12/29/08

The Paradigm of Profitability

Thomas Kuhn's paradigm shift theory says that once a system (usually a scientific school of thought) has answered all the questions it can and then created a bunch of questions it cannot answer, a shift occurs and a new system emerges designed to answer these new questions. These shifts occur over time as schools of thought are born, grow and die. The legal profession is of course not immune to this idea, but it does tend to hold on to morbid systems longer as its main paradigm is precedence. This paradigm of precedence looks back, and as such remains blind or at least blissfully ignorant to many things in the future (and some things in the present). For quite some time (at least since 1994) I have wondered when the paradigm of the billable hour would mature and die enabling a shift to a new approach. Client pressure would surely force law firms to open their eyes and make the shift. Clients might even demand a new pricing approach. Well, three recent events have caused a shift in my thinking on this topic. 1) Ron Baker's post on the billable hour debate makes the point that pricing model changes come from sellers, not buyers. This of course challenges my theory that clients will drive change to firms. Ron makes solid points on why customer driven price pressure does not change the pricing model, merely the price. 2) ... which is playing out in large firms right now. Clients are really ramping-up the pressure for rate freezes and discounts. Neither of these actions change the pricing model, they merely increase the financial stress on law firms. Firms are initially reacting within their known field of comfort, doing all they can to hold the line on expenses. These efforts will buy firms time. One might argue that the length of the current economic downturn will be pivotal. Firms may ride out the downturn like they have in the past. Things always go back to normal, to the way they were. Don't they? 3) Maybe not this time. Susan Beck's article notes that seven of the best leveraged law firms in the US have announced layoffs or even dissolved this year. What? Leverage is the bedrock of profitability for for firms. Beck comments on leverage:
It seemed like a sure-fire way to make money. But high turnover and rocketing salaries ate into profit margins. Now, the whole pyramid model is looking fragile.
The combination of these three things brings me to a new position on the billable hour. Law firms shifting to non-billlable hour pricing will come from profitability pressure, brought in part by client rate pressures. Clients can bring certain pressures to bear on profitability, but they are not in a position to dictate law firms' business models. Which brings us to profitability. Law firms do not measure profitability. This statement may and should sound crazy. Firms measure billable hours, utilization, realization and hopefully leverage. But none of those measure profitability. Even Profits Per Equity Partner (PPEP) is not a profitability measure. That measure does not tell you the margins a firm has on revenue, only the average pay of an equity partner. My Theory: Financial pressures on firms will shift the focus away from leverage to profitability. This focus on profitability will shine a bright light on the limitations of the billable hour. And this in turn will open the door to law firms seriously exploring alternative billing methods.

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9 comments:

USA Best lawyer directory said...
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Jackie Hutter, Intellectual Property and Patent Business Strategist and "Recovering Patent Lawyer" said...

In an unregulated system, I believe your theory of profitability replacing leverage would play out. However, innovation historically has been limited (or even retarded) in regulated environments. In my opinion, this is why we see the medical and legal professions operating in clearly inefficient manners, even while other businesses have changed their models or failed. Law and medicine may be the last bastions of the guild i.e., leveraged, professions (along with academia-but that's a different story). We see medicine changing today, but at the most basic level, lawyers make the rules that all of us play by. Accordingly, I think that it will be a longer time before we see fundamental change in how the legal profession as a whole functions as a business.

Toby Brown said...

Thanks for the comment Jackie. Change may well still be a ways off for lawyers, but I sense a new level of pressure on firms. Your point on guilds is well made too. I've long told lawyers the three letters they should most fear are: H M O. The doctors waited too long to change and let the insurance companies take over their industry.

Thanks again,
Toby

Brett Owens said...

Great analysis and discussion.

I've spoken with a couple of managing partners recently about this, and they've mentioned that they have a very hard time getting a handle on the profitability of fixed price contracts.

One partner in particular mentioned that they are now inheriting business and existing fixed priced contracts from competitors, and he's not sure if they've make money on one yet.

Do you see smaller, more agile firms getting a grasp on profitability before the larger ones can rechart their course?

