With the recent announcement by the SRA of three key financial ‘warning signs’ it will use to assess law firms’ financial stability over the next year, the imperative is becoming ever clearer for firms to get their financial houses in order, or face the threat of regulatory action – and even insolvency.
The key indicators, which will form the basis of the SRA’s risk assessment, are: drawings exceeding profits; borrowing exceeding net assets; and borrowing over a certain level. Firms showing two or three of these will be given a red rating; those with one – amber; and those with none – green.
According to SRA executive director Samantha Barrass, ‘Red-rated firms are therefore identified as high-impact firms in serious financial difficulties, with the potential to collapse. These firms will receive intensive supervision. Such firms will be required to prepare detailed contingency plans and obtain professional insolvency advice.’
It's all about P's and Q's
In light of this, a major focus for firms should be on managing costs to reduce the borrowing requirement. In this, our starting point is that it is all about P’s and Q’s – price and quantity. A basic tenet of economic theory is that Revenue = Price x Quantity. We use a very similar equation as a basis for cost reduction:
Cost = Price x Quantity
We have in the past analysed the reasons for the prices of the goods and services we buy (it usually comes down to specification), and the quantity used. One very clear conclusion from this has been that there is much more scope to reduce costs by focusing on volume rather than price. By focusing on units, square feet or numbers of people, we have regularly been able to reduce costs by over 30%.
When we look at the profit we make on the services we sell, the equation becomes:
Profit = (Revenue – Cost) * Quantity
That is to say, the amount of profit the firm makes is inextricably linked to quantity sold – and this is becoming an ever more important factor as prices are increasingly being fixed by outside agencies. Nowhere is this more clearly the case than in Personal Injury, where as many as 1 in 5 managing partners in the North West are considering closing their firms or departments because of pressures on price (see our related article). Around a quarter of firms surveyed felt that profitability will fall by 50%, with 1 in 10 believing it will drop by as much as 80%.
The question here for PI firms is whether portal work will become inherently unprofitable. This depends on your perspective – some clients believe that doing portal work profitably (at a fixed fee of £500 is not possible.
However, we also have clients who estimate that, with a properly functioning IT system, the time taken by a fee earner to process a straightforward portal case is less than 3 hours. The work does not need a qualified lawyer, rather a trained paralegal – in which case the income will amount to over £150 per hour - and the staff cost to less than a tenth of that. So the gross profit margin should be 90%.
In this case (and not all portal cases are so straightforward), then it is perfectly possible to make a profit from portal work. The price, in itself is not the problem - provided that you can get enough cases. Once again, it is quantity rather than price that matters.
The Battle for Market Share
To generate quantity requires paying much more attention to marketing and selling. The battle for market share has barely begun, and many PI firms will pay the price for taking the easy route and subcontracting the marketing to claims managers. Referral fees may be banned, but outsourced marketing programmes will take their place.
This is why perspective matters. Outsiders, looking at a market where there is an established demand, a potential gross margin of 90% and a lack of true innovation from the incumbent suppliers, will see a major opportunity. This is why the "reverse take-over" by claims managers of established PI firms, or setting up their own legal process businesses (as ABS), makes sense.
Their background may just make them better innovators and managers than the trained lawyers –and we should remember that ‘he who owns the client owns the margin’ (Wilko’s Law #1). New entrants may not get things right, but they will try – and this will be hugely disruptive in itself. Open markets are unforgiving, and it is possible that those in the North-West who prophesy the end of their practices will be proved right.
The politicians perceive that for some claimants, the PI market has in recent years provided the equivalent of a free lunch. In future the customised case support that clients have been used to will not survive such a transformation in the market, but they will get what they are prepared to pay for. As an old friend used to say – many will soon be getting value for money – worth nothing, cost them nothing. Alternatively, those who want a superior service will have to be prepared to pay more – even if on a contingency basis. It might not be fair, but it is the Law of the Market.
This may of course prove to be overly pessimistic, but what is absolutely clear is that the quantity component of the cost and income equation is crucial – and those firms that choose to ignore this will find life increasingly difficult. Or, as Bill Clinton might say “it’s the volume, stupid”.