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6 posts from November 2011

November 30, 2011

Legal pricing (Part 2 of 8): The cost-plus approach

A few weeks ago, when I gave a speech at the retreat of a 1,000 lawyer firm, a senior partner asked: “In your experience, how do large firms determine costs?” I replied: “Mostly, they don’t. Until recently, most firms were making so much money they didn’t need to precisely calculate their costs.”

Many lawyers seem to think of their standard hourly rates as being equal to the firm’s costs. But traditionally, rates have actually been based on “cost plus a lot” and no one was quite sure which part was the cost and which part was the “plus a lot.”

One underlying problem is that compensation of equity partners typically is based on dividing the firm’s profits at the end of the year. To cite an extreme example, consider Wachtel, which had the highest profits per partner in the AmLaw 100 last year: $4,350,000. Some equity partners were paid more than this average, some were paid less. But let’s consider a lawyer who was paid exactly that amount.

He may think of his $4,350,000 annual draw as a cost of doing business. But the chances are Wachtel could stay in business if he were forced to scrape by on $3 million, or even $2 million. What fraction of his draw is a true cost and what part is his share of the profits? Until the day that Wachtel guarantees equity partners a baseline salary, and identifies the rest as a discretionary profit-sharing bonus, the line between cost and plus will remain arbitrary.

Despite this lack of precision, most law firm pricing has traditionally been based on the cost-plus model. As Ron Baker points out in his influential book Pricing on Purpose (p. 88), it seems fair to start from costs and add a reasonable markup for profit. But Baker strongly favors value pricing over cost plus. After listing twelve bullet points that people use in arguing in favor of the cost-plus approach, he notes “It is amazing how many businesses still cling to the cost-plus pricing method… Doing something stupid once is just stupid. Doing it twice is a philosophy.”

The authors of the fifth edition of The Strategy and Tactics of Pricing (p. 2-3) are a bit gentler when they say:

Cost-plus pricing is… in theory, a simple guide to profitability; in practice, it is a blueprint for mediocre financial performance. The problem with cost-driven pricing is fundamental: In most industries it is impossible to determine a product’s unit cost before determining its price. Why? Because unit costs change with volume.

In traditional legal work, the “unit” you are selling is the billable hour. To see how its cost changes with volume, consider the case of Beth, an AmLaw 200 senior associate who specializes in labor law, and is considering going out on her own.

Last year Beth billed 2000 hours at an average rate of $300 per hour. Since the firm charged $600,000 for her time, and Beth was paid a salary of $250,000, the firm’s share of her billings was $350,000. It seems obvious to Beth that if she hung her own shingle, she should be able to charge less, and make more.

Her first question is what she should charge per hour. She goes on the web, and finds this cost plus formula:

Average Billing Rate = (Expenses + Desired Profit)/ Realized Hours.

Realized hours, of course, are the hours which are not only billed but also paid. Since she will be a solo practitioner, the “desired profit” equals the amount she would realistically expect to take home in addition to her salary at the end of the year.

Beth is not a numbers person, so she asks her math-loving sister to do the calculations which appear in the table below.

Projected expenses and revenue


Desired salary


Overhead (fringe benefits, taxes, rent, phone etc.)


Total expenses


Realized hours (billed and paid)


Break-even hourly rate or cost per billable hour (Expenses/ realized hours)

$175 per hour

Total revenue (Realized hours x hourly rate)


Profit (loss) for end of year bonus or correction


At the beginning of the year, Beth’s salary is only an estimate, since she will be her own boss, and what she earns will depend on her revenue and expenses.

Although her calculations suggested an hourly rate of $175, Beth decides to start by charging $200 per hour to leave a safety margin in cases expenses are higher than predicted, her billable hours are lower and/or some clients fail to pay their bills.

Beth asks a CPA friend to review her sister’s thinking. He says that he would like to see more details about exactly what she will spend on rent, insurance, payroll taxes, and everything else, but the analysis is basically sound. However, he says that Beth needs to factor in one more thing: the non-billable hours (indirect labor) that she has to work to set up the office, send out her bills, and find new clients.

Consultants often don’t track the unbilled time they spend on marketing and administration. But from a CPA’s point of view, that time has a value, and is a cost of doing business, so it should be included in the cost analysis. This may seem like hairsplitting to a new solo, but as Beth’s firm grows it will be extremely important to track.

