Costs & Revenues: Health Check Time

So maybe you can't save your way into profitability, but you can save money more and less intelligently.

And I'll give you a hint: It's not about how many meetings are held at times when food should be served. (Think I'm making this up? Firms have sent out memo's to encourage non-food-appropriate meeting times.)

Here's a primer from McKinsey, admittedly addressed to investment banks, but utterly applicable to you.

They start from the analytical premise of segmenting investment banks into quartiles based on noncompensation costs per head count. That strikes me as a strong indicator since it abstracts from the absolute value of growth in noncompensation costs (you can expect headcount and noncompensation costs to grow as the firm grows) as well as from the impact of one-time investments such as opening new offices.

Using only publicly available sources, they benchmarked eight major financial institutions over the past three years and found, perhaps not surprisingly, that "the difference in noncompensation costs per head count between the top- and bottom-quartile banks is significant:"  Banks in the top quartile had average costs by this measure of $148,000 and across the bottom three quarters, $212,000, or a 43% difference.  When you look at it from the perspective of potential savings (assuming, that is, that banks in the bottom three quartiles could duplicate the cost structure of banks in the top quartile), the numbers are striking indeed:

What accounts for these sizable differences in the cost base?

Simply put, during the good years (2005—2007), some banks permitted themselves to bloat up.  Here are the "CAGR" (compound annual growth rate) figures for noncompensation costs (light blue bars on top) and revenue (dark green bars on bottom) for the eight banks:

Only three of the eight had sufficient discipline to keep cost growth below revenue growth.  (The "N/A" for the last two listed is a result of their revenue "growth" in 2007 being negative vis-a-vis 2006, which vitiates the CAGR calculation.)

So much for the background:  Now for the interesting part.

How precisely do you cut costs without sabotaging morale?

First, let's assume you've done any staff and attorney headcount "right-sizing" that may be called for.  If you're going to do it:

• Do it surgically;
• Do it once and only once;
• Tell people it will be once and only once;
• Tell the people who have been saved that they've been saved and that it's for keeps;
• Even if you think in hindsight you might have made some mistakes, do not go back to the well; and above all
• Do it once and only once.

Now that you're past that, the good news is that "80% of fixed costs have minimal or no impact on a bank's employees or culture."  In other words, you can draw blood from the 80% of your noncompensation cost base that is relatively invisible to people on a day-to-day basis.  You can go, in the famous phrase, "where the money is."

Here's the breakdown (understanding it won't be identical for law firms as for investment banks, but the comparable notional amounts are worth thinking about):

Obviously, some of these don't map one-to-one to law firm land.  You probably don't spend nearly as much on "data," for example (or you charge it through to clients if you do), and your sum total of spending on "other professional services" and legal is probably de minimis (if it's not, we should talk).  

But the point is not how your noncompensation costs break down vis-a-vis investment banks.  Rather, the point is how relatively small a component of that goes to activities that are highly visible and have a direct impact on morale:  Travel, entertainment, and firm events.

Times like these give you the opportunity to cut out the deadwood and to re-examine unspoken assumptions about what customary activities would really justify themselves all over again in a "zero-based budgeting" world.  In some ways, these are the best of times to cut costs; everyone understands the imperative.

When things turn up again, however, I have a word of advice:  Keep in mind that CAGR chart comparing cost growth to revenue growth.  And make your firm one of the three, not one of the five.