“(Pricing) can just destroy you if you don’t do it right. It doesn’t matter whether you’re putting out a novel you’ve written or providing a service through a pest control company or you’re a veterinarian. The bottom line is that pricing is extraordinarily important.”1
Until the past decade, most law firms simply billed clients according to their current rate sheet (with occasional discounts) and gave pricing scant thought. In today’s market, that won’t do. Pricing is much more important than in those good old days, not just in terms of the amount charged, but in terms of the billing structure (e.g., caps, collars, fixed fees, contingencies, hold-backs, success bonuses.)
With law firm margins thinner than before, it’s necessary to understand the profitability of each matter and client. Effective pricing means structuring fees so the firm wins the work and that the work is profitable. This is also a marketing opportunity in that optimal pricing helps clients meet their strategic goals (e.g., predictability, and “win at all costs” when needed); and it’s an opportunity to strengthen client relationships by increasing transparency.
Business Intelligence and Competitive Intelligence can substantially help manage the risk inherent in those pricing decisions. Optimal pricing requires three types of intelligence:
- Profitability of the matter and of the client under various fee models.
- Understanding of the fees being charged by competitors for similar services.
- Buyer price sensitivity.
At its core, the pricing of legal services is like pricing anything else, a matter of supply and demand, elasticity, competitive forces and buyer values.
See my previous post for definitions of Competitive Intelligence, Business Intelligence and Artificial Intelligence.2
Profit is simply revenue minus expenses. If revenue (i.e., the net amount collected) is not greater than the sum of all related expenses, there is no profit.
In some professional service industries, the amount billed is simply the sum of (Billing Rate) x (Hours Worked) for each person working on a matter. Time-based billing was introduced in 1914, law firms started the switch to “billable hours” in the middle of the last century, and by about 1980 hourly billing dominated the industry.3 In fits and starts, the industry now seems to be moving away from straightforward hourly billing to alternative fee arrangements (AFAs).4
Expenses (a.k.a. “costs”) are of two varieties: direct and indirect. (There are other ways of thinking about expenses such as “contribution margin” and “fixed expenses” but we don’t need to go that deep.)
Direct and indirect expenses
Direct expenses are the costs directly related to the specific matter. This should be calculated at the matter level. Direct expenses (i.e., costs directly related to providing the service) might include:
- Staff payroll (including benefits and taxes) proportional to the time spend on the work
- Partner compensation for that work
- Any other costs related to conducting the work (e.g., eDiscovery vendors, office materials, travel)
Indirect expenses are the costs of running the business that are not directly caused by a specific client or matter. They often include but are certainly not limited to overhead such as:
- Depreciation & amortization
- Stationary and supplies costs not assignable to a specific matter
- costs of staff (e.g., marketing, finance, HR, IT) not assignable to a specific matter
- Attorney compensation not assignable to a specific matter
- Business insurance
- Meals, entertainment, travel expenses, sponsorships, advertising and other business development/marketing costs not directly related to a specific client or matter
- Professional association memberships
- Software licenses
- Legal and accounting fees
- Other consulting fees not assignable to a specific matter
A gray area
Falling into a gray area between direct and indirect expenses are:
- The cost of acquiring the business
- Any costs associated with maintaining the client relationship
These are overhead, and though they are not billed to the client they can and should be allocated to relevant matters and clients when calculating profit, proportionately according to the size of the matter relative to the rest of the firm’s work.
I mentioned above that “amount billed” is often the sum of (billing rate) x (hours worked) for each person working on a matter. If only things were always that simple. That’s a standard starting point for calculating revenue, but then, to come up with our real revenue, we need to factor in:
1) The impacts of any AFAs (especially discounts)
2) Further discounts given after the bills have been received by the client, and
It is this net revenue (the amount actually collected) that must be considered in profit calculations. (Revenue should also include relevant direct expenses billed to the client. More on that later.)
Price sensitivity (a.k.a., price elasticity) is the amount demand decreases when cost increases. The price sensitivity of legal services varies enormously from commodity services (very sensitive) to bespoke services (relatively insensitive), and depends on the other factors valued by clients discussed below under “Customer Value-Based Pricing.” Sensitivity also varies by individual client, by client industry, by client location, and depends on other competitive factors such as over-supply of certain types of lawyers.
More about profit
Law firms have historically struggled to agree on the profitability of specific matters and clients. This generally boils down to disagreement as how to allocate indirect expenses. Without this allocation, every matter (or client) could seem profitable while the firm loses money. So, this essential debate can be reduced to allocation formulae, and how various distribution methods will benefit some partners/practices/offices more than others.
Partners often argue that certain work should be brought in, even though they know it will be unprofitable. Reasons include:
- We’ll use it to train associates. (If that’s the reason, then those training costs should be included with the direct expenses of the matter that are not billed to the client.)
- The people who will work on it aren’t very busy, and it’s better to have unprofitable work than no work
- This matter is a “loss leader” to get the client in the door
- Once this small company grows up, we’ll have a lot of very profitable work from them. (This is often the argument for sponsoring business incubator projects.)
- This will help us learn about a new industry, or will help us establish credibility in a new industry.
It’s unusual for any of these rationales to prove out at the end of the day. There are better ways to train associates, it’s more prudent to downsize the firm than bring in unprofitable work in an effort to find something for idle partners to do, the “loss leader” rarely leads to very profitable work, once the small company “grows up” they usually move their work to another firm, and there are more efficient ways to learn about new industries.
It’s about staying billable
Some attorneys who need the work might say the matter will be profitable, knowing it won’t be, just to stay busy. They’ll then give further discounts when the work is underway, or simply write off some of the amount billed. Or they’ll bring in the matter intending to leverage associates to ensure profitability only to end up doing the work themselves to keep their hours up.
|“The single most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10%, then you’ve got a terrible business.” 5
Some partners might bring in what turns out to be unprofitable matters because they simply do not know at the outset how much work will be required, but they promise the client a fixed fee or something close to it. This is common in many firms where profit calculations are difficult or just not done.
Historically, most firms have mistakenly focused on revenue, giving profit little or no attention. Revenue is easy to measure, and it avoids those unpleasant discussion about the allocation of overhead. This is borne witness by many firms’ strategic plans, which focus strictly on revenue growth.
The other side of the profit equation
The other side of the profit equation is expense. In lean times when profits seem to be in jeopardy many law firms have made arbitrary budget cuts to administrative expenses, expecting the staff responsible for running the business of the firm to find ways to cut overhead without significantly inconveniencing the partners or impacting the client’s experience. This was often very effective in the past few decades when most law firms were not being run like “businesses” and there was certainly fat to be trimmed. However, during the past decade, most firms have effectively trimmed that fat, making it very difficult to make more administrative cuts without substantially impacting the business of the firm.
To calculate the final revenue and expenses attributable to a matter (and hence its profit), the matter must be “closed.” It’s possible to calculate the profit of an incomplete matter within a specific period, but it’s only when the matter finally wraps up that you can get an accurate picture of its total revenue and expense.
But, partners are often reluctant to close matters
This sometimes results in matters remaining open for several years after the last hour has been billed. Matters are left open because:
- The partner believes some sort of add-on work may be needed after the deal is done or the dispute put to rest, or
- They may want to include what should be new matters under the old matter number, or
- They do not want it to be possible to calculate the matter’s profitability, or
- There is no motivation by the firm to close matters, and it’s easier to nothing than something
The profit of a matter should be calculated as the revenue in the door minus the sum of all expenses, direct and indirect, allocated to the matter. To get a true picture of profitability, ALL firm expenses should be allocated to specific matters. Again, the proportionality of the allocation is very debatable, and it’s unlikely that any two firms will use exactly the same methods.
Calculating profit by client
Once the profit of each matter has been calculated it’s possible to add up the profit of those matters to calculate the profit attributable to each client. Because the attorneys and staff doing the work on a matter are often in different locations and/or practice group, calculating the profit of an office or practice is more complex, requiring more allocation decisions.
Note: Partner comp should not be based solely on the profit of the partner’s matters (and certainly not revenue). Other factors to consider include, total book of business, bringing in new business, community activism, work in the administration of the firm, and support of other firm values such as diversity and pro bono work. A related controversial topic is whether to “sunset” assignment of origination credit. The answer is absolutely “yes” but let’s save that discussion for another post.
This is not the only way to treat profit, much has been written about various ways to doing so in a law firm environment, such as employing the recent concept of “margin per partner hour.”6
Tomorrow: The three types of pricing and their dependence on Competitive Intelligence and Business Intelligence
Thursday: Pulling it all together for specific proposals
1 Charles Toftoy (George Washington University Professor Emeritus) https://www.inc.com/guides/price-your-services.html
In 2015 large law firms were using AFAs for 22% of their revenue (The American Bar Association, Making Alternative Fee Arrangements Work for Any Size Law Firm (July 2015), http://www.americanbar.org/publications/youraba/2015/july-2015/makingalternative-fee-arrangements-work-for-any-size-law-firm.html.
More than half – 56 percent – of corporate counsel say they currently use AFAs, and 88 percent of legal departments and 92 percent of law firms believe they’ll remain a permanent part of legal billing. ALM Legal Intelligence, Speaking Different Languages: Alternative Fee Arrangements for Law Firms and Legal Departments (Lexis Nexis, April 2012), 18, http://www.lexisnexis.com/counsellink/documents/ALM-Survey-Alternative-FeeArrangements.pdf.