After talking to the CPA, Beth does not change her projection for the bottom line, but her sister does add a few lines to her chart as follows. (Note to readers: Feel free to skip this chart, and all the rest. The text summarizes the main conclusions.)

Projected expenses and revenue




Number of hours worked


Salary per hour


Direct labor ($100 salary per hour x 2000 realized hours)


Indirect labor overhead ($100 salary per hour x 500 unrealized hours for administration, marketing and unpaid bills)

$ 50,000

Other overhead expenses (malpractice insurance, health insurance, fringe benefits, taxes, rent, phone etc.)


Total expenses


Overhead rate ((Indirect labor + other overhead)/ Direct labor)


Break-even hourly rate or cost per billable hour (Expenses/ realized hours)


Actual hourly rate


Total revenue (Realized hours x hourly rate)


Profit (loss) for end of year bonus or correction

$ 50,000

The point is that she has used the cost-plus equation. She raised her hourly billing rate so as to add to her expenses an amount for desired profit – and she had to know what her expenses were and do the math.

So Beth goes out, rents an office, and gets started. At the end of the year, her big picture projections turn out to be close, but of course many details turn out to be different. On the negative side, her clients don’t give her quite as much work as she expected, one client fails to pay a small bill, and it takes more time than she predicted to start the business. She ends up with only 1500 realized hours instead of 2000, and worked 550 unrealized hours instead of 500. On the positive side, she controls other expenses like a hawk, and is able to spend 14% below her initial budget. At the end of the year, her figures look like the next table. (Again, feel free to skip to the text after the table.)

Actual expenses and revenue




Number of hours worked


Salary per hour


Direct labor ($121,95 salary per hour x 1500 realized hours)


Indirect labor overhead ($121.95 salary per hour x 550 unrealized hours for administration, marketing and unpaid bills)

$ 67,073

Other overhead expenses (malpractice insurance, health insurance, fringe benefits, taxes, rent, phone etc.)


Total expenses


Overhead rate ((Indirect labor + other overhead)/ Direct labor)


Break-even hourly rate or cost per billable hour (Expenses/ realized hours)


Actual hourly rate


Total revenue (Realized hours x actual hourly rate)


Profit (loss) for end of year bonus or correction


All in all, a reasonable first year. She “lost” $35,640 (that is, she had to reduce her desired salary) instead of making a profit of $50,000, but she also worked 450 hours less than planned and covered most of her salary while working independently. Most new solos would be happy with this result.

In terms of our example, however, the point is that the only way to truly know her costs was to wait until the end of the year, see what she actually spent, see how many hours were actually billed and paid, and then do the math. When her sales volume changed, her unit costs changed as well.

It could have turned out very differently. If she had been able to bill the full 2000 hours and all were paid (realized) as originally planned, her cost per billable hour would have been $167.82. If her billable hours had declined to 1000, the same expenses would have led to a cost per billable hour of $335.84.

Now take these uncertainties, and multiply them by 100 lawyers or 1000, with laterals coming and going, and client needs constantly changing, and you will begin to get an appreciation for how difficult it would be to accurately predict a large firms's cost per hour at the beginning of the year. Any cost estimate at the beginning of the year will depend on a number of assumptions. And when some of those assumptions inevitably turn out to be incorrect, the cost numbers will need to change.

However, it can be done. Government contractors who work under cost-plus contracts are required to estimate their costs at the beginning of each year, bill the government all year long at the estimated rate, and then do a reconciliation at the end of the year to determine actual reimbursable costs. If actual costs exceed the original estimate, contractors typically must request permission to exceed the contract limit, giving the government 90 days advance notice. If costs are lower than the original estimate, at the end of the year the government gets a refund.

To make money within these rules, contractors set up elaborate financial reporting systems to provide early warning of variance from their projections, and they change their spending at the first sign of a problem. So it is certainly possible to run a company within narrow cost limits, but it requires a degree of financial analysis and control that would be a revolutionary change for law firms.

