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Focusing on the Bottom Line

29.11.2011

The past month has seen the appearance of two more significant surveys, both of which suggest that rising costs coupled with falling demand are putting yet more pressure on law firm profitability.

Both Citigroup’s Third Quarter Report and Hildebrandt’s Peer Monitor Index are largely focused on the US market – but with the UK market due to open up to Alternative Business Structures, in our opinion the trends identified could have an even more significant impact here than on the other side of the Atlantic.

The main points emerging from the analysis are clearly worrying: law firm costs (both overheads and headcount) increased, as firms finally made investments they had been putting off in 2009-10; meanwhile, demand for legal services dropped.

Furthermore, fee rates have been overtaken by increases in costs – effectively meaning that productivity is falling amongst law firms. Just as concerning is the fall in the level of WIP and the decrease in cash collected – for the first time since the second half of 2008.

A Fork in the Road

What the above analysis does not reveal, but other reports do identify, is the divergence between firms. As 2012 approaches and economic forecasts suggest that another recession is more and more likely, we firmly believe that the profession is reaching a fork in the road.

Those successful firms, with a keen focus on the financials of the business and a clearly articulated business development and investment strategy, will continue to distinguish themselves from the crowd. Other firms without such focus are starting to fall further and further behind. This is being exacerbated by increasing lateral moves as successful partners in less successful firms prepare to desert. The choices facing firms become ever harder.

Ultimately, increasing spending while revenues fall is a recipe for disaster. The linked trends of divergence between the best firms and the rest, and the squeeze on profits from higher costs and lower income, will only accelerate the consolidation that we believe is coming in any case.

A Structural Approach to Managing Cost

One of the biggest issues facing law firms in 2012 is therefore how to manage costs, not just how to manage capacity. I will be addressing this issue at the Financial and Business Planning for Law Firms conference in London on December 8th.

Having trained as a Cost Accountant, and spent many years reorganising and restructuring, this is a subject I take very seriously – I believe that cost structure will become a strategic issue rather than a tactical afterthought – and the penalties for getting it wrong will be severe indeed.

My thoughts on Law Firm cost structures have moved on significantly over the last year – turning fixed costs into variable is more important than ever. It is now apparent that cutting overheads whilst still necessary will no longer be sufficient. The erosion of the billable hour means that realisation rates will suffer, and so fee earner costs will have to be managed down. In those sectors which are opening up to Low Cost Competition the necessary cuts will be beyond many. And so the divide may widen further.

The key thing to remember is that it is not just headcount that matters – cost structure is a crucial element of the business model, and this is something that will separate the winners from the losers in 2012 and beyond.

If you would like a conversation, please email barry.wilkinson@wilkinsonread.co.uk.

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