Twin Pillars or Foolish Systems?

It has been said that Warren Buffet has just two rules: rule number one, “don’t lose money”, and rule number two, “never forget rule number one”.

Pricing and managing costs in law firms used to be almost this simple.

To make a profit firms simply had to divide their annual operating costs by a reasonable estimate of the number of saleable hours, add a generous margin to convert this into a selling price per hour, and be sure to bill consistently.

However, courts insist on cost budgets and clients increasingly demand fixed prices (see this piece from the Gazette), and it is far from inconceivable that firms could be losing money on some clients and some matters – although it could be asked how important this is if the firm makes a profit overall.

Our contention would be that this does matter. A firm’s actual profitability can be compared with the potential profitability were all clients and all matters equally profitable (at least within reason). Analysis across a number of industries regularly throws up an “inverted J curve”, showing that the first 80% of customers create approximately 120% of the profit, with the last 20% of customers losing a significant amount of money for the business (see this article).

Price and Value

A great deal of attention has been paid in recent years to the issue of pricing. Indeed, there is an increasing predominance of pricing professionals particularly in the larger firms, illustrated by Bruce MacEwen’s (aka Adam Smith Esq.) comment that “if you’re serious about running your firm as a professional business operation” then coaching on pricing is something you should try.

There is an increasing amount of literature and commentary regarding different pricing models, with some commentators prioritising a ‘value’ price to the extent of saying that cost of production is irrelevant.

This, however, assumes that the value price exceeds the cost – which is known both before and after the event. In many firms this is a worryingly grey area.

Alan Hodgart has argued that, having matched the price to the value perception of the client ahead of doing the work rather than discounting after doing the work, and having managed the cost of doing the work so that it meets the price for the client and the target profit margin for the firm, “the challenge is to develop cost structures that differentiate the cost base of work types given the perceived value of each work type in the firm’s market.”

Assessing Costs - Assessing Clients

The first question ought to be whether firms actually know their current costs accurately enough to assess profitability, particularly at the level of client or matter. In theory it should not be difficult to establish hourly standard unit labour costs based on an appropriate level of capacity usage.

Unfortunately, in practice the quality of time capture varies greatly between firms. In many firms there is endemic under-recording of matter related time. Many fee earners feel that it is pointless recording time if it cannot subsequently be charged to a client. (Unit labour costs were in fact originally established as a costing tool and only later did they also become entrenched as a pricing mechanism too).

Therefore, even if the management systems produce reports comparing income to cost at standard rates, the cost is understated because of the under-recording of time – and therefore matters (and by implication clients) will look systematically more profitable than they actually are.

Of course, this goes a stage further when matters are being sold on a fixed fee basis because many fee earners do not bother to record time “because we can’t charge for it”.

There is an assumption that in the world of big data we will be able to be more scientific and accurate in our estimation for pricing and cost budgeting because we will be able to learn from historical data – but if historical information is systematically distorted, the errors of the past are bound to be repeated.

As competition becomes ever tighter and the risk of prices being forced below costs increases, the twin pillars of pricing and costing will require equal attention. Much of the recent focus has been on pricing, but we believe that as experienced cost accountants our core skills will come to the fore before long.