These days, many partners in large firms do not understand even the rough costs of each billable hour. Does it matter? Yes it does. As one AmLaw 100 decision maker put it in the LegalBizDev Survey of Alternative Fees:

Our partners are the salesmen as well as the producing managers on a lot of this work, so they’ve got to be armed with our own internal costs and how we can adjust those internal costs. If somebody comes back and says [that they’d] like to do this work, and [they know] what [they] need, but [that they] can only get $150,000 for the project, then we have to say [whether we can make it work, or] if we’re doing it with no profit margin or as a loss leader. There need to be people in the organization that can sit down with the partners and talk to them about costs and [then] arm them to talk to the general counsels.

Cost-plus may or may not be a good basis for setting prices. But if law firms want to stay in business in an ever more competitive world, they must ultimately charge at least as much as they spend. And that starts with understanding their costs. In future posts, we will discuss how this relates to value billing and more.

This post was written by Jim Hassett and Matt Hassett. Part one of this series can be found here.

November 23, 2011

Legal pricing (Part 1 of 8): What lawyers need to know and why

Some law firms are going to large companies and offering to do all their legal work for one fixed price, but the firms don’t know how it will work out in the long run. I suspect in some cases it will come out really ugly.

This prediction was made in 2009, by a senior partner from an AmLaw 100 firm who took part in our LegalBizDev Survey of Alternative Fees.

In the two years since, this prediction has become a reality, and many fixed price legal deals have indeed turned out badly. In the 2011 Law Firms in Transition study, Altman Weil asked managing partners and chairs “Compared to projects billed at an hourly rate, are your firm’s non-hourly projects more profitable or less profitable?” 32% said non-hourly matters were less profitable.

Of these 32%, there is no data on how many turned out “really ugly.” But based on many stories I have heard off the record, I would guess quite a few. I also suspect that the true number of less profitable deals is much higher than 32%.

In college, I had a friend who spent a lot of time at the race track. He seemed to remember the times he won much better than the times he lost. I suspect many lawyers have a similar talent for forgetting deals that turned out badly. Especially when they answer questions in a survey.

In the survey results, 12% said non-hourly arrangements were more profitable, and 36% said they were about the same as hourly. The remaining 20% were “not sure.” Apparently, their accounting systems weren’t set up to analyze mere details like the profitability of individual fixed price engagements.

Would you invest in a company that didn’t know which deals were profitable? Of course not. But if you are a partner in a large or mid-sized firm, there’s a good chance you already own one.

How did this happen?

The answer can be traced to too many years of good news. For the last few decades, the law firm pricing model could be described as “cost plus a lot.” Just keep raising prices until the overhead is paid and key partners make a lot of money. But now the game is changing, and clients are resisting rate increases.

When money is flowing freely, everybody thinks they are smart, and nobody has to count too carefully. As Warren Buffet famously put it, “It's only when the tide goes out that you learn who's been swimming naked.”

Many lawyers seem to believe that the tide will come back in soon, and the good old days of raising prices every year will return. But, as Barbara Boake and Rick Kathuria noted in their book Project Management for Lawyers: “The recession was merely a catalyst for an inevitable shift in the balance of power from seller to buyer that will have a long-term impact on the way lawyers work.” Very simply, clients are demanding more value for their legal dollar, and that is not about to change, no matter what happens to the economy.

In the foreword to our LegalBizDev Survey of Alternative Fees (p. 2), Bruce MacEwen wrote that “this type of sea change in law firms’ fundamental revenue model is a once-in-a-career event.” It will require lawyers to develop many new skill sets, including project management to deliver high quality legal services within limited budgets, and better bidding in the first place. That’s one of the reason some large firms are starting to establish high level posts focused on this area, including Toby Brown’s new job as Director of Pricing at Vinson & Elkins, Stuart Dodds’ recent recruitment as Director of Global Pricing at Baker & McKenzie from a similar role at Linklaters, and Michael Byrd’s position as Assistant Director of Pricing Strategy & Analysis at Mayer Brown. Practice management staff are also increasingly involved in planning how to price proposals. For example Womble Carlyle has identified Bill Turner, the Director of Practice Management, as an internal point person to evaluate every significant price proposal in the firm and to analyze the pricing on every large RFP response.

For the average partner, learning more about pricing must start with a very simple insight. As Bruce Clearing Sky Christensen, Executive Director of Warner Norcross & Judd put it, “Lawyers must understand that client perceptions of value may have nothing to do with the hours it takes to do the work.”

