Zero-sum Game: Hourly Billing, Productivity and Profitability
Law departments and law firms are not locked in a zero-sum game. Law departments can get higher quality work at lower cost while law firms increase profitability. In a flat-fee environment, the dynamic is obvious—cost reductions via productivity gains from investment in process and technology outpace price reductions. But even under the reign of the still-dominant billable hour, an extended decline in realizations has created an opportunity for rigorous collaboration to lead to a positive fiscal impact for both sides.
The conventional wisdom is that the billable hour incentivizes inefficiency because the longer something takes, the more hours are billed, the more money the firm makes. I’m not going to argue with the conventional wisdom, but I will add some nuance:
- Lawyers do not record every hour spent
- Firms do not bill every hour recorded
- Clients do not pay for every hour billed
In short, time is truly wasted. Time is expended but not deemed compensation worthy by the lawyer, firm or client. This dynamic has a direct impact on profitability. Reduced realizations (ratio of time spent to time collected) come straight out of profits. According to Toby Brown, a 1 percent drop in realizations will, on average, result in a 2 percent drop in profitability when realizations are near 100 percent. But the impact is magnified as realizations drop and the rate collected nears the cost rate level of the timekeeper. The point-of-no-return — where margin reaches zero before going negative — is generally around 67 percent realizations but can range from 50 to 80 percent depending on the timekeeper. It is therefore of profound importance to the profitability of law firms that the Peer Monitor data indicates that average collected realizations have fallen from 93 percent to 83 percent over the last decade.
This data combined with some defensible assumptions can get us to a crude model of the relationship between hours worked, hours collected, profitability, and client spend.
In the model above, the lawyer is spending about 2,500 hours per year in the office and working from home (Hours Worked). Not all of this time is focused on compensable client matters (Bill-Eligible Hrs.) because of marketing, administration, pro bono, etc. The lawyer then self-censors out of principle or due to poor tracking so that not all time spent on client matters is recorded (Record %). Before billing it to clients, the firm writes down some of the lawyer’s recorded time (Firm Write-down %). The clients then ask for further reductions (Client Write-off %). Multiplying the number of hours post-client reduction (Collected Hours) by the rate the client actually pays (Discounted Rate) provides the dollars collected on the lawyer’s time (Total Collected), which can then be compared against the lawyer’s cost to the firm to calculate profitability (Profit). The non-discounted rate (Standard Rate) is included for the purpose of completing the realizations calculation.*
Although it is not essential to the model, I envision a scenario where the lawyer spends 200 fewer hours per year at work to highlight the fact there is a human cost to inefficiency. From the firm perspective, part of the efficiency gains show up in the non-billable administrative work as well as the level of self-censorship. The firm itself is writing down less time, as is the client. Without any change to the rate, the firm is able to increase profits by 15 percent while lowering client costs by 13 percent.
A quick glance might suggest I cheated. The cost per client only decreases because the number of clients increases. But deeper reflection should reveal that this is the entire point. Higher productivity enables the lawyer to serve more clients in less time. In a rational world, higher productivity should result in more clients, as well as more business from existing clients. But we do not need to imagine a rational world for improved realizations to lead to higher profitability for the firm. If the total available business remains flat, the law firm is still more profitable because fewer lawyers are required. The chart below takes the productivity gains from above and applies them to different scenarios.
Even in a billable hour environment, law departments and law firms are not locked in a zero-sum game. Law departments can get higher quality at lower cost while law firms increase profitability. But the two sides need to work together to fully realize the gains of the productivity improvements.
I will discuss the dynamics of deeper relationships in my next post.
* While not worth disrupting the flow of the post, it should be noted that one of the major challenges with realizations is that they are near impossible to deconstruct with any level of precision (hence my “crude” calculations). First, we don’t know how much time spent is not recorded. By definition, there is no record of that time, just surveys and other “anecdata” of lawyers claiming to have self-censored. Second, realizations are calculated from something called “standard rate.” Standard rate is not standard in any common sense of the word. Standard rate can, but need not, be one of the lawyers’ published rates. Standard rate can, but need not, be one of the rates that some client is actually paying for the lawyer’s time after discounts. Standard rate can be whatever the firm chooses according to whatever logic the firm applies. Because of this, it is impossible to know from the realization data how much of the drop in billed realizations (difference between what is recorded and what is sent to a client) is due to discounts versus write-downs. Also, because published rate ≠ standard rate ≠ discounted rate, what the client believes to be their discount (versus highest published rate) may differ substantially from how the firm calculates the discount (versus standard rate).
This post was written by Casey Flaherty, founder of Procertas and former outside and inside counsel who first rose to prominence when he created the Service Delivery Review (“SDR”) to change the way he communicated with his outside counsel. Instead of generic complaints about inefficiency and arbitrary reductions in invoices, Flaherty sought to use metrics and benchmarking to foster structured dialogue, drive continuous improvement, and deepen the integration between his law department and his outside counsel. Follow Flaherty on Twitter at @.