In this two-part series, we examine how profitability analysis has become a crucial strategy for many smaller or solo-practitioner law firms and how these firms can best capture the profitability they need to flourish
The formula for law firm profitability had been the same for well over a century and is shockingly simple: bill as high an hourly rate as possible to cover costs and then some. This formula applied to all lawyers, from solo-practitioners to small law firms on to the largest law firms.
Of course, moving beyond this simple formula takes time to consider and critically examine the revenue, costs, and methods of practicing law. To the lawyer, the limited billable time in a day cannot be wasted in doing so. Thus, law firms merely set the prevailing hourly rates for their lines of work in their community; and ultimately, consumers had no influence on price because the only marketplace was the one established by lawyers.
The ever-rising hourly rates were justified to consumers because practicing law is indeed complex, though not all aspects of practicing law are equally complex. Nevertheless, many in the legal profession insisted that profitability would sully the integrity of law. The practice of law is an art, they contended, and the result yields what it yields. For the most part, many legal services have always beyond reproach — short of a malpractice accusation — and therefore, the price to consumers and the cost to law firms related to these methods stayed beyond reproach, too.
Even when presented with cost saving methods, such as electronic research, the billable hours that could have been saved were merely worked and billed in other ways.
Today, however, there many more alternatives fueled by technology, money, vision, and changes in regulation. Today’s clients expect great service, value, and results — all at a price they perceive to be better, just like everything else they buy. This creates downward pressure on prices for all law firms.
The largest law firms spent billions of dollars and hired expertise to meet the challenge with improved profitability as the goal. Meanwhile, most lawyers seem oblivious as rates and services have remained steady, creating a “take it or get no services” proposition for consumers. In the face of this failing model, profitability analysis should be a welcomed change.
What is profitability?
For most midsize to smaller law firms, profitability is the balance in the operating account — cash on hand to pay office rent, salaries, the mortgage on the house, college tuition, all with some left over. In short, bringing in more revenue than the expenses.
In reality, this has little to do with actual profitability.
To stay competitive all lawyers must examine and measure the actual variables of higher profitability. That means managing costs and pricing & revenue, along with other variables that I will discuss in the second installment. Now, let’s look at how cost and pricing & revenue can be addressed to improve profitability.
In nearly every other business, examination of costs is a critical function. Concepts such as margin, fixed and variable costs, operating leverage, billing utilization and collection, return on investment, and cost per unit, while crucial, are seldom part of a law firm’s business plan.
Consider for example lawyer wages. In business, labor and wages are generally considered variable costs. The more a business produces, the more labor the business needs — and this holds true for law firms as well. Yet, where law firms disconnect from other businesses is in that their associate wages are often seemingly an entitlement based on the number of years an associate is out of law school.
Some will argue that this is how professionals are paid. In other businesses, however, costs, including wages and profit, are driven by many variables in the marketplace. In law, wages of lawyers and support staff are merely baked into the billable hour. Associates are expected to bill hours to the detriment of their lifestyle in order to cover expected wages plus partner profit. And because law firms compete for talent based upon the entitlement system, the labor cost analysis is stunted from the outset.
Scale is another critical element of cost. Instead of partners merely passing billable hours onto associates, which is not scaling, the analysis should be how to efficiently scale everyone’s time and work, including staff. Lawyers and staff must be keenly aware of how they spend all their time, including on flat fee and contingency matters, and not just the time that ends up making it on to a bill. Through this, everyone at the law firm can consider the actual cost of labor, the return on investment, and then find ways to scale. As in every industry, when scale improves more money is made by everyone.
Price & revenue
The idea of doing work at a lower price seems anathema to most attorneys; however, some work will have to be done at a lower price point. When it is done more efficiently and at scale, more work can be done, which can actually bolster revenue. While the challenge in this scenario is finding more work and clients, lower prices should attract more clients and bills should be easier to collect, which equals more revenue.
Other legal work can be done at the same price or even higher prices, if clients find value in the product — even when that work is produced at lower costs unbeknownst to the client. Examples of this span the horizon of the changing legal marketplace — from the complex, such as cross-discipline collaboration, multi-jurisdictional practice, and artificial intelligence to simpler things, such as lower real estate costs made possible by remote work, document automation, texting and video communication, better billing and meaningful use of technology that will lower costs and lead to better financial outcomes.
There is more to explore related to calculating and improving law firm profitability, and we will explore that in the next part of this series as we examine client expectations, how to capture measurable data for profitability, and the ultimate benefits of robust profitability analysis.
Next: How law firms can best capture profitability and its benefits