The Perils of a Fixed Cost Structure

One of the problems we regularly come across working with law firms is the lack of headroom, or buffer, the partners have when it comes to the firm’s cost structure. In balance sheet terms, the late Professor Larry Ribstein summed it up best – law firms behave as ‘thinly capitalised workers’ cooperatives’ – they have very little in retained earnings, which puts huge pressure on partners’ profits when times are difficult.

In terms of the Profit and Loss Account, conventional analysis is misleading. Law firm profit margins are usually quoted before allowing for partner drawings, or allocating a notional salary for the partners. If this taken into account, the Law Management Section (LMS) Survey carried out by the Law Society shows that the profit margin is typically only in the region of 5%.

The LMS survey has highlighted that, in the median firm, fixed costs (most of which can be allocated to people and premises) represent over 90% of the firm’s cost structure. Very few costs in the typical law firm vary in line with activity – which is a good thing when volumes are rising. Simply put, higher income with fixed costs means disproportionate levels of profit. In stable, growing markets, firms can get away with having high fixed costs. In uncertain or contracting markets, being able to respond is essential.

If volume falls, either in the short or the long term, the only areas that can be cut quickly are ‘decision costs’ such as marketing and training. This in itself is likely to produce a vicious cycle of decline, as lack of investment in areas that deliver longer term return leads to falling revenues, which further eats into profit margins.

Turning Fixed Costs into Variable

So the question is, how can fixed costs be turned into variable costs? A limited amount can be done with IT, by using cloud storage and replacing hardware, and procuring software as a service. Similarly, break points can be negotiated and property contracts can be renegotiated as they expire.

However, people costs represent the majority of the fixed costs in a law firm – and so people costs must be made variable, and ideally not be cutting the partners’ drawings. In other industries this would be called sub-contracting, but in the legal world we like to say outsourcing.

Business processes can be outsourced, including secretarial and transcription services, IT, finance, HR, and most non-fee earning functions. This has so far been popular among very small firms who cannot afford the overheads of employing in-house staff, and also with very large firms, where the efficiency savings and the redirection of management time have justified the approach.

Outsourcing the Middle Market

However, many more firms in the middle market can also benefit from business process outsourcing as a way of procuring the requisite expertise without the fixed overhead of in-house staff.

Legal process outsourcing is an exploding market, which has already reached a market size of $1bn and is growing at a compound rate of 85% per year. To date it has largely been exploited by larger firms, but is increasingly becoming available to consortia of smaller firms, and there could be great benefits to be had by exploring this avenue.

In the short term firms can maintain their cash flow through better lock-up management, and this is an approach we would wholeheartedly endorse as a short-term solution to a short-term problem. However, the bottom line is that in the medium term the break-even point simply has to be lowered in order to preserve margins and mitigate the effects of fluctuating volumes of sales.

This means that fixed costs must be reduced, and in many case replaced by variable cost structures. This may be unpopular with many people in the firm, but it is better than the alternative when firms start to struggle to break even.