The Unkindest Cut: Why Efficiency May Be Better than the Knife in Improving Profitability

Topics: Billing & Pricing, Law Firm Profitability, Law Firms, Peer Monitor, Thomson Reuters

Q3

I recently had the opportunity to co-present a webinar with Jack Bostelman, President of KMJD Consulting. The initial concept behind the webinar, entitled Tracking and Growing Your Profitability: Strategies for Competitive Law Firms, was to discuss how law firms are looking to make strategic cuts in expenses in order to boost profitability. There’s a problem with that focus, however. Cutting expenses can only take a firm so far when it comes to protecting profitability.

Firms are encountering difficulty with their traditional strategy for growing profitability: bill more hours at higher rates. Peer Monitor and other sources show us law firms continue to raise their standard “rack” rates. But those increases are not translating into higher rates billed and collected. And law firms’ impulse to offer discounts off of hourly rates only result in a lower realization rate. Data also shows that demand has fluctuated but stayed relatively low, and expenses continue to grow steadily at around 5% year-over-year. So what is a law firm to do when rates are being held down, expenses continue to grow, demand is far from encouraging, and clients continue to push back on bills?


Cutting expenses can only take a firm so far when it comes to protecting profitability.


The first impulse seems obvious: cut expenses.

One great example is the efforts firms have taken to reduce headcount. Early in the recession we saw firms either limiting or completely eliminating their summer programs and first-year classes. In the short-term, this was a way to limit the expenses associated with those programs and those timekeepers who were the least likely to be revenue positive. In 2008 and 2009, when the legal market went into a tremendous tailspin, not paying young associates was a seemingly reasonable way to protect profits per partner (PPP).

But how did that work out long-term? Not as well.

While expenses are one lever firms can pull to impact profitability, they are only one lever. Another key lever, and perhaps a more impactful one, is a firm’s leverage — that is, the ratio of fee-earners to equity-owners (a.k.a, all attorneys compared to partners). Law firms that can use leverage to push work down to lower-rate timekeepers can increase the overall profitability of a matter, even if it takes longer to complete. The problem many firms are encountering now is they don’t have a large enough pool of seasoned associates to whom the firm can push the work down. Why? They didn’t hire them a few years ago. For the sake of protecting PPP in 2008 and 2009, firms limited the strength of their bench in the long run. A firm cannot survive on laterals alone. Cutting expenses can only take a firm so far before the fat has been trimmed and you begin cutting into muscle and bone.

So if the answer isn’t cuts, what is it?

Growth. Or perhaps more accurately, increasing efficiency for the sake of encouraging growth. When I start talking to lawyers about efficiency, often the first reaction I get is “Why would I want to be more efficient when I get paid by the hour?” My response: Is there really a downside to being more efficient?


Even if you are the rare lawyer who has a 100% realization rate on their hours at rack rates, efforts to become more efficient will not hurt you.


Few lawyers get paid for 100% of their time. For those that don’t, any gains in efficiency go straight to the bottom line. As Jack modeled it out in the webinar, in a firm where 5% of partner hours and 10% of associate hours are lost to write-downs, efficiency efforts that can cut those figures in half lead to an 11% increase in PPP. Market research conducted by Thomson Reuters shows that these assumptions regarding write-downs may actually be incredibly generous. In a study a few years ago, we found that the average associate with a billable hour requirement of 1,875 hours lost 545 hours (nearly 30%) per year to write-downs and write-offs. Think of how much money that represents.

Even if you are the rare lawyer who has a 100% realization rate on their hours at rack rates, efforts to become more efficient will not hurt you. And if there is new work available, then the additional time gained by becoming more efficient can go to that new work, keeping utilization stable, allowing overall fees to actually decline, and preserving the firm’s profitability. But what if new work is scarce? Time generated through efficiency can be used for business development to create new work opportunities. Efficiency also frees up time to devote to existing client relationships. (BTI Consulting has some amazing data on the positive effects of a focus on client relationships.)

And you can rest assured that even if your firm isn’t making efforts to reduce rates through efficiency, your competitors are. You may well find yourself in the equivalent of a “fare war” — pressured to meet reduced rates offered by more efficient competitors. Would you rather be fighting that “fare war” on offense or on defense?