By Steve Barrett, Principal, LegalBizDev
Several years ago, an AmLaw 100 COO told me that his kids' Boy Scout troop had a more sophisticated financial management than his firm. I remembered that…
We all were saddened by the recent passing of CBS TV’s 60 Minutes curmudgeon Andy Rooney. But his death leads one to question some basics in our professional lives, as Rooney often did. With the serious challenges facing the legal industry since the 2008 downturn, the expressed need for far more predictability and transparency of costs by major law firm clients, and the dip in law firm revenues, staffing and profitability, some thoughts arise.
The other night I was re-reading the Hildebrandt Baker Robbins/Citi Private Bank 2011 Client Advisory, a report that I’ve found gets to the heart of what’s going on amongst major law firms. Several numbers leapt off its pages:
- From 2001-2007 “demand for legal services was growing at…4.5% or so per year and…(firms passed along) annual rate increases in the 6-8% range.” (p. 5)
- Secondly, while the 2010 HBR/Citi report noted a softening in law firms’ 2009 realization rates, this latest report notes that (chart 9, p. 13) by the end of the 3rd quarter of 2010, they had softened even further – even after more than 18 months of law firm headcount reductions and cost containment. Indeed, billing realization averaged 89% and collection realization 87%, among the respondents.
What conclusions can we draw from these numbers? In the first case, when times were good law firms’ rates increased much faster than the rate of demand growth. So while the pie was growing, law firms’ appetites grew even faster (or their financial management wasn’t so hot). Wonder how table manners would respond to a shrinking pie?
In the second case, combining the two realization rates, we see that law firms didn’t bill some 11% of their incurred hours (the 89%), and then also didn’t collect 13% of what they billed (the 87%). Taken together, these two figures yield a combined realization rate of approximately 77% (0.89 X 0.87=0.7743). Thus, in a rough sense, everyone’s been giving away an unintended 23% discount.
If major clients walked into a firm and demanded a 23% off-the-top, first dollar discount, brows would furrow. But what if ALL clients demanded that discount? Likewise, if a sophisticated Fortune 500 company’s management saw a recurrent 23% hit to their gross margins, whether from inventory shrinkage, loss, or inefficiency how long would it take for them to find the source and correct it?
In the past there's been little serious cost accounting – of the sort most big product-driven enterprises do – in the legal business, and there’s been little pressure for granular examination of cost structures. Just add everything up at the end of the year, subtract expenses, set associate and staff bonuses, divvy up the remainder and give it to partners. (A decade or so ago, I read that when the three major accounting software vendors - Aderant, Elite and Juris - were polled, they reported that only a tiny percentage of their law firm customers had either installed or used cost accounting software modules.)
Almost all law firms practice cash accounting, and most of their indirect costs of servicing clients (copying, telephone calls, travel, lodging, etc.) have traditionally been reimbursed by clients, lessening the need for comprehensive cost accounting. There are many firms who still mark up reimbursements (e.g. charge $2 per page for faxes when they cost pennies, 15 cents per page of copying, when Kinko's or Staples can do it for much less, add handling charges to telephone costs, etc.). So there’s been little pressure to seriously examine costs of service.
Hourly rates have often been set based on the “rule of three”: multiply salary by three so that 1/3 covers salary, 1/3 overhead (direct + indirect) and 1/3 partner profit distributions. About the most significant adjustment made for cost variability is to set attorney hourly rates for expensive markets (e.g. New York, Los Angeles, DC, San Francisco) well higher than less expensive markets (like Atlanta, Denver, Omaha, Seattle and countless smaller markets). This is because their payroll and occupancy costs are so much higher. And each year rates were re-set like clockwork after budgeting time, by incrementing them upwards to cover next year’s projected costs.
BUT…law firms do spend a maniacal amount of time tracking and measuring HOURS. Hours are – after all – not only the firms’ products, but also their inventory and Work-in-Process (WIP). They’re the key component of most firms’ associate and partner compensation. What gets measured, gets managed, right? As Paul Lippe recently pointed out in a piece titled “Managing What You Measure” on LegalOnRamp: wrong! He correctly says that what SHOULD get measured is “Value.” But it’s stunning that perhaps the most-measured “value” in law firms is time. Partners are compensated through Byzantine hours-based formulae, associates are bonused and advanced based on hours, firm performance is reported in units of time (“3rd quarter hours are up/down”). In tenths of hours, no less!
But we’re losing 23% of the revenue from all this time by not billing it, or not collecting that which has been billed. (This ignores hours worked but never recorded, but that’s another post.)
Let’s have a closer look:
Traditionally, most firms have struggled to police their WIP, since they haven’t been able – despite all sorts of initiatives – to get timekeepers to post their time promptly. Remember, time equals overhead, inventory AND product. An hour worked on the first day of this month often won’t appear on a pre-bill until after the end of month, get billed in mid-next-month, and collected 45-60 or 90 days later. So WIP/inventory typically goes unpaid for from three to five months. But the “suppliers” (timekeepers), landlords, equipment lessors, Lexis and WestLaw are all paid in “real time.” So law firms start out well behind on the cash flow curve.
And who hasn’t heard the story of the associate given a task that should take five hours and he does it in 65? Or the partner who submits $5,000-$10,000 in time from last March spent on a deal (and file) that closed before Labor Day? So…when it comes time to up the efficiency of law firms, using Legal Project Management (LPM) and process improvement, one of the key constituents on the path to making gains stubbornly resists management. Even in law firms where filing, document management and library systems have been bar-coded for years.
LPM encourages more-frequent matter status updates. If we cannot get all the costs entered at least every week, how are we ever going to get our arms around this problem? Efficiency gains are becoming mandatory, and clients expect them. Project management can substantially reduce that 23% going out the window. It minimizes surprises. It mandates time allotments for tasks assigned to others. It demands real-time querying of case status. It prefers daily time entry, but could settle for weekly. In any event, it cannot tolerate March time appearing in late August…or hours filed in the wastebasket.
One positive thing about many alternative fee arrangements is that they provide a real opportunity to improve cash flow. Some are based on an annual or monthly retainer, paid in installments. Some propose a stated number that can be pre-billed, then adjusted after the matter’s conclusion. Where pre-agreed figures are settled on, it becomes simple to seek half down, half on conclusion, or a third, third and third…just like an orthodontist or your kitchen remodeler. AFAs can also greatly reduce the staff needed for processing all those hourly invoices, reimbursements, etc.
Of course, today’s competitive environment is changing everything. Firms are improving their financial systems, their internal procedures, their matter management, progress tracking and billing processes. The ones that move quickest are most likely to thrive in this “new normal.”
Before Steve Barrett became a principal at LegalBizDev, he spent nearly two decades heading marketing at four AmLaw 200 firms and consulting to many more. After reviewing drafts of the pricing series that started recently in this blog, he sent a long e-mail ruminating on his personal views of law firm finances. That e-mail evolved into this week’s guest post by Steve.