Legal Technology Journal

Why are law firms continuing to avoid addressing the issue of return on investment for their technology systems? It’s tricky to do, but certainly not impossible, and could increase their profits.

MY 2002 article ‘Show Me the Money’,₁ written shortly after I had left the CIO role at Kirkland & Ellis, attempted to make a case for financial analysis of IT investment. The intent was to contrast economic analysis of technology selection with purchase decisions based on peer review or functional analysis. ‘Show Me the Money’ proposed that law firms should (a) address the question of whether they should acquire technology that others have deployed or that has useful or beneficial features, and (b) additionally determine whether the technology will improve bottom line profitability and offer competitive advantage.

It is, however, interesting to observe that despite the importance of objective metrics, there has been little further discussion of financial analysis of IT investment in the past few years, despite the fact that, during this same period, law firms have continued to spend large sums on it.

Challenges to effective measurement: three paradoxes

The lack of rigorous analysis is understandable. Investment analysis of IT strategies is a difficult and often inexact science. As discussed in the earlier article, law firms face three main challenges – or paradoxes – to making a case for measuring financial returns.

Productivity paradox

First, the productivity paradox questions whether technology investment yields efficiency gains commensurate with its cost. The question was raised in the 1980s, and made famous by the article ‘The Productivity Paradox’, by C Wickham Skinner, and published by the Harvard Business Review (1986). Or, as Robert Solow said more bluntly: ‘[Y]ou can see the computer age everywhere but in the productivity statistics.’2 This is, however, the one area where progress has been made; today there is broad acknowledgement that automation has brought about greater productivity in business and industry.

Efficiency paradox

Secondly, even if you can prove productivity gains, law firms, billing by the hour, have little incentive to increase productivity. As Ed Wesemann of Edge International observed: ‘For firms tied to hourly billing, the result of a successful knowledge management system is less time billed and lower revenues. The benefits of stronger client relationships and competitive advantages are difficult to quantify against million-dollar KM operating budgets and recurring losses in revenue each time the information is used.’3

Realisation paradox

Finally, even if productivity gains can be realised and shown to benefit law firms billing by the hour, the question remains whether financial advantage can be proved to the satisfaction of law firm management. Wesemann further points out that ‘[i]t is difficult for managing partners and executive committees to push for the capital investment and partner co-operation necessary to implement knowledge management without a demonstrable financial benefit.’4

Addressing the paradoxes

Given the continuing controversy surrounding the efficiency and realisation paradoxes, this article will focus on ways that firms can better understand the challenges and effectively measure the value of their IT investments.

Efficiency and law firm profitability

The assertion that efficiency reduces revenue is, in fact, a half-truth. It is true with respect to gross receipts, but not necessarily correct when computing net profits. Law firm profits, as demonstrated by David Maister,5 are based on five principal drivers.6 They are leverage (the ratio of equity partners to other fee-earners), billing rates, hours billed, realisation (the percentage of fees billed to fees received) and expense margin (the percentage of overhead expense to revenue). Each of these drivers can be analysed to find ways to improve law firm profitability. For example, in the context of leverage, David Maister writes: ‘The successful leveraging of top professionals is at the heart of the successful [professional service] firm… by leveraging its high-cost seniors with low-cost juniors, the professional firm can lower its effective hourly rate and thus reduce its costs to clients while simultaneously generating additional revenue to its partners.’7 In other words, the efficiencies sought by automation are not limited to helping individual lawyers to do things faster, but rather enabling organisations to deliver their services more efficiently to their clients.

Perception and lawyer compensation

The chilling effect of perception is even stronger with regard to the disincentives caused by misunderstanding law firm compensation systems. Since lawyers are compensated based on the revenue they generate, individual practitioners view knowledge management and other technology programmes aimed at promoting efficiency with skepticism. Due to a perceived inverse relationship between revenue and efficiency, many technologists have asserted that law firm interest in IT automation must await a transition to fixed-fee billing. Yet, technologists have long predicted the demise of the billable hour, despite the fact that it remains the predominant method of billing.

But, just as efficiency can be seen as compatible with organisational leverage, then the same can be said for compensation, even under current systems. While many lawyers may believe they are compensated based on hours worked, this is again a partial truth. It may be true with respect to associates, but it does not paint a complete picture for equity partners. For example, a partner who typically works alone, perhaps acting in the capacity of an adviser to major clients, is less valuable to a firm than a partner who sponsors the work of one or more associates. As shown in the example (see box, Partner revenues), partners are compensated for hours worked and hours leveraged. To illustrate this point, consider a firm in which Partner A and Partner B each have a billing rate of $400 per hour and bill 2,000 hours per year. The firm has a realisation rate of 95% and an expense margin of 45%. Associates in the firm bill at the rate of $200 per hour and also work 2,000 hours per year. Partner A employs the services of 1,000 associate hours per year, while Partner B engages the full-time services of three associates.

In this case, Partner B generates greater value for the firm. Should Partner B be paid more than their colleague? If so, the recognition of the value of hours leveraged would provide greater incentive to deploy technologies that allow lawyers to effectively manage cases (case management), delegate tasks without loss of time (knowledge management) or quality (practice guides and training).

