Navigating the “Bermuda Triangle” in Professional Service Firms

Shouldice Hospital is a small, 89-bed hernia hospital that, over the past several decades, has provided excellent health outcomes for patients, a congenial work atmosphere for doctors and nurses, and handsome economic returns for its owners. The hospital’s leadership has forsworn expansion to avoid dilution of its unique offering as scale grows.

But there is also the example of Narayana Hrudalaya, a cardiac hospital headquartered in India, that has grown dramatically over the past two decades by following an approach its founder calls “the Walmartization of healthcare.” The hospital delivers world-class results for cardiac patients, provides an excellent work environment to its medical staff, and has yielded excellent returns to its stockholders. The hospital is able to drive costs down and benefit from specialization because of its high volume of activities.

Among law firms, Wachtell Lipton, which maintains a premium market position, exciting work setting for its lawyers, and remarkable profitability for its partners. Here too, like Shouldice, the small size and focused profile of the firm seem key to maintaining its collegial, service-oriented, client-focused environment. But a counterexample would be the Magic Circle firm Linklaters, which offers seamless, high-quality, cross-jurisdictional, cross-practice legal service to its clients, opportunity to work on complex matters with highly skilled colleagues to its lawyers, and very good profitability to its partners. Its footprint, spanning geographies and practices, is key to its success.

These observations are consistent with the general sentiment among professional service firms (PSFs) that successful firms are either small, informal, and specialized, or large, formal, and broad in their client base and service offerings. Firms that are in-between are in a challenging zone, a “Bermuda Triangle.” Several PSFs enter this zone as they grow; not all emerge from this zone as successful, large firms.

The term “Bermuda Triangle of Management” was first used by D. Darryl Wyckoff to explain why the operating ratio (operating cost to revenue) was highest for mid-sized firms in his study of the trucking industry (Organizational Formality and Performance in the Motor Carrier Industry, 1973). It applies, perhaps with even greater power, in the human capital-intensive professional service industry.

As a PSF grows, the way it is managed has to change. Continuing an informal approach to management strains performance. Costs begin to increase and errors in operations and service delivery begin to cumulate. Formal systems and processes have to be introduced. But formal systems are costly and introducing them changes the culture of the firm. If PSF leaders wish to scale up their enterprises, they must ask a critical question: “Are there countervailing benefits that lead scale to become a source of advantage for my firm?”

Scale can benefit a PSF in four ways: cost economies, demand economies, and learning economies, and network economies.

Cost economies? If a firm incurs significant fixed costs, operating at a large scale helps distribute the fixed costs, reducing per-transaction cost. Narayana Hrudalaya, for instance, has installed cutting edge, expensive equipment for heart procedures, but the high volume of its operations drives down per procedure cost.

Demand economies? Some matters require that the professional service supplier have large footprints. Linklaters’ clients, for example, derive comfort from knowing that Linklaters has the resources to work on major, high-stakes, cross-jurisdictional matters. A 2007 analysis had found that the more the offices that worked on matters, the higher was the Average Billing Rate. This suggested that clients particularly valued Linklaters’ ability to work on matters that crossed jurisdictions.

Learning economies? Major strategy consulting firms, such as McKinsey and BCG, emphasize to their clients and professionals that, because of their broad universe of clients and effective internal knowledge management system and culture, they are able to learn best practices from their multitude of engagements, ensure the confidentiality of specific information, and yet apply cutting-edge knowledge to assignments throughout their network.

Network economies? Across various professions, firms such as Emeritus in executive education, Axiom in legal services, Eden McCallum in management consulting, and Gerson Lehrman in expert services, present themselves as platforms that bring together professionals and clients. As in other platform settings, scale is important, because of cross-side network effects: the more the clients, the more professionals will want to join the platforms, and vice-versa.

Thus, PSF leaders must ask the following questions if they are contemplating whether to scale up:

• Do our operations incur significant fixed costs?
• Do our clients (and potential clients) value working with firms having larger size?
• Do we have the internal processes and culture to learn while working on client matters, and apply the knowledge thereby gained to other client contexts?
• Are we trying to establish a platform that connects clients with professionals?

If the answer to one or more of these questions is in the affirmative, the PSF leader must then weigh the benefits of scaling up against the costs of formalization. Only if the benefits outweigh the costs should the firm scale up. None of the benefits of scaling up accrue by themselves. The PSF leader must ensure that, as the organization grows, its systems, processes, and culture so evolve as to benefit from its larger scale.

PSFs can thrive as focused, informal, specialized, low fixed cost practices. PSFs can also be successful as large, formal, high fixed cost organizations. But PSF leaders should be cautious that their firms not end up somewhere in-between, suffering the costs of not formalizing appropriately without gaining from scale advantages. These are the firms that risk sinking in the “Bermuda Triangle.”