But don’t feel bad, lawyers are not the only ones who could be better at pricing. In the fifth edition of one of the most widely respected texts in this field (The Strategy and Tactics of Pricing, p. 98), Thomas Nagle, John Hogan and Joseph Zale note that:

In many business-to-business markets, where high-volume repeat purchasers negotiate their purchases, buyers are ahead of suppliers in thinking strategically…. Buyers have goals and a long-term strategy for driving down acquisition costs, while suppliers rarely have comparable long-term strategies for raising or at least preserving margins.

Wikipedia lists 21 different pricing strategies suppliers use in other businesses, ranging from loss leaders to premium pricing. Two of them are of special interest to lawyers: cost-plus and value pricing.

Cost-plus pricing is the traditional approach, and is exactly what it sounds like: a price is based on the cost of delivering a service plus a markup or profit margin. But that is much harder than it sounds, and not necessarily a good idea, as we will discuss in the next post in this series.

The most popular alternatives are built around the idea of value pricing, where the client’s perception of value is the most important factor. The best known proponent of this approach is Ron Baker, author of several books on the topic including Pricing on Purpose. In practice, this can be harder than it sounds, as we will also discuss at length in later posts.

In a highly competitive marketplace like legal services, where some firms these days seem downright desperate for new work, there is also a giant complication: price competition. That too will be discussed in future posts.

The legal profession is changing rapidly, and law firms are just starting to apply experts’ insights into pricing, so there is controversy about what will work best. But on one point everyone could agree: law firms could make more money if they got better at setting their prices. In Part 2 of this series, we will begin to explain how.

This post was written by Jim Hassett and Matt Hassett.


Legal Pricing, Risk, and My Brother

Matt_hassettI have had a number of conversations lately with clients about how to price alternative fee arrangements while controlling risk, and with my brother Matt about his work as a mathematician addressing similar problems in other industries, including helping to set prices for mortgage backed securities and medicare supplement insurance.  I recently convinced Matt to join LegalBizDev to help us develop new workshops and consulting programs in this area.  Today’s post on pricing is the first of many we will write together.

November 16, 2011

Bloomberg Law Reports on Project Management (Part 2 of 2)

A few weeks ago, Bloomberg Law Reports published an article I wrote with Jonathan Groner entitled “Legal Project Management in the Trenches: What Lawyers Are Doing Today to Increase Efficiency.”  Part 2 of this article is reproduced below; part 1 can be found here.  To download a pdf of the complete article, click here.

As they transition to this new world, some firms are exploring increasing roles for professional project managers who are not lawyers. One example is Jim Hannigan, a project manager at Fenwick & West, who describes the goals of his firm’s LPM program very simply as: “Increased client satisfaction, increased realization, and increased productivity leading to more engagements.”

One thing Fenwick & West has been doing lately is “historical task coding,” in which financial analysts at the firm look back at past matters and use American Bar Association task codes to see how much particular aspects of each case cost and how much time they took. The firm then uses this past data as a basis for future bids in response to RFPs issued by prospective clients.

Another approach that Fenwick & West uses is to require the responsible attorney for every case over a certain amount to produce a budget in advance. To assist the lawyers, the firm employs a staff of four in-house budget analysts.

Non-lawyers also play a key role in Baker & McKenzie’s approach to LPM. In 2010, the firm brought in professional project manager Sarah Prime in its London office to help increase efficiency in key matters. Sarah often works as a billable member of the client team. In one instance a client requested that she be included on the team because “they valued the involvement of a project management resource and saw that it represented a cost effective approach, freeing up lawyer time to deliver high value services.”

Sarah works not just on individual matters, but also “on wider process efficiency. Both are equally important, as refinements captured on one matter can be fed into subsequent matters.”

The key to true efficiency is lawyer behavior, and the way things get done. Stuart Dodds, who was recently hired to fill Baker & McKenzie’s new position of Director of Global Pricing, explained that is why “Project management training is a key component of our associate and partner skills development, with a number of courses already implemented worldwide.”

According to Kirsty Wilson, Baker & McKenzie’s global head of reorganization, the result of this broad and deep commitment to LPM is that “Our clients go home happy in the knowledge that throughout each stage of the project there is complete transparency.”

While Fenwick & West has a required budget rule, Williams Mullen has instituted a two-hour staffing rule to eliminate the problem of “lawyer creep.” When they systematically analyzed staffing of past cases, Williams Mullen found that some cases that were supposed to have four lawyers assigned ended up with twice as many lawyers billing time to the client in a given month. This type of lawyer creep surprises clients and adds unneeded expense.