Financial metrics for IT investment

In theory then, the efficiency paradox can be questioned, since automation can be shown yield financial gains to law firms, even for those predominantly billing by the hour. But the question remains whether such benefits can be proved – and measured – in practice. Here again, numerous challenges must be overcome. The principal obstacles to effectively measuring ROI are time and causation. First, time must be considered because there may be a time lag between investment and a consequential improvement in profitability, just as a new business will likely require many years before realising positive returns. Secondly, causation must be considered because technology is just one of the many factors affecting law firm profitability, and it may be difficult to prove to lawyers – masters in the art of causation – that the technology yields some determinable portion of the resulting benefits. Given these challenges to proving ROI through long-term and direct measures of profitability, law firms may also apply short-term, indirect measures of profits.

Direct, long-term financial drivers – measured by reference to revenue and costs

Some observers have argued that firms should focus on revenue (as opposed to costs) because ‘[o]nly by looking at the revenue side of the legal business… can you achieve the multiples of return on investment in technology’.8 Indeed, a focus on revenue may be advisable because history has shown that it is difficult to reduce overall expense, as the capital costs must be offset by some form of expense reduction by retiring existing technologies or cutting other costs, including staffing. In many cases, investment simply increases overall costs. Applying this advice, law firms can build strategies around each of the five key drivers and measure the effects of the technology strategy. For example, firms may seek to improve realisation through the deployment of knowledge management programmes to promote sharing and efficiency, or deploy case management software to promote leverage and help partners manage higher case loads, or through training programs to assist lawyers in achieving maximum billing rates early in their careers.

Indirect, short-term financial drivers – measured by reference to the technology

Alternatively, firms may choose to apply short-term, indirect measures of effectiveness, because technology has an indirect influence on profitability and the impacts of investment may require some time to take effect. For example, firms investing large sums in knowledge management systems will likely want to assess the impacts sooner rather than later. These short-term measures focus on the effectiveness of the technology and make assumptions that effective deployment will yield financial benefits for the firm in long run.

One method of the evaluating the cost-effectiveness is to apply a metric computing the ‘cost of information’, calculated with the formula:

cost of information = document preparation cost/document rate of reuse₉

where:

• Document preparation cost captures the expense of collecting and profiling each document and can be calculated by dividing the total cost of the knowledge management system by the number of documents managed by it.
• Document rate of reuse is the number of times a document is reused in a designated period, such as a year. It can be calculated by dividing total usage by the number of documents in the system.

The formula shows that costs are relative. Expense can be measured only by reference to usage in order to compare and benchmark knowledge management strategies. For example, the metric can be used to evaluate the strategy of a law firm with 2,000 lawyers building a knowledge management system costing $5m, containing a collection of 200,000 documents and used 400 times per week. In this example, the document load cost is $25 (5,000,000/200,000) per document. Evaluated from this perspective, the costs may appear reasonable and comparable to expenditures incurred by on-line publishing businesses. But by examining usage rates, relative costs can be seen more clearly. Let us say that the document reuse rate is 10.4%, ie approximately one document in ten is reused in the evaluation period. The result is a cost of information equal to $240 (25/0.104). Now the question can be addressed whether the firm considers the cost reasonable, and one way to consider this is to evaluate whether clients would be willing to pay the cost (whether as a disbursement or as a factor of the billable rate charge).

Applying metrics to guide business strategies

Despite the importance of metrics, their value should be put in context. Financial measurement methods are only tools; they do not set strategies. Nevertheless, they can be helpful when choosing alternative business goals and assessing the effectiveness of the tactical response. Prevailing opinion, however, continues to dismiss ROI as an impossible standard. In an interview with Patti Ryan reported on Ron Friedman’s website the position was asserted: ‘Knowledge management professionals frequently discuss the ROI on KM, but I think the topic is misplaced. If a firm consistently measures ROI on all investments, for example, new offices, marketing initiatives, and hiring laterals, great. Then apply those metrics to KM. But few firms are serious about metrics. So why should KM be subject to unique standards?’₁₀

One reason why it can be challenging to effectively assess the ROI of technology investment is the scope of the analysis. Precise measurement of investment returns is unlikely to be effective with respect to individual software acquisitions, simply because it would be impossible to isolate the effects of an individual system. However, this circumstance should not lead firms to abandon metrics, but rather they should sensitively select the appropriate yardstick. First, at the strategic level, metrics can guide firms choosing alternative strategies. For example, as we move from technology as plumbing and address strategic business imperatives, its role can be better seen. For example, firms may approach a high-level business strategy by addressing the following questions:

• What are the markets we seek to serve?
• What are the margins in these markets? Are they high value (35% margins or above) or commodity markets (25% margins or below)?
• Who are our competitors?
• What about these competitors do we most admire?
• What are their weaknesses?
• What do we need to effectively compete?

Secondly, at the tactical level, after the firm has selected its broad business objectives, financial metrics can be applied to fine-tune IT systems to get the most from the investment.

