Making Money in a Margin World

Revenue - Cost = Profit: The basic equation that governs business. Yet this remains an elusive, not-yet-understood equation for most law firms. This fourth post in a series on law firm profitability will examine what this equation could and should mean to law firms.
As various legal markets shift from rates to fee pricing, the law firm business model will need to shift from a cost-plus model to this new (actually old) margin model. My good friend Kingsley and I presented at TECHSHOW last spring and used a slide that sums this transition up well:

The first bar shows how much firms used to make on a given piece of business. The second bar illustrates the impact of market price pressures. What use to be $25k, is now selling for $20k. The third bar then shows our challenge. How do we move the cost of services line to the left to restore profitability? I would note that this shift is independent of AFAs. The same market pressures are occurring regardless of the type of billing used.
I want to emphasize the magnitude of this challenge. Law firms have lived in a cost-plus world for 50 years and their structure reflects that. This history has ingrained a deep mindset that hours equal profits. Every aspect of a firm’s structure is currently driven to this end. Most importantly, compensation almost exclusively rewards this behavior. That being said, let’s explore what issues firms will need to address.
First off – firms have spent considerable effort in the past two years cutting overhead in an attempt to maintain profitability. By cutting various costs, usually administrative, they lower a firm’s overall “Cost” (see our initial equation), holding the line best they can on profitability. This effort is typical and healthy in a downturn. However, “cutting your way to prosperity” only takes you so far. At a point you have to turn your attention to cutting the cost of service delivery. This approach actually requires investment. Firms need to invest both money and time into changing their delivery models such that the cost of delivering a service goes down. This enables firms to compete in a market where pricing pressures exist as they do now.
As a professional services firm who sells time in some fashion (whether it’s priced by the hour or not), a law firm has two options to lower its cost of delivery:
  1. Cut the amount of time it takes, or 
  2. Reduce the cost of time. 
 The first option is the focus of much discussion right now, especially related to LPM and process improvement. The second approach has had much less attention (if any) and requires: 
  1. paying people less, 
  2. giving people less resources to do their jobs, or 
  3. pushing work to lower cost labor sources (a.k.a. leverage). 
 In the next post of this series, I will peal back the layers on these two approaches and explore the potential of success using them.
Even at this level of discussion, the depth of the challenge becomes obvious. Law firms have deeply embedded attitudes and structures designed to:
  1. increase the number of hours it takes to deliver, and 
  2. increase the price of time. 
 So for law firms to succeed in this emerging market dynamic, they should focus first on changing these attitudes and structures. Compensation is an obvious place to start, but also the most daunting to change. Messing with someone’s income is never taken lightly. Yet if it isn’t address, that income will increasingly become jeopardized because clients are not concerned with how firms pay their people.
This brings us back to our main issue – law firms need to shift their structures and focus to delivering more for less to their clients. And the focus on “less” should be internal. Merely giving bigger discounts and providing fixed fees only addresses the external needs. The internal needs of using fewer and cheaper hours are where the real work lies. As mentioned, the next post in this series will look at the specific options for how firms can meet this challenge.
My prediction/hope: 2009-2010 were the years of reducing overhead. 2011 should be the year of reducing the cost of the delivery of legal services.

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