Many professional service firms sell time. And yes, many would love to figure out how to not sell time but rather, sell value. That’s a conversation for a different day (which I will happily take up). But for law firms, the notion of time as a sellable product creates an interesting conversation when talking about the financial notion of operating leverage. Law firms who understand operating leverage and act on it can build a more powerful (and profitable) business engine. Here’s how you can utilize law firm operative leverage!
What is Operating Leverage?
The concept of operating leverage is a measure of how well a firm can increase profit by increasing revenue. A firm with high operating leverage typically has high fixed costs and very low variable costs (costs that vary with the amount of revenue). A firm with low operating leverage typically has lower fixed costs but higher variable costs (yes, think law firms). A company’s degree of operating leverage can be calculated as follows:
Degree of Operating Leverage = Contribution Margin / Profit
Note: Contribution margin = revenue – variable costs = the amount of margin available to cover fixed costs
Here is an example of two companies with the same amount of revenue and operating income but very different cost structures. Which one is most likely the law firm? If you guessed Company A, you would be correct! As revenue increases, the profit percentage is less than Company B. Company A, therefore, has low operating leverage. Company B (which might be a software company), as you can see, has high operating leverage, hence more profit for each % increase in revenue (so long as they generate enough revenue to cover those higher fixed costs).
So What Can You Do with the Knowledge of Your Law Firm Operating Leverage?
Here are some ways you can use operating leverage in your business…
- Measure It: If you measure operating leverage consistently then you can see trends in how your business is dropping contribution margin to the bottom line of profitability. Half the battle for most law firms is just looking at the financials and making them meaningful.
- Compare It: You can use operating leverage to look at performance across your partners. Some partners may do a very good job managing their contribution margin, and as such, drop more to the bottom line. What are they doing well? What we can learn from looking at high performers?
- Optimize It: Knowing law firms have a low operating leverage model, consider what you can do to continue pushing down your fixed costs so even more drops to the bottom line.
- Experiment With It: Many law firms, like Equinox Business Law, for example, are experimenting with fractional general counsel recurring revenue models which have higher operating leverage because its services are more than just time-based. They are aiming to be more profitable while providing clients with more value on a consistent basis. The point here is….knowing your financial level of operating leverage can give you a baseline for experimentation.
Law firms, like many professional service organizations selling time, have low operating leverage business models. To become more profitable, they can either lower their fixed costs and drop more to the bottom line and/or increase the amount of contribution that drops to the bottom line. To do the latter requires re-thinking how their business model is delivered, something I know is happening at partner meetings of many law firms around the country.
At Stride, we work with many law firms to help them manage and understand their finances in order to make better business decisions. If you are interested in learning more, please Contact Us.