These days, according to partner John Paris, chair of Williams Mullen’s Innovation Committee, an essential element of any case management plan includes identification, in advance, of the lawyers who are authorized to work on the matter. Any member of the team who wants to bring in a new lawyer who will spend more than two hours on the matter must contact the responsible attorney for permission in advance.

“This does two things,” says Paris. “It avoids lawyer creep and it makes the responsible attorney truly responsible. It forces them to think through and solve issues on their own. There’s less redundancy. Fewer people need to know all the facts. It’s not just what the tasks are, but who is going to do them, and when. This type of planning, including the staffing rule, has proven extremely attractive to our clients.”

At Tucker Ellis & West, trial lawyer Jonathan Cooper has focused on process improvement, especially budgeting and risk assessment tools to plan litigation costs.

“We’ve developed software tools that help us estimate well in advance what something will cost, at least roughly, at the RFP stage,” Cooper says. “The idea is to turn budgeting more into something like TurboTax.”

The software, Cooper says, helps the firm ask questions like: “What are the really expensive points here? Do we really need to depose this expert?”

If you understand the risk, Cooper says, you can assess whether it’s worth the potential reward. One result has been that Tucker Ellis & West, which works mostly in the areas of defending mass tort claims, product liability, and pharmaceutical liability, is now deriving 60 percent of its revenues from non-hourly alternative fee arrangements.

Fasken Martineau, one of the largest law firms in Canada, is making legal project management a part of the firm’s culture through a series of “Lunch & Learn” and “Breakfast Club” sessions in which lawyers experienced in project management train six to eight other firm lawyers at one time.

“The intent is to break down barriers to understanding what LPM is,” says Sean Morley, a partner in the business law section. “In many instances lawyers are intuitively practicing LPM but not always in a disciplined way. We are developing standardized templates to assist in planning, budgeting and budget review, including task lists. We want to make the connection between planning discipline and cost-effective management of legal mandates. The firm is then in a better position to manage the file and to price it with a greater degree of confidence, whether the price is based on hourly rates or on an alternative fee arrangement.”

Clearly, LPM is gaining momentum.

As Foley’s David Simon summed it up: “It surprises me that more firms aren’t doing this already. Litigators need to think about a case from the point of view of the client’s business objectives. Corporate clients want more for less. . . . Your clients are telling you what they want you to do, so just do it.”

 © 2011 Bloomberg Finance L.P. Originally published by Bloomberg Finance L.P. Reprinted with permission. The opinions expressed are those of the authors.

November 09, 2011

Bloomberg Law Reports on Project Management (Part 1 of 2)

A few weeks ago, Bloomberg Law Reports published an article I wrote with Jonathan Groner entitled “Legal Project Management in the Trenches: What Lawyers Are Doing Today to Increase Efficiency.”  Part 1 of this article is reproduced below.  To download a pdf of the complete article, click here.

Any lawyer who has ever managed an associate or planned a budget has acted as a project manager. But a new movement is now underway to improve legal results by applying best practices from the formal discipline of project management.

The Project Management Institute (PMI) was founded more than 50 years ago for professionals who are focused on increasing efficiency in engineering, construction, government contracting, information technology, and other professions. PMI now has more than half a million members in 185 countries, organized into dozens of chapters and subgroups. But until last year, none of them focused on the law. PMI’s legal project management (LPM) community of practice was founded in September 2010, and already has more than 1,000 members.

When The American Lawyer published the results of its annual “Law Firm Leaders Survey” of AmLaw 200 firms last December, 55 percent reported that they offered legal project management (LPM) training to partners, and 34 percent said they offered it to associates. But there is a big difference between offering a workshop and getting lawyers to change their behavior. LPM requires a new mindset with increased focus on up-front planning, disciplined team management, and client communication. To date, there has been more talk than action.

Nevertheless, at some leading firms, internal champions have quietly begun taking the first steps toward changing the way the legal profession does business.

According to Samuel Goldblatt, former head of litigation at Nixon Peabody and now firm-wide co-chair of its LPM task force, the firm kicked off the Nixon Peabody Project Management initiative last January, and it has already led to a number of new engagements.

