AFAs and Secret Codes: Knowing Cost Rates

Jordan Furlong added an excellent comment on a recent post and followed up with a personal note encouraging me to expand and define the idea of a cost rate versus a billing rate for a lawyer, or any other time keeper. So here we go.
There is an old Rule of Three that generally applies to non-partner time keepers that says the billing rate of a time keeper should be three times their hourly compensation. Looking at it from a profit perspective, this rule suggests that the hourly billing rate of this time keeper has three portions: The first is compensation. The second is overhead (benefits, office space, computers, software, admin support, etc.). The third is profit (a.k.a. partner comp).
Implied in this rule is a cost rate (composed of the first two portions) that is about two-thirds of the billing rate. As noted above, this is a general rule. Cost rates can actually vary from the 67% of billing rates quite a bit. So what becomes important is the difference between the cost rate and the billing rate. This really determines the profitability of a non-partner time keeper on an hourly basis. And this becomes important when a firm starts discounting billing rates, since a 10% billing rate discount would actually be a 30% reduction in profits under the general Rule of Three.
Where do cost rates come from?
At the highest level, an hourly cost rate equals the overall cost of a time keeper divided by the number of hours they bill (or should bill). If their comp is $100k per year, their overhead is $100k per year and their billable hours are at 1800, then their cost rate is $111 per hour (200k / 1800 = 111). Some firms use two cost rates – one based on a projected number of hours billed (e.g. the 1800) and another based on the actual number of hours billed. If the actual number is higher than the projected number, then the “actual” cost rate is lower than the “projected” one.
The challenges for calculating cost rates come in establishing the overhead cost number per time keeper (harder than it sounds) and agreeing on the appropriate number of projected hours. Using actual versus projected rates is a point of contention for most firms, as each rewards a different kind of behavior by partners.
Why would cost rates matter for an AFA?
Profit = Revenue – Cost. In a fixed fee AFA, the revenue is equal to the fixed fee, so we need to know our costs in order to determine the AFA’s profitability. The most direct way in a professional services environment that sells people’s time is to add up hours times cost rates to get that cost number for the equation. This means in a fixed fee arrangement to maximize profit you will want to push tasks to their lowest appropriate cost source since that will minimize the cost number in our equation. Having a $200/hour cost rate time keeper do tasks a $100/hour time keeper can do drives down profitability.
As you might guess this type of thinking runs directly counter to traditional hourly billing thinking. Looking at billing rates only, you would be encouraged to use the highest appropriate billing rate time keeper for each task since that behavior maximizes revenue.
This conflict highlights a fundamental challenge for law firms. Most compensation systems currently reward revenue, NOT profitability. Firms looking to embrace AFAs in a profitable way will need to face this question head-on. Taking on fixed fees and other AFAs and continuing with traditional ways of practicing that encourage the use of high cost rate people will lead to reductions in profits and failed firms. Given the nature and significance of this challenge, I expect to see a number of firms fail this basic math test.

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Wheels of Justice said...

Great post BUT I disagree with some of your assumptions. Costs have little to do with hours, so if you estimate costs based on hours, you will probably not maximize profits. Profit maximization is defined as MC=MR. Marginal Cost equals Marginal Revenue. You do not incur additional occupancy cost, insurance cost, utilities cost, or most importantly personnel cost (professional, paraprofessional or staff) when someone bills an hour - that is, unless you pay them by the hour (which is pretty rare except for contract lawyers and paralegals). To the contrary, when an additional hour is worked (regardless of whether it is billed as such), you make better use of the largely fixed costs that are associated with your firm's structure. Since you cannot stop the flow of tie, assigning an hourly rate and calling it a "cost" is always going to lead you in the wrong direction. Check out the discussion at the Alternative Fee Lawyer's group on LinkedIn for a lively debate on this topic.


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