Measuring tactical performance at a granular level

The approach of using broad business goals combined with granular financial assessment tools can be illustrated by Richard Susskind’s Legal Grid. In the book The Future of Law,11 Susskind proposes an analysis matrix with technology-focused systems on the left side and information-focused systems on the right side (see box, ‘The Susskind Grid’). In terms of financial measurement tools, this can be summed up as follows:

• External technology (client relationship systems)
• Indirect revenue measures – client retention
• External information (on-line legal services)
• Direct revenue measures – profit
• Internal technology (back-office technology)
• Direct costs measures – costs reduction
•  Internal information (internal knowledge systems)
• Indirect costs measures – cost of information and leverage
• Internal technology – direct costs measures

The lower-left quadrant describes technology that serves basic operational needs. It remains the predominant focus of law firm IT expense. Accordingly, in this sector, financial analysis of expenditures is no different than any other business.12 It is an overhead expense. This is particularly important considering the fact that larger law firms are bloated with hundreds of computer programs. Many organisations may wish to evaluate whether their systems can be streamlined and determine whether two or more current systems can be replaced by a single application. Accordingly, the metric that can be applied to assess the effectiveness of a streamlining strategy is technology expense benchmarked by reference to functionality, quality and timeliness (standards that can be captured in a service level agreement).

From a broader perspective, the business strategy of deploying operational technologies has facilitated a transfer of drafting and scheduling functions from secretaries to lawyers. Viewed in this manner, the investment has been offset by expense reductions realised through lower secretary to lawyer ratios. Moving forward, firms may wish to evaluate equally broad strategies, such as outsourcing infrastructure and operational systems.

Client collaboration systems – indirect revenue measures

The upper-left quadrant of the Susskind Grid describes technologies that provide technology services to clients. Examples of such client-focused technology systems include e-billing, extranets and deal rooms. From a business perspective, the upper half of the grid captures outward-looking IT systems that move from those of pure technology on the left to those based on e-commerce on the right. They reflect a continuum from value-added services to highly valuable client service, and illustrate the fact that value and profit margins increase from left to right. The more technology-focused the system and the more generalised the information, the less likely that investment will yield direct financial compensation. In other words, it is unlikely that law firms can separately charge for e-billing systems, or even extranets, while clients have shown willingness to pay for customised legal services delivered through the means of computer systems.

So why would a firm invest in client technologies that have no direct financial benefits? Again, by looking at the business factors, the rationale for such investment is to deepen the client relationship or, in modern e-commerce terms, increase ‘stickiness’. Then, if this is the purpose, the effectiveness of the investment can be measured by client retention statistics or the rate of return business. Where such benefits cannot be shown in broad theory and seen in practice, then the utility of the investment can be questioned.

Internal information systems – indirect cost measures

The lower-right quadrant of the grid describes internal information systems designed to capture, organise and share knowledge with the goal of promoting quality and efficiency. Such knowledge management systems may provide business knowledge of the firm’s market, organisation knowledge of the firm’s resources, substantive knowledge of the law or procedural knowledge of legal tasks.

The business justification for investment in knowledge management systems includes the competitive advantage of reducing the cost of legal services and increasing law firm profit margins through leverage. As described above, the effectiveness of the firm’s knowledge management investment can be indirectly measured by applying the cost of information, and directly measured by evaluating each of the Maister profitability elements. In the case of direct financial metrics, firms can improve the sensitivity of the assessment tools by measuring performance at more granular level, such as the profit margins realised by individual partners and individual matters. By narrowing the focus of the benchmarking statistics, firms will be able to assess tactical performance of their strategies more quickly, compared to benchmarking financial returns for the firm as a whole.

On-line client information and legal service systems – direct revenue measures

Finally, the upper-right quadrant comprises information systems delivered directly to clients, such as client-facing e-commerce systems providing on-line forms or advice tailored to individual client needs. In most cases, these on-line legal systems are priced on a transactional or subscription basis, and therefore offer a direct correlation between IT investment and profitability. Accordingly, the measure of financial effectiveness can be based on standard business models, computing profits by deducting expense from revenue.

However, while Susskind and others have long held the view that electronic delivery of legal services represents the future of law, it is not clear, at least in complex situations, that clients want to undertake their own representation using self-service delivery models, any more than patients want to perform self-diagnosis and medical procedures, or motorists want to repair their own vehicles. If this is true then greater emphasis should be placed on the investment strategies in other sectors of the grid.

Conclusion

Today, law firms have the ability to benchmark their financial performance with peer firms, comparing revenue, costs and operating margins at very detailed levels.13 Clients have access to systems to compare law firm costs.14 Together these systems portend a time when suppliers and consumers have detailed market information offering effective benchmarking (at least in terms of the external performance of law firms) and will likely further fuel the competitive market for legal services. Given the advent of such assessment applications, law firms may wish to consider internal benchmarking methodologies to help them set their IT strategies and evaluate their effectiveness in realising their financial objectives. However, at the end of the day, it must be acknowledged that financial evaluation of IT investment is complex and fraught with challenging issues, and it continues to be difficult to persuade lawyers who have developed a highly successful business model to change their approach. 

Kingsley Martin is a senior director at Thomson Global Resources.