financial Times research shows that the stagnation of productivity since the crisis is largely explained by just four sectors — professional services, telecommunications and computing, banking and finance and manufacturing.

Why might this be? The article’s authors suggest a couple of reasons:

Productivity in professional services has stalled for many reasons including corporate reluctance to fire staff even as business dried up in the recession and subsequent new hires taking time to become more productive.

And they also quote a view from the legal sector:

Stephen Denyer, head of City and International at the Law Society, said staff in law firms were spending more time than before on activities that were not “billable hours”, such as business development and compliance.

“You have to work harder to win each mandate, and a lot of time on compliance, the requirements not only of our regulator but also in relation to money laundering, sanctions, particularly for people doing international work.”

These are probably good explanations, but a much more thorough analysis was provided by Steven Toft for the UK Commission for Employment and Skills. In his piece, Toft concluded that poor productivity at the national level stemmed from poor performance in the workplace.

Much of the fall in productivity is due to what the ONS calls Multi Factor Productivity (MFP) or Total Factor Productivity (TFP):

Output growth which cannot be explained by increasing volume of inputs and is assumed to reflect increases in the efficiency of use of these inputs.

In other words, how resources like capital and labour are managed. As the Growth Through People report comments:

One big part of TFP is the ‘black box’ of the workplace, and how employers turn skilled workers and tools into products and services which customers value. We may have a more qualified and – if qualifications are of good quality – a more skilled workforce, but are those skills being used effectively? It seems that as world markets have become more difficult in the past decade, many of our work-places have struggled to adapt.

The inability to turn a highly skilled population into high productivity is a symptom of failure in the workplace.

By comparison with some enterprises, law firms derive much more value from their people. Without doing the comparative revenue per lawyer analysis that I described in my last post, it is impossible to be sure that law firm productivity is not stagnant. My suspicion is that even if the sector as a whole looks more productive, few firms stand out as particularly good performers. (Sadly, I don’t have access to the relevant data and I can’t afford to buy it at the moment.)

Twisted rootsMy conclusion comes in part from thinking about a very simple model of law firm operations. (Please excuse the very basic nature of the next few paragraphs. I find it helpful to go back to first principles.)

(In the background to this analysis is a continuing downward pressure on fees. One reason for productivity apparently being depressed is that, although output (if measured in terms of chargeable hours worked) may be constant, clients are no longer willing to pay the headline hourly rate for that work. The need to extract maximum value from each hour worked only reinforces the importance of increasing productivity or yield.)

At its most basic, a firm can be understood as a facility for producing legal advice, information or execution capability. It contains people who do those things in return for fees. There are a number of ways in which their output can be increased.

  • If there is still capacity for additional work, any new instructions (and the fees that come with them) go straight to the bottom line — all additional income increases profit and the profit margin.
  • If there is no additional capacity, new work will require additional people to do it. In this situation, additional work will not increase the profit margin, but it should increase the size of the firm’s profit.
  • In order to extract additional value when capacity appears to have been reached, a firm may insist on more intense production. If, for example, the current target for chargeable hours is 1400, the firm might push for a higher target of 1600 or more hours. (Information about the current range of hours targets in the UK has been collated by the Legal Cheek website.) A change such as this is unlikely to be possible in a short time period, and will almost inevitably come with a cost as salaries rise alongside the additional work requirement.
  • Firms can make changes to the fee-earning machinery. They can shift work from qualified lawyers to paralegals. They can move staff from high-cost centres like London to cheaper areas of the country. They can change their resourcing model to use more contract staff rather than permanent employees. If the value of the work produced does not change, any and all of these changes will shift the revenue per fee-earner equation in a positive direction for the firm. It will look more productive.
    But each of these shifts (what Bruce MacEwen calls ‘labor market arbitrage’) is a one-off gain. Once work has been moved to paralegals and contract staff in a low-cost city, that tactic cannot be tried again. In effect it is a re-basing of the productivity curve, giving no recurring advantage to the firm. It is also a tactic that is easy to adopt, so it gives no firm a lasting advantage.
  • Looking to more long-term changes, a firm might turn its back on low-value work and build a capability to do higher-margin work. This is not an easy strategy, unless few other firms identify the same opportunity.
  • Real increases in productivity or yield will only come if firms find ways to generate more income from the same amount of fee-earner work.
  • Alternatively, continuing improvements to productivity and yield come from products or services that can generate income without incurring costs at the same time. At present, however they resource the work that they do, most firms incur salary costs at a similar rate to the income they generate (unless they run below capacity). Firms with products or services that ‘make money while we sleep’ (as a managing partner once described them to me) will produce income that goes straight to the bottom line once the investment costs of creating those products or services have been met.

Looking at these options, there are clearly limits to the power of firms’ business development (sales and marketing) or HR functions to improve the long-term financial health of the firm. They can affect work levels and resourcing (the first four bullet points), but they are unlikely to play a central role in shifting the firm’s focus (the last three bullet points).

To go back to my agricultural metaphor, the combination of successful sales/HR work is like a farmer buying a new field. The farm will generate more income with that field, and more profit, but overall profitability or yield is not changed. Real improvements in yield come from using the land more intelligently by developing better farming techniques or leveraging new technology to extract more value.

Similarly in law firms: changing the way work is done, the kind of work that is done, or the products and services the firm provides, is a job for those who understand the work best — together with those who can see into the future. In a law firm, those people should be in the leadership function together with knowledge leaders and (because that is the direction of travel for the foreseeable future) technology leaders.

Firms that really want to make lasting changes to their productivity beyond one-off improvements to process or labour market arbitrage and without overworking their staff, need to use their knowledge and technology teams better. If they continue to rely solely on BD and HR, their gains are more likely to be short-lived.

When firms turn to their technology and knowledge teams, they need to be sure that those teams are capable of providing the help needed. That will be the subject of the next post.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s