Archive for the ‘Economics’ Category

Evolving leverage

May 9th, 2016 by Jim Cotterman

Changes in leverage are positively correlated with partner profits (as are the other four profit levers - utilization, pricing, realization and margin).  Increase leverage and partner profits increase, if all else remains the same.  David Maister wrote about the profit model over 30 years ago (See Profitability: Beating the Downward Trend, The American Lawyer. July August 1984), including the interdependency of the profit levers.  From that conceptual framework came the understanding that practices had optimal business models where the levers for profitability are managed appropriately to that business model.  Too much, too little, the wrong kind of leverage all hurt profitability.  Not new, but tends to get lost in the discussion.

 

For example, a compliance practice is leveraged differently from a high end advisory practice.  A traditional insurance defense practice is leveraged differently from a traditional corporate practice.  The same is also true regarding the other profit levers.  For example, the profit drivers for an insurance defense firm were traditionally their high leverage, utilization, and realization.  While the profit drivers for a corporate practice were traditionally good leverage and utilization with above average pricing.   

 

What is current and changing is the business model.  Practices that enjoyed leverage from reviewing documents for due diligence or discovery are finding that piece of their business model under assault by specialty service providers and technology.  Clients are less willing to pay for process and more willing to pay for judgement, experience and expertise.  Technology has, and particularly looking forward at artificial intelligence, the potential (and I suspect the promise) of major change in how law firms serve their clients.  The watchwords for leverage today should be flexibility and adaptability.  Firm’s must respond to changing and differing client buying preferences while at the same time investigating, implementing and “leveraging” technology - all in an environment of rapid technological change.  The future should be quite interesting.

 

 

 


Pricing

June 23rd, 2014 by Jim Cotterman

Pricing should reflect a fair value to the client for the product/service/result provided and the market in which they are provided.  Thus hourly rates vary by location, practice specialty, practitioner experience and work/issue sophistication.  They are also sensitive to market factors.  For example, insurance defense rates are less and slower to move for a given practitioner than rates charged for similar work paid by the client directly.

Hourly rates have long been augmented by alternatives such as contingent fees and fixed fees for certain practice/market specialties.  And interest in moving beyond the hourly model is accelerating.  Law firms are investing resources in more sophisticated tools to understand cost of services and in people to analyze and structure pricing options.

The key is finding a means to best address a client’s needs for predictability, cost reduction and risk sharing in its legal spending.  How does the client define value and how can the firm better define the value it provides to the client?  Conversations with clients are critical as needs, issues and priorities vary.

The Trouble with Billing Rates

June 9th, 2014 by Jim Cotterman

The long historic ability of the legal profession to raise rates well in excess of inflation year over year has largely ended.  Two factors combine to raise a practitioner’s hourly rate –

1) an elevator lift of all rates to reflect an overall increase in pricing structure (pre-recession averaging each year 4.5% and higher than inflation’s 3.2% and post-recession from a bit more than one-third to a bit less than one-half of that which was pretty close to inflation), and;

2) the up escalator increase reflecting an additional year of experience (2% to 5% for each additional year depending on where the practitioner is in their career).

Realization, a law firm’s ability to collect those rates and the opposing force against increases, has been on a long steady decline from 95% in 1985 to 82% recently.  With pre-recession increases well in excess of inflation, the minor one-half of one percent annual decline in realization was largely ignored.  However, now that rate increases are modest the decline in realization is more noticed.  Increased price discounting at the front end and more aggressive push back from clients on bills on the back end reflect increased pressure for lower cost and better value. 

Collected hourly rate increases fueled revenue growth on a per timekeeper basis.  Thus making it possible for high year over year compensation increases.  Concurrently, demand, at least as measured by average billable hours, is diminished.  Result:  Modest revenue per timekeeper growth and in some pockets real challenges at holding the status quo.  The consequence is that unless overhead and the service delivery model are radically altered, there will be little room for the historic annual compensation increases.

Financial transparency

May 24th, 2014 by Jim Cotterman

Law firms are somewhat unique in the amount of information that is publicly available regarding their finances.  Most closely held businesses do not operate in such an open manner.  Of course, the accuracy of that publicly available information is a separate matter to consider, particularly when obtained from unofficial sources.  Here each firm must decide what is appropriate for public disclosure and how to best convey that information.

Yet, transparency in the governance and operation of a law firm is a good practice for the owners of the firm.  They are a large group relative to their firm’s total employment and are all active and personally invested in the firm.  But such disclosure is not sufficient to avoid financial distress.  Two additional factors are also important.

First, lawyers are not schooled in accounting or financial analysis.  If transparency is to have meaning, partners must be able to understand and interpret the financial information and metrics.  Firms should Invest in training sessions to acquaint partners with the financial reports and operating information, how to interpret that information, banking covenants and the metrics the bankers rely on, and how to reconcile the tax return, year-end financial statements and internal financial reports. 

Second, and possibly most important, is a culture where 1) firm leaders welcome questions from partners and others about the firm and 2) where integrity and honesty is embedded in the ethos of the firm.  Transparency assists accountability, but it also establishes responsibility.  The responsibility to ask and then act when action is required.

Realization

March 14th, 2014 by Jim Cotterman

The profit metric that tells how efficiently work done at standard rates is converted into cash.  It does not tell you how fast this happens, just the amount of slippage that occurs from end to end.  There are key intermediate steps that are measured such as billing realization (converting time value into bills) and collection realization (converting bills into cash) and a number of variances (see below) critical to isolating and confronting slippage. 

But first a bit of history and why it is now getting so much attention.  Realization has been dropping since the mid 1980s — a long, gradual and persistent deterioration.  But until the recent recession, rates were going up much faster; yielding a collected rate increase well in excess of inflation.  Strip away the historic ability to increase rates and the realization slippage is uncovered for all to see.  To confront this problem, examine realization where the slippage occurs.  There are four general areas where losses occur that must be understood and managed.

1.  Timesheet discounts — those adjustments individuals make to the time they record when they believe something took longer than it should.  This is one area that does not show in the financial system realization numbers because it is not captured.  It prevents firms from identifying budgeting issues and training needs.

2.  Pricing discounts — the difference between standard and actual rates.  Both the frequency of use and level of discount have been increasing and accordingly realization suffers.

3.  Efficiency adjustments — those adjustments to the value of time recorded at actual rates before billing.  These are done by the billing partner.  They may be targeted or prorated across the timekeepers on the matter in proportion to their recorded time value.

4.  Value adjustments — those adjustments made by clients when they perceive that the bill does not reflect fair value for the agreed to budget for services, the services rendered, and/or the outcomes achieved.

Each of these areas require separate tactics to tackle the associated realization decline.  Terms like pricing variances, efficiency variances, value variances should accompany any discussion around realization.  The realization journey begins with client acceptance and continues on to matter engagement, work planning, staffing, project management, billing and collections.  Thus, firms should examine their policies about client selection, engagement letters, pricing/retainers, staffing, practice management, billing adjustments, AR write-offs and collection efforts.  Those policies should be administered through the practice leaders who should hold individual partners accountable.

Also consider how the firm strategically positions itself with respect to pricing.  Does it set high standard rates with an expectation of using discounts to satisfy financial and/or procurement departments in client organizations.  Just look at the medical and accounting professions where these models have been in place for many years.  Historically the legal profession did not adopt this pricing model, thus it has strived for high realization and little, if any, discounting.  Clients are now more aggressive at pursuing pricing discounts, without the law firms having a pricing model with sufficient margin to easily accommodate them.

 

Realization issues also tend to concentrate among individuals, practices, offices and clients that are struggling — underperforming.  It is important to look for outliers across these segments.  Firms should manage their way through these issues by identifying the problem and taking corrective action.  In the current market where there remains an imbalance between supply and demand for legal services, that corrective action is more likely going to be to shed the problem.  It is not fixable by changing status or compensation, which unfortunately, is what is attempted all too often.

 

So, if you are going to the Managing Partner or Executive Committee to talk about low realization; be prepared to talk about what kind(s) of variance(s) exist, where and who is the problem, and the targeted options to correct or shed it.

Working Capital Requirements Likely to Rise

April 17th, 2013 by Jim Cotterman

The Wall Street Journal had an interesting and sobering article today about companies stretching payments to suppliers.  What caught my interest is the discipline and aggressiveness of these policies in a post recession environment.  Such tactics increase working capital requirements for suppliers.  Working capital is the amount of money a business needs to pay its bills while it waits to be paid for its goods and services. While this article focused on the portion of working capital attributable to the gap between invoicing and payment, there is also an equally important portion attributable to the gap from produced/worked to invoice.

Combined, the work to invoice and invoice to payment cycles can represent three to eight months of cash flow for a law firm.  The median length of time is four months.  Some specialty firms can be much longer.  Law firm have over the past several years increased capital requirements and reduced their dependence on debt for financing.  This latest move by clients could add to capital needs even more.

The article also mentions how the companies are approaching this problem by bringing banks into the mix.  Essentially the bank buys the suppliers invoices at a discount and collects from the manufacturer.  There is a great graphic depicting this approach in the article.  While this may work well now, in measured amounts and with historically low interest rates; how it plays out when rates increase and the investment in these receivables grows is yet unknown.

A Different Use for Your Malpractice Insurance Application

September 25th, 2012 by Jim Cotterman

I suspect that for many professional firms the malpractice insurance renewal application is not something to look forward to.  That was not the case for a member of the AICPA’s professional liability insurance committee.  That intrigued me, so I read more of the article.

Law firms can benefit from this insight.  I regularly request the application as part of merger due diligence to understand the firm’s practice as well as its known and anticipated claims.  As an overall picture of a firm’s business, is quite comprehensive.  Using that snapshot to evaluate and manage the associated risks (as the article suggests) is a tremendous opportunity. 

Compensation season coming to an end

February 17th, 2012 by Jim Cotterman

About now most firms should have finished their compensation deliberations and possibly their communication efforts.  Assuming no Spring surprises, there should be a lull before the next round kicks off.  But before you set your compensation committee free, we recommend one more request on their time.  Take a few moments to reflect on this year’s process.  What went well?  What challenges did you have?  Think over the entire process – economic data review, partner written input, partner interviews, input from administrative leaders, personal study, committee deliberations, feedback to/from partners and the like.

It is all fresh in your minds, so capture that knowledge now.  This does not need to be laborious.  Just a quick memo to the committee chair with bullet points and short narratives.  Capture both positive and negative aspects of this year’s efforts.  The Chair can organize this and determine how best to proceed.  The conclusion might be to continue as is, but I suggest there is always room to improve and ongoing incremental improvement should be integral to your operations.

Retirement update

July 25th, 2011 by Jim Cotterman

The common wisdom is that defined benefit (DB) plans have largely been replaced by defined contribution (DC) plans such as the 401(k).  While generally true, DB plans are still being adopted.  According to the GAO’s March 2011 Private Pensions report, “most new DB plans were started by highly paid, middle-aged professionals who run small businesses and were looking for ways to put as much tax-deferred income aside for retirement as possible.”  The top three business classifications sponsoring new DB plans have been doctors, dentists and lawyers.  Doctor and dentist offices are uniquely well suited because of their advantageous business model.  Law firms are a bit less well suited, but there are still reasons to consider a DB plan in the right circumstances.  The report’s data is for years 2003 - 2007 where 14,150 small DB plans (those with fewer than 100 members) were newly formed representing 8% of the total number of all plans created.  Of those, approximately 1,000 were for law firms.

The GAO goes further to point out that these new DB plans are sometimes sponsored to supplement an existing DC plan that has reached its statutory contribution limits.  Using a combination of plans can greatly enhance the ability to save for retirement.  The attractiveness of securing retirement savings on a tax deferred basis is significant with a GAO estimate of 18% improvement in after tax retirement income after 10 years and 40% after 20 years.

Unfortunately, even with significant tax advantages, the private plan participation remains stalled at roughly half of the private sector workforce.  Plan formation just barely surpassed plan terminations.  And this was prior to the recession.  Now un- and under-employment remain stubbornly high, with particular note to the growing problem of the long-term unemployed.  The consequences of all this on participation rates and asset accumulation are still largely unknown.

The eternal search for cost advantage

July 7th, 2011 by Jim Cotterman

Much has been written pro and con regarding cost reduction strategies.  One of the more contested approaches is outsourcing, particularly the more aggressive off-shoring.  This is the movement of tasks and often jobs from internal positions to somewhere else.   That somewhere else can be a lower cost rural area or another country.  Successful strategies have been built around both, understanding that there is no single correct answer to these challenges.

This article, Outsourcing Pioneer Brings Work Back To The U.S., in Law Technology News reminds us that not only is there no single correct answer, but that yesterday’s best approach may be replaced by a new, or even old, alternative tomorrow.   Some say first movers capture the bulk of any temporary advantage while late entrants capture very little.  This identifies an important trait of leadership — the ability to move quickly enough to seize on opportunity (even to change direction), yet simultaneously slow enough to be thoughtful and build consensus.