Jackie Hutter, Intellectual Property and Patent Business Strategist and "Recovering Patent Lawyer" said...
This comment has been removed by the author.
Jackie Hutter, Intellectual Property and Patent Business Strategist and "Recovering Patent Lawyer" said...

I am reluctant to hi-jack this thread, but this is a topic that I am fascinated by and I feel that I have to respond to Brett at a couple of levels.

First, in relation to the fixed price contract issue, I am very familar with this topic because often patent matters are done at a fixed price within a range. This can be hard for many patent lawyers to get a handle on and, as a result, when I was a patent law firm shareholder, I wrote off huge amounts of time when associates (and partners) could not meet the negotiated fixed fee limit.

In short, it is very hard to instruct someone as to how much is enough and lawyers, by their very nature, are perfectionists. In truth, many lawyers are unable to function in a fixed price environment. In this regard, a dear friend of mine at a super high end patent law firm related this to me about fixed price scenarios at her firm. When a new patent attorney asks her how long it takes to read a patent she responds "How long do I have?"

This is the crux of profitability in fixed price scenarios and this question is no different from the question that guides any business: how much do I have to charge for my product to make the profit I want? Sometimes, you must decide not to make a product because it makes no sense from a business perspective.

Law firms are no different in that the managing partner must know what her margins need to be and then back the total to be obtained from the fixed price contract out of this margin. If quality work cannot be done with that profit margin, then the work is not "profitable" to the law firm. Still further, if the law firm cannot do the work "profitably" within the confines of the fixed price contract, they should either try to negotiate a higher rate with the client or decline to take the work. Of course, in this day and age, a law firm managing partner may need to adjust her perception of what "profitability" means.

In short, no business is in business to lose money. Clients understand this, and good clients will try to work with their lawyers to get the appropriate results at the appropriate price. However, as has been discussed on this blog before, often clients and lawyers do not know how to have this conversation and the "dance" of alternative billing never starts, leaving both parties unsatisified.

Second, as for Brett's comment about whether small firms will be successful, I think that the model that has been and will continue to emerge is the so-called "micro firms" where highly experienced attorneys with low overhead will be preferred providers of many services (but probably not litigation). As corporations move toward virtual employees, they will become less accepting of the overhead that comes with high end law firms. And, as corporate travel becomes less desirable, there will be less need to impress clients with groovy offices and cute receptionists.

I could go on and on, and I will likely write a blog post on this topic in the near future.

Julie said...

Excellent post! I have found the lack of focus on (or ability to find) profitability in law firms to be quite frustrating in my years. As an admin professional in this industry, I have this argument constantly, and particularly so at budget time. The way to get more $ in a partner's wallet isn't simply by reducing overhead ...

And although the industry is slow to innovate (waiting until others have tested the waters first - precedent, ya know), I do think a paradigm shift is coming. I don't think it will be an abrupt shift, and I don't think it will be a shift exclusive to small/micro firms although they may well pave the way.

One of the big problems I see is that there are very few good lawyers (at least that I have worked with over 10+ years) who are also good business people. And typically, those who are good business people are usually not the managing partner, and don't want to be for lack of desire to beat one's head against a brick wall a hundred times a day.

NEERAV said...
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yogendra said...

i agree with you. Excellent post! I have found the lack of focus on (or ability to find) profitability in law firms to be quite frustrating in my years. As an admin professional in this industry, I have this argument constantly, and particularly so at budget time. The way to get more $ in a partner's wallet isn't simply by reducing overhead ...

And although the industry is slow to innovate (waiting until others have tested the waters first - precedent, ya know), I do think a paradigm shift is coming. I don't think it will be an abrupt shift, and I don't think it will be a shift exclusive to small/micro firms although they may well pave the way.

One of the big problems I see is that there are very few good lawyers (at least that I have worked with over 10+ years) who are also good business people. And typically, those who are good business people are usually not the managing partner, and don't want to be for lack of desire to beat one's head against a brick wall a hundred times a day.
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yogendra
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