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Q1 2016 EDITION

Forefront
 

Cost Accounting – The New Reality in the Legal Industry

Let’s face it. Back in the day, there was an easy fix for shrinking revenues. When a firm saw its profitability slipping, it could push the billing rate up a little bit. This made all the difference. It was a great solution for firms: it meant they could maintain profitability through thick and thin. And once top-tier firms made the “rate” move, others soon followed.

Well that was then. Then a bad thing happened. You’ll recall that in 2008 an enormous credit bubble burst and triggered a huge economic downturn.

In its wake, we’ve all seen that the majority of law firm clients have become considerably more cost conscious. They want legal firms to account for the size of their bills. They want a better deal from law firms. They want to see new payment models put in place. They want predictability around their legal spend, and so they increasingly ask for fixed fee pricing. Mainly, they want to pay less for legal services. It means that using rates to guarantee profitability simply doesn’t work anymore.

For a while, firms could console themselves that this was a blip while the economy struggled. Unfortunately, the blip persisted, and frugal clients became the new normal. Eight years from the crash, truth be told, it’s not even new normal anymore. It’s just how things are, i.e. “normal”.

It appears that the business of law has genuinely changed. And there’s statistical evidence to back this up. The Peer Monitor Index, for example, shows us that 2015 saw the slowest growth in worked rates since Q1 2011. At the same time, collected realization (the proportion of legal bills that actually get paid) hit an all-time low at 83.2%. Weak rate growth coupled with failing realization are clear signals that rates are under pressure and clients are diligent in their legal spend. This is now a cause for concern because, in a highly competitive environment, it represents a serious threat to law firm profitability.

Taking a New Perspective

So that’s how we got to where we are today The next challenge is what can be done about it? I’m arguing that the answer lies in taking a new perspective; and by that I mean understanding the cost side of your business. The fact is that, traditionally, firms have not paid a huge amount of attention to costs because they’ve not had to. Now, things have changed. Under these new conditions, costs matter a great deal, for a couple of reasons.

Reason number one is that if you’re being asked for fixed fee pricing—and more than 50% of today’s transactions are done on this basis—you must know what your costs are in order to fix the fee at the right level, one where you make a reasonable margin.

Without a clear understanding of cost, it’s very possible to pitch the fixed fee at a level where you’re not competitive, where you make no profit, or worst of all, at a level where you potentially incur a loss. Firms need to have access to data which helps them predict, with accuracy, how much a matter will cost. This enables them to set the right level of fixed fee for each matter.

Reason number two is that if you still have clients who operate on an hourly rate, you still need to know costs to make sure that the hourly rate is pitched at a level that’s both competitive and keeps you in profit.

Understanding the Cost of Costs

In addition to knowing what your costs are, firms also need to understand how costs are made up. Why does that matter? Because some costs can be rationalized.

For example, costs can be rationalized in terms of the service provided to the client. In this regard, it’s really important to gain a clear understanding of what it is that the client actually wants. To put it another way: do they want a Cadillac or Chevrolet?

In fact, these days, clients are often pretty upfront about their expectations and will say: “Here are 1,000 matters, and taking into account past performance, we want you to settle 40% of them at a specific price point.” So the goal is to actually deliver that. To do so, firms now have to actively manage results by having a project manager in place who oversees what each lawyer is doing and decides which cases are going to be settled. Without that oversight, the risk is that your conscientious lawyers end up settling fewer than 40% of matters, and your firm carries the costs of doing the extra work, which eats into profitability.

Another way in which costs can be rationalized is by ensuring that the right resources are allocated in the right way. For example, making sure high-priced partners don’t work on paralegal-level matters. It might mean reconfiguring teams (i.e. cost allocations) to get exactly the right blend, for instance instead of two partners, one partner and an associate. Again, this needs to be actively managed to ensure that the cost allocations keep making sense. Remember that if you can shuffle the resources so that the cost behind each $1,000 of billing is $600 instead of $800, that’s a way to double your profit.

Technology Is Your Friend

How do firms actually make the changes necessary to underpin future profitability? Well, in all of this, technology is definitely your friend.

For one thing, technology will generate the data that will give firms the visibility on costs that is necessary to optimize their pricing. Data analytics will tell you what’s actually happening in the firm so you know precisely where rates and fees need to be pitched.

Additionally, technology is playing an ever-greater role in enabling firms to strip out costs by automating certain tasks and allowing others to be performed more efficiently. This makes your firm more able to price competitively and to handle higher volumes of work – both of which support greater profitability.  

Thirdly, technology can play a key role in helping firms deliver the transparency that clients increasingly look for. Indeed, lately I’ve come across some instances where clients want to collaborate with the firm on setting up a pricing model. This will almost always depend on the firm generating hard data which it can easily and promptly share with the client.

Finally, where hourly rates still apply, the right technology will help optimize revenue by ensuring that all the time taken by lawyers on a matter is efficiently captured and that no ”crumbs” of activity are forgotten. Bear in mind that this has become crucially important in an environment where rate increases don’t work anymore. The only way to increase revenue is by increasing hours.

Moreover, when technology enables firms to provide prompt, precise, and incontrovertible data accounting for time, clients are more likely to pay invoices without question, so realization rates rise. Remember the figure of 83.2%? That number offers the potential for 16.8% of profitability opportunity, which better quality of hours can help achieve. An extra bonus is that client confidence in your firm also rises which leads to better, more long-lasting client relationships. A true win-win opportunity!

The Way Ahead

In the new world in which we live, firms must collect cost data. As I’ve explained, this both helps optimize traditional billing and contributes to effective fixed-fee pricing.

How do you get a handle on this? The place to start is with effective timekeeping software that builds an accurate time inventory on both the cost and the revenue sides. By effective, I have in mind the kind of software which dovetails with the lifestyles of today’s lawyers and takes advantage of consumer technologies like smart phones, tablets, and more recently wearables: platforms that exhibit high adoption rates with lawyers. Capturing time using these devices becomes second-nature and ensures your firm has accurate, high quality time data to use.

In my experience, when firms are in possession of this type of data, it yields rich rewards. Whether they are on an hourly rate or fixed fees, having technology that delivers cost visibility puts firms in a much stronger position to ensure consistent profitability going forward.

 

Tikit

Tikit is one of the largest suppliers of technology solutions & services to legal & accountancy firms, and is part of BT Group. Tikit's client list totals more than 1,450 firms globally, including 90 of the UK's top 100 law firms, 250 US law firms, 12 of the top 20 European law firms and 18 of the UK's top 50 accountancy firms. Click here for more information.

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