« Legal project management tip of the month: Focus on communication | Main | The future of legal services: More project management and better collaboration »

December 14, 2011

Legal pricing (Part 3 of 8): Price competition, discounts, and loss leaders

“Law Firm Price Wars Break Out as Some Try ‘Loss Leader’ Bids for Work” said a November 2009 headline in the ABA Journal. The article was based on a post from this blog quoting AmLaw 100 senior partners who said things like:

“I have become aware of a large number of bids by competitors which I don’t think are sustainable…”

“Some firms are bidding alternative projects at very low costs. These are loss leaders which cannot survive in the long term.”

“Many firms are willing to discount their fees in order to keep people busy... It’s a jungle out there.”

In the two years since this piece appeared, in many markets legal price wars have evolved from front page news to a way of life.

As Peter Zeughauser noted recently in The American Lawyer (October 2011, p. 64): “The Achilles heel of many firms is that they use discounting to achieve high levels of client satisfaction … without focusing their partners on improving profit margins.”

This problem is familiar in other businesses. The widely quoted text The Strategy and Tactics of Pricing (p.4) notes that:

Customer satisfaction can usually be bought by a combination of over delivering on value and under pricing products… The purpose of strategic pricing is to price more profitably by capturing more value, not necessarily by making more sales.

Discounting can have a bigger much bigger effect on profitability than you might think. If you want to work through the math, see the table below to review the effects of a 10% discount for Beth, the fictional labor and employment lawyer we introduced in Part 2 of this series. Or you can skip the table and take our word for it: in this case, a 10% discount reduced profits by 80%.

 

No discount

10% discount

Salary

$250,000

No change

Number of hours worked

2500

No change

Salary per hour

$100

No change

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

$200,000

No change

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

$ 50,000

No change

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

$100,000

No change

Total expenses

$350,000

No change

Actual hourly rate

$200

$180

Total revenue (Realized hours x hourly rate)

$400,000

$360,000

Profit (loss) for end of year bonus or correction

$ 50,000

$10,000

When law firms calculate their partner compensation for 2011, many will see all too clearly how last year’s discounting reduced their income much more than they expected.

Lawyers often justify discounts as loss leaders, under the theory that low prices will start a new relationship and later lead to more profitable work. But will it? Once clients become accustomed to low rates, it will be very difficult to get them to pay more.

As Ron Baker notes in Pricing on Purpose (page 146):

…purchasing agents have been rewarded for demanding low prices by getting discounts, concessions and other price decreases, thereby creating little Pavlov’s dogs. If you subsidize something, you get more of it, including low-price buying behavior.

If you do decide to use loss leaders to build new work, it might be wise to make sure the first job is a large one. A few years ago, Ron Paquette published an article (in the September 2007 issue of Strategies: The Journal of Legal Marketing) describing research conducted by Redwood Analytics to evaluate the widely held idea that small jobs often grow into big clients:

It’s called the acorn theory – from a tiny seed of work in one legal area can grow a mature oak of a client, which provides work across many practices. Nice theory. But how often does it happen in practice? We thought this theory was largely a myth… We’ve observed that regardless of the firm involved, most large clients appeared to have retained the firm for significant matters from the start of the relationship.

So Paquette and his colleagues looked at the top five percent of clients at one AmLaw 100 firm, and went back 23 years to see whether these clients had started large or small. More than 90% had started large (that is, already in the top 20% of the firm’s clients in their very first engagement). When Paquette analyzed similar data from an AmLaw 200 firm, they again found that today’s large clients had been large right from the start (in this case 84% of the clients). They concluded that:

Firms should be highly selective with regard to small clients. It is commonly held that small clients are on average less profitable than large clients. If your firm’s growth strategy depends at all on growing small clients into larger and more profitable clients, think hard about the likelihood that this will happen.

So what should law firms do? There are no easy answers in today’s challenging environment. But when this series resumes in a few weeks, we will continue to explore what lawyers can learn from pricing experts in other professions.

This post was written by Jim Hassett and Matt Hassett.

TrackBack

TrackBack URL for this entry:
http://www.typepad.com/services/trackback/6a00d8341c72a653ef0162fdbb377c970d

Listed below are links to weblogs that reference Legal pricing (Part 3 of 8): Price competition, discounts, and loss leaders:

Comments

"Once clients become accustomed to low rates, it will be very difficult to get them to pay more."

Exactly!

I argued publicly against the sustainability of lowering prices in 2009, when law firms were resorting to chopping prices as a short term solution to the recession. Many in the blogosphere argued that prices were inflated and to compete firms had to lower their prices.

I never understood this logic from clearly intelligent people. The most likely outcome, if you succeed at first, is a price war. Your success would inevitably be copied by otherwise intelligent people now panicking. Or as you mentioned, by clients increasingly demanding lower prices! If you're lucky to be part of a highly efficient law firm or at least one with very deep pockets, you can at best hope to be the "last one standing", the pyrrhic victor of a price war.

I wonder if it could have been infinitely more rewarding for firms to collaborate with some of their clients and competitors in a more candid and transparent way to find mutually agreeable solutions.


Jorge
Founder of The Online Bar
www.theonlinebar.com

Verify your Comment

Previewing your Comment

This is only a preview. Your comment has not yet been posted.

Working...
Your comment could not be posted. Error type:
Your comment has been saved. Comments are moderated and will not appear until approved by the author. Post another comment

The letters and numbers you entered did not match the image. Please try again.

As a final step before posting your comment, enter the letters and numbers you see in the image below. This prevents automated programs from posting comments.

Having trouble reading this image? View an alternate.

Working...

Post a comment

Comments are moderated, and will not appear until the author has approved them.

My Photo