Beyond Profits Per Partner

Profits Per Partner troubles me.

As I've written before, it has (at least) the following defects:

• It's extraordinarily manipulable, with especially toxic consequences for firms whose approach is to hack away at the denominator while taking few or no steps to grow the numerator.
• Its ascension in the constellation of financial measurements to the one star that outshines all others owes more, I believe, to its inherent sexiness quotient than to its intrinsic merit as a metric that reflects strong or sustainable performance or growth.
• And its unintended consequences have been dire.

Moreover, most of you seem to agree with me.  When I asked you point-blank whether PEP was a proper measure of success, you rejected it by a more than 2-to-1 margin.  Indeed, the only option that amounted to wholesale endorsement ("Yes; I believe it's highly accurate and highly informative") garnered just over 1% of votes, while "At one point it was informative, but it's outlived its usefulness" captured  18% and "Absolutely not...the Emperor has no clothes" took another 45%.

That said, it's unhelpful and feckless to mount an assault on an incumbent (be it in politics or financial accounting) without nominating an alternative, so let me throw out a candidate for consideration.

Or, actually, not just yet.

I want to hold my fire on nominating my favorite candidate to first discuss an enlightening McKinsey piece, "The new metrics of corporate performance:  profits per employee."   If you think that "profits per employee" should be translated in law firm land into "profits per lawyer" and that profits per lawyer is dangerously close to PPP, you're exactly right.  Which is why the McKinsey piece deserves examination.

They of course start from the premise that our traditional GAAP methods grew up in and still reflect to this day the assumption that the world is made up of manufacturing firms ramping up widget production and bending metal:

"Let’s get right to the point: companies focus far too much on measuring returns on invested capital (ROIC) rather than on measuring the contributions made by their talented people. The vast majority of companies still gauge their performance using systems that measure internal financial results—systems based on metrics that don’t take sufficient notice of the real engines of wealth creation today: the knowledge, relationships, reputations, and other intangibles created by talented people and represented by investments in such activities as R&D, marketing, and training.

"Increasingly, companies create wealth by converting these “raw” intangibles into the institutional skills, patents, brands, software, customer bases, intellectual capital, and networks that raise profit per employee and ROIC."

And they follow with a fabulous statistic.  If you make the rough and ready assumption that the "intangible capital" of a company is its market capitalization minus its book value, the intangible value of the world's 150 largest companies in 2005 totaled $7.5-trillion, vs. $800-billion 20 years earlier in 1985.

We may thumb our sophisticated noses at the down and dirty, obsolete assumptions of GAAP, but when it comes to driving decision-making, we are probably more in GAAP's thrall than we would care to admit.  One of the most powerful behavior-modification force fields GAAP exerts is that we amortize capital investments but we expense intangible investments.  Thus:  Buy a new desk, a new computer, or build out a new office?  Painlessly amortized.  Pay a partner shadow points to mentor associates, or send senior lawyers to executive education courses?  Direct hit to the bottom line.

Now, neither you nor I in our lifetimes can change GAAP.  But McKinsey recommends this:

"To boost the potential for wealth creation, strategically minded executives must embrace a radical idea: changing financial-performance metrics to focus on returns on talent rather than returns on capital alone. This shift in perspective would have far-reaching implications—for measuring performance, for evaluating executives, even for the way analysts measure corporate value. Only if executives begin to look at performance in this new way will they change internal measurements of performance and thus motivate managers to make better economic decisions, particularly about spending on intangibles."

In corporate land, if the highest level of overall  profits is the goal, but "profits per employee" is the interim metric, you can drive profitability either by improving productivity per employee and/or by hiring more employees. Microsoft takes the first approach, Wal-Mart takes the second.  Thus:

This charts profit per employee on the vertical axis (in $thousands) vs. employee headcount on the horizontal axis (in thousands) and shows, for example at the extremes, that NTT DoCoMo generates about $225,000 in profit for each of its 30,000 employees, while Wal-Mart generates about $6,200 in profit from each of its 1.7-million employees. 

McKinsey goes on to examine overlap among the largest 150 global firms between:

• Net income and market capitalization:
  • The finding is that 17 of the top 30 firms on each measure overlap
• Total income and market capitalization per employee
  • The finding is again that 17 (a slightly different 17) of the top 30 firms on each measure are on both measures.

An interesting intellectual excursion?  I think so.  We've learned something about the value of talent as opposed to the value of bricks and mortar.

But if I don't like PPP, and if "profits per employee" --> "profits per lawyer" --> "profits per partner," then what do I like better?

Stay tuned.