Ignore the cost of production at your peril

[Australasian Law Management Journal,Finance & Accounting,General Management,Strategy & Leadership] May 11, 2017

Gaining a better understanding of the cost of production in law firms – and how to minimise it – is a must for ambitious leaders and managers as they seek to succeed in a highly competitive and disrupted legal market, writes Neil Oakes.

Not that long ago, law firms were price-setters. They decided what profit they wanted, tallied up the expenses, set a chargeable hours budget and, hey presto, they had an hourly rate to charge.  And charge it they did. Profits often met or exceeded budget. Want more profit? Easy, just whack up the rate – job done.

How times have changed. Insourcing, digital disintermediation, commoditisation of repetitive (hitherto high-margin) work, increased client mobility, a shift away from relationship purchasing to professional procurement and the re-entry of the global accounting firms in mid- and top-tier markets have swung the pendulum. For some time, law firms have become price-takers in a competitive market.

Some lessons about profitability

Profitability ultimately comes down to price, volume and cost of production. From 1992 to 2007, law firm profitability grew exponentially. This growth was not achieved through efficiencies or productivity gains, nor was it produced as a result of greater client satisfaction or significantly greater demand. During this time, margins, utilisation rates and realisation rates remained pretty constant.

The lever that took large firm partner incomes from $400,000 to $1 million-plus was price; the fees went up between 5 per cent and 7 per cent a year. This had a significant compounding effect.

I know that not all segments of the legal market experienced this ride, but I use it here as an example of the historical importance of price to profitability. Before the shoot-the-billable-hour brigade rushes to Twitter to comment, I would make the point that this observation relates entirely to quantum, not pricing methodology. Price as the most important profit lever is a germane historical fact for all major Australasian law firms and their contemporaries in other jurisdictions. This is why a shift from being a price-setter to a price-taker presents as a significant disruptor, probably more so than any ‘killer app’ that we are likely to see in the foreseeable future.

Price will always be important to maintaining and improving profit, but in highly competitive, commoditising markets the management of the cost of production has, during the past few years, become the most significant lever.

Managers are embracing strategies such as automation, contracted lawyers and legal project management (some better and quicker than others; some through their own initiatives and others that are client-led). In this article, I am not going to present a grab bag of cost savings measures for managers. Instead, I want to reflect on the management of the cost of production by all practising lawyers to encourage a shift away from the belief that costs are ‘largely what they are and there isn’t much one can do about it’.

I have seen firms trade at profit margins below 20 per cent and others with profit margins above 60 per cent. While price accounts for some of the difference, managing cost contributes significantly.

It’s time to understand costs

For many years, it has intrigued me how few lawyers understand cost; whether determining the cost of a matter or the cost of producing an hour of chargeable time. Of course, many firms have invested in professional financial managers and business intelligence software to do the math behind the scenes, but in firms of all sizes all lawyers should understand cost and what they can do to minimise it without jeopardising the client experience.

I speak here to partners in firms of all shapes and sizes. ‘How much does it cost for you to do what you do?’ ‘What can you do to minimise the cost?’ The answers are pretty straightforward and most relate to structure and productivity.

Consider two distinct practising approaches; one that does not utilise employed lawyer leverage, and one that does. I have used typical averages from smaller firms (two- to 10-partner firms). In these firms, non-lawyer support per lawyer varies. I have assumed some economy of scale in partner B’s practice because relatively junior lawyers do not utilise the same amount of ‘support’ that partners tend to. Non-salary overheads per person (lawyers and support) also vary slightly from year to year, but it averages $50,000 (or near enough).

 

PARTNER A

Partner salary – $200,000

Number of employed lawyers – 0

Employed lawyer total salaries – 0

Total direct support salaries – $35,000 (say 0.5 FTE)

Average non-salary overhead per person – $75,000 (50k x 1.5 FTE)

Total cost – $310,000

Total available chargeable time – 1200

Average cost per chargeable hour – $258

 

PARTNER B

Partner salary – $200,000

Number of employed lawyers – 2

Employed lawyer total salaries – $180,000

Total direct support salaries – $75,000 (say 1 FTE)

Average non-salary overhead per person – $200,000 (50k x 4FTE)

Total cost – $655,000

Total available chargeable time – 1 x 1200; 2 x 1000 = 3200

Average cost per chargeable hour – $171

 

The assumed numbers are not the important lesson here; it is all about the relativities. There are three take-out lessons. First, leveraged practices are invariably able to produce legal work significantly cheaper than sole operators. This is particularly the case for non-time pricing lawyers and those whose fees for a particular service are set by the client. This is primarily why ‘employed lawyers per equity partner’ correlates so strongly to ‘net profit per equity partner’.

Second, the bad news. The most immediate lever for reducing cost is available chargeable time, regardless of pricing strategy. As admirable as ‘working smarter, not harder’ is served up to be, working harder would seem to have its merits. I know that is a cheap shot at ‘managerialese’, but the fact remains that salaries are usually paid on an annually negotiated basis and non-salary costs vary little with volume; therefore, the greater the volume relative to this fixed cost base, the greater the resulting profit margin. Without the lever of price, productive, chargeable effort becomes integral to profit. In the professions it has been forever thus.

Third, the difficult news. The more junior (and therefore cheaper) capable employed lawyers there are, the greater the impact of employed lawyer leverage on cost minimisation. Again, this is most pronounced when clients set fees or the firm determines a fixed price for a service. In a price-taking business, firms that recruit graduate lawyers, train them and retain them for three to five years are going to be more profitable than firms whose employed lawyers are all highly paid senior lawyers.

Why you should invest in partnerships

Having said all that, law firm strategy is a complex beast. Profitability is a small part (although its absence does sharpen the focus in most partnerships). Regardless of the impact on the cost of production, the long-term strategist should, in my view, continue to invest in diverse partnerships that accommodate part-time equity partners. We should continue to invest in training and retaining of graduate solicitors. Finally, we should never stop investing in improving the client experience.

Firms and partners should not be driven by price and cost, but they should understand them. Find out what the client wants, what they are prepared to pay for it, and then manage your costs accordingly through structure and productivity.

Neil Oakes is the director of FMRC, which has provided research, training and management advice to law firms throughout Australasia for the past 30 years.

www.fmrc.com.au