Nixon Peabody has trained hundreds of its attorneys and more than 80 of its paralegals and legal technology specialists in the methods, which include tools to assist with project scoping, budget planning, project/budget tracking, and client collaboration.

For example, one key aspect of the program is client debriefing – an exhaustive discussion between the lawyers and the key executives at the client company AFTER a deal or litigation is concluded. The topics, Goldblatt says, include: “How accurate was the budget? If there were changes, could we have anticipated them better? Did the economics work for the client? Did we have the right level of communication with the client during the matter?”

The constructive criticism at these debriefings, Goldblatt says, has often led to discussions of new engagements for the firm: “What is our next project going to be like?”

According to Stacy Ballin, the Litigation Group Business Partner at Squire, Sanders & Dempsey, and founding Chair of the firm’s Project Management Committee, her firm’s commitment to LPM grew out of the Association of Corporate Counsel’s Value Challenge.

“We accepted the Value Challenge a few years ago and rolled up our sleeves,” Ballin says. “The litigation group began by requiring an internal budget for all new cases, even if the client never requested one. We also required a case management plan that all team members could review to increase their efficiency.”

Then Squire Sanders opened the process to the client. A custom-designed extranet database called MyMatter contains all the relevant documents for each case – case plans, court pleadings, witness lists, expert information, deposition summaries, engagement letters, budgets, invoices, and more. This gives immediate access to the key documents in a single location to the Squire Sanders team, to in-house counsel, and to client representatives.

To illustrate how it works, Ballin described the example of a major international financial services company that is prosecuting a large number of foreclosure cases. Their in-house counsel and executives can access their MyMatter database in real-time and obtain a bird’s eye view of the status of every foreclosure case, including valuation determinations, expenses and potential risks. The client can also track the budget for each case and compare it to the legal spend to date.

At Squire Sanders, this extranet is just the tip of the LPM iceberg. Ballin was one of the first attorneys to complete LegalBizDev’s demanding Certified Legal Project Manager™ program, and she is now participating in its first Client/Firm Collaboration Workshop. In-house counsel from a large client and their Squire Sanders team will follow a structured brainstorming process to address the fundamental question raised in the ACC Value Challenge: “Working together, how can we improve the value of legal services?”

Similarly, David Simon, the Vice Chair of Strategy and Business Development for the Litigation Department at Foley & Lardner emphasizes a business-oriented approach to the firm’s cases. Litigators, he says, historically have been trained to read every single document that arrives at the doorstep during discovery – but “sometimes a client doesn’t want to pay for all that. We work with the client and say, ‘Here are the risks, the costs and the benefits. We need to make a judgment that is business-driven.’” Foley has developed a variety of internal tools to promote this business-driven orientation, including Foley LitAdvantage, a suite of tools that features, among other things, “a Master Checklist for new cases, designed to help firm lawyers tailor litigation work plans to the client’s business objectives, and the firm’s highly regarded Budget Management Tool software.”

Simon says Foley & Lardner’s approach is not only good for the client; it can also help differentiate the firm and increase its market share.

“Two years ago, I read the marketing description that we sent to clients,” Simon recalls, “and I said, Who cares? Every law firm in the country can say this stuff. We started with what our clients want to hear and built our service delivery model around that. I want to describe our firm in a way that differentiates, and LPM is an indispensable part of that.”

The current competitive environment is making this new way of thinking take hold. As Simon put it, “When lawyers find that they have lost a client to a firm that is efficient and effective in LPM, they listen.”

© 2011 Bloomberg Finance L.P. Originally published by Bloomberg Finance L.P. Reprinted with permission. The opinions expressed are those of the authors.

November 02, 2011

Legal project management tip of the month: Identify tasks that take 8 to 80 hours to complete

According to Erik Verzuh (in The Fast Forward MBA in Project Management, p. 134):  “The secret of successful project management [is to] break the project into small, meaningful, manageable units of work.”  Individual tasks should be manageable, should not overlap, and should be easy to track. Each activity should be budgeted for a manageable chunk of time (typically 8 to 80 hours).  The interval should be long enough to give team members freedom to perform the task as they think best, but short enough to assure accountability.

The first Wednesday of every month is devoted to a very short and simple tip like this to help lawyers increase efficiency, provide greater value to their clients and/or develop new business.