My last post talked about revenues.  This time let’s look at expenses.  People costs represented 77% of total in 2002 and now run closer to 79%.  This includes all compensation costs (fully loaded) as well as partners.  Nearly half the law firms recently surveyed indicated they have terminated associates and staff while a quarter have reduced their partnership ranks.  And they may not be through as three-quarters are considering partner reductions and over half more associate and staff cuts.  We are way beyond the critical mass necessary for it to be acceptable to reduce headcount.  Now even law firms in good condition are taking a critical look both the number and quality of personnel.  This is when organizations return to a lean and flat operating philosophy.  The result is that personnel who do not directly deliver a necessary service are most likely to be made redundant.

Partner reductions are a bit more complex.  If key partners abandon ship, it will likely accelerate the firm’s decline.  And too many partners leaving for whatever reasons may trigger default provisions in debt and lease covenants.  But a careful review with strategically focuesed reductions are going to be necessary at many firms.  Reducing draws may also be required.  Smaller draws eases working capital needs and the firm can always make spot distributions if economic conditions/performance warrant.

Personnel turnover is expensive and disruptive.  An alternative to layoffs is to reduce cash compensation.  Working for less pay while retaining benefits might very well be preferable for both employer and employee then not working at all.  This is not a common approach in law firms, other than for partner draws and distributions.  Hourly staff will probably not be asked to reduce pay.  Exempt staff may, but it is still likely to be a minority of these folks. 

However, law firms are universally giving this a very careful study for associates.  While law firm leaders are carefully considering their year-end associate bonuses (no one is anxious to be out in front this year and only a few have gone public so far) and their own year-end partner distributions; it may be wise to take heed of the reaction to the Big Three auto executives riding to Washington on private jets and the bonus announcements at some endangered investment banks.  Justified or not, one needs to pay attention to optics.  Your clients are already seething over high outside counsel costs and struggling mightily with budget cuts of their own.  Another round of big associate bonuses and year-end partner distributions will not help your cause, particularly with pricing in 2009.

There is a need for balance in this situation.  No bonuses or adjustments might not yield the proper result any more then throwing money at everyone would.  High performers should be recognized and earn more, but this should happen within the context of the firm’s culture.  A true firm mentality where the individual rises and falls based on how well the organization does is different from an organization where it is all about the individual.  I am not advocating for or against either style, only that your pay decisions be consistent with the operating philosophy.

Benefit costs are likely to rise again this year for employers and employees.  The most significant cost is health care coverage and employers are shifting even more of those costs to employees.  Most notable are the higher deductibles in PPO plans where half now require a deductible of $1,000 or more as reported by Mercer.

Occupancy is the next most prominent expense line item.  These costs averaging around 7% of revenue in 2002 and in better more recent years closer to 6%, are long term fixed costs, likely with escalators built in.  In a robust economy that is an advantage as growing revenues allow you to leverage the fixed investment.  However, in a down economy those fixed costs consume an even greater share of diminishing revenues.

Marketing, technology and personnel training/development costs are prime areas for reduction in difficult times.  Projects will be reduced in scope and/or scale, some will be deferred and others will be cancelled outright.  Certainly there are savings to be had, but a more prudent action would be to prioritize and invest across all of these areas for the most critical needs in each.

Next year’s budget should be well underway — maybe for the nth iteration as forecasts are updated with each new low in the Dow.  Revenue forecasts will be particularly tricky this coming year.  63.5% of respondents in a recent survey indicated that they expect 2009 revenues to fall up to 10% from 2008 levels, with 2008 being a challenging revenue year for many firms as well.

Price increase is the single most significant factor to enhance revenue in most businesses.  Over two decades law firms have been able to raise billing rates at about 1.7 times the change in CPI.  This is down from a long term price increase average of nearly twice the CPI.  Not many businesses can claim a long term pricing pattern of this magnitude.  This year half of law firms surveyed are expecting only minimal and targeted increases in hourly rates.  And 14% hope to increase rates consistent with inflation.

Productivity in terms of average billable hours decline in a recession and an industry-wide 5% decline in 2009 could be a prospect worth considering.  Clearly some practices have contracted severely (securitized finance and real estate being prime examples), while others may hold up well (insolvency and regulatory come to mind).  While a modest decline does not sound serious, it really is very serious.  Those declines translate dollar for dollar into lower profits.

Pricing variances have increased from 2.5% to 4.7% over the past five years.  Meanwhile efficiency variances have held their own at about 7.5%.  We expect further pressure to discount rates and therefore higher pricing variances in 2009.  We further expect that clients will scrub your bills in greater detail, particularly with respect to staffing decisions.  The likely result will be increased downward pressure on realization.  And this will be on top of the more modest rate increases so the revenue affect will be more significant then it has been in the past.

Although law firms have not yet experienced a dramatic increase in the aging of their accounts receivable; anecdotal comments from corporations (your clients) indicate that they are more carefully managing their cash position, including stretching their accounts payable.  How quickly you turn over your receivables directly affects your working capital requirements.  Law firms have been particularly adverse to maintaining liquidity averaging about a half-week of free cash flow at year end.  The top quartile firms in terms of profitability however, average 1.7 weeks of free cash flow at year end placing them in a far more advantageous position to navigate these challenging times.

Budgeting this year should test the resiliency of your capital and profit profile against slower collections, more modest rate increases, a potentially slipping realization rate and varying challenges with respect to productivity.  Partners should be talking with key clients to understand their needs and expectations for the coming year — both in terms of the client’s business and industry environment and their legal needs.

This may be a good time to build up capital and liquidity.  Hopefully the credit markets will soon begin to function in a more orderly and rational fashion.  But until that time, law firms should be wary of the availability of credit, particularly on lines of credit that are far more vulnerable to being reduced or withdrawn on short notice.  Two means to improve liquidity include retaining earnings to raise your year-end free cash flow to two weeks from the aforementioned half-week norm.  The second approach might include additional debt to ensure its availability even if you only buy short-term treasury securities with the funds until they are needed.  Be mindful that if you raise debt that it still conforms to good financial leverage practices.