10/24/12

The Economics of Law and the Future of Legal KM - Part 2

In Part 1 of this series, we introduced the concept of tying Legal KM (LKM) closer to a law firm's bottom line  We also introduced the concept of law firm profitability  In Part 2 we explore the first 2 (of 4) profit drivers for firms: Rates and Realization

The Profit Drivers:

Rates

Although obvious, the point needs to be made. Billing Rates are the core pricing structure used in the industry and the level of a firm’s rates are key in determining its level of profitability. As a rule-of-thumb, a 1 point increase in rates leads to 2 points increase in profit. The reverse applies as well. In my experience, there might be a range of 1% to 3% increase in profit for each point of rate change. The range exists since it depends on the specific time keepers involved and the relationship between the billing rates and the time keepers’ cost rates (more on that later).

Realization

Realization is the percentage of money collected versus the standard rate. Once you have a standard rate there are three basic ‘events’ that drive down the actual dollars collected against that rate.

#1) Discounts

Discounts are the market (via specific clients) telling a firm their prices are too high for a piece of work. One might think firms should lower their prices in response to his information, however, that could be a mistake. Sometimes clients shop price by the level of discounts. They are not concerned with the actual price but instead focused on the amount of discount they are extracting. Whether this is rational behavior in an economic sense is not relevant. Firms need to adjust their pricing and pricing strategies in response to the market, but need to do so in smart ways.

#2) Write-Downs

These are reductions from a bill before it goes to the client. This reduction signals the firm / partner deciding certain effort had no value. This becomes important as firms look for ways to lower the cost of delivery of a service. By identifying recurring types of write-downs and eliminating the effort before it is done, a firm will lower the costs of the service.

#3) Write-offs

These are reductions requested by the client after they have seen the bill. This client signal says they did not see value in some effort. This may occur because a firm did not communicate the value of the effort properly or it may just be that work should not have been done. It should be noted that in some cases, write-offs are just good ole fashion flakey clients who don’t pay their bills. For this discussion, we will treat that as a cost of doing business.

Adding these three elements, gives you total realization. The final number is important, but the three components are instructive as to what is driving a level of realization.

The impact of realization is much the same as that of rates. A 1% drop in realization will, on average, result in a 2% drop in profitability. Well, at least it does when you are relatively close to 100% realization. As that realization number drops, the impact magnifies. As you approach 60-70% realization, it becomes infinite. This is the case since you are approaching the cost rate levels of most time keepers. This means you are reaching the point where your margin goes to zero and when you pass that point it goes to negative. At a general level, this point-of-no-return is about 67% percent. However, it can vary based on the mix of timekeepers involved in a given piece of work. Some time keepers cost rates can be 50% of billing rates, whereas others may be closer to 80%.


In Part 3, we will take on the other two profit drivers: Productivity (a.k.a. utilization) and Leverage.

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2 comments:

Tony Chan said...

Toby, thanks for insightful analysis.
I'm wondering where you obtained the figures below. I'm assuming that this applies to all firm sizes. Is there any literature that I can read up on?

A. 1% increase in rates leads to 2% increase in profit.

B. 1% decrease in realization leads to 2% decrease in profitability (with a 67% threshold)

Toby Brown said...

Tony - good questions, and sorry for the delayed response.

Actually classic law firm financial management books explore these concepts. I recall Arthur Greene's book laid this out well.

Arthur's book was actually written for small firms, so yes the metrics generally apply to firms of all sizes. The one exception would be a solo lawyer, since they are the only timekeeper.

 

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