10/26/12

The Economics of Law and the Future of Legal KM - Part 4

Having defined profitability and categorized the four drivers of profit for firms, in Part 4, we now turn to the market's impact. 

Why Does This All Matter?

Over the past five to ten years, there has been a significant shift in the economics of the legal market. Previously law firms were able to raise rates to increase profit, typically 8-10 percent each year, with costs growing at only 4-5%. These rate increases resulted in increased profit. About 10 years ago, things began to change. The market finally became saturated with a sufficient number of lawyers (a.k.a. supply) so economic forces took over and started to impact prices. At first, firms felt this in realization. Clients began asking for discounts. However, at the same time, firms continued their price increases, so profits were only marginally impacted.

Two other forces came to bear in the market. The first was technology. Accelerated changes in technology enabled new competitors and encroachers. However, this change has been on a slow burn. The other force was The Recession, beginning in 2008. This forced in-house counsel to increase rate pressure on firms. Leadership in client companies no longer accepted “I can’t” as an answer from the General Counsel (GC) when asked to lower legal costs. Previously the GCs would say they couldn’t predict litigation or deals and therefore could not control costs. The CEOs finally said “enough.” The amount of legal work was not the question. The cost of it was. So clients really turned up the pressure on firms on price, to the point of demanding rate freezes. The days of significant rate increases and high realization were over.

Firm were pushed from a “cost-plus” business model, where profit was built in to the price (hourly rates) to a profit margin model. Now the game is managing costs of delivery such that a reasonable margin is made.

If you consider the four drivers of profit, the first three are clearly under intense pressure from market forces. Rate increases for firms have dropped from 8-10% per year to about 3-4%. Realization has also been dropping, currently at about 86% of standard rates. Finally with over-capacity in the lawyer ranks at most firms, productivity is dropping as well, driving up cost rates. This leaves firms with leverage as the only real alternative for counter-acting the other market forces. You might think this would give a clear direction for firms to respond to market pressures.

However, in this new economic world we have a significant challenge: Firms have not recognized the change. The vast majority of partners and firm leaders still focus on hours billed and realization to maintain profitability. Most firms did implement efforts to try to control costs. However, these controls were not focused on lowering the cost of delivery, but instead were just administrative overhead cost reductions. These overhead reductions have helped stem the tide, and allowed holding ground on profits. This approach will not sustain as no business can cut its way to growth. Instead, investment in new methods and technologies is needed if firms expect to grow their markets and enhance their profitability.


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