Plugging the Profit Leaks
How innovation in pricing and collection can help your bottom line.
These days, innovation is key in overcoming the challenges facing solo practice lawyers, law firms and corporate legal departments. 2010 may have been lukewarm for the legal industry, but the good news is it’s recovering.
Opportunities exist for firms willing to adopt innovative pricing structures and tighten their billing and collection of fees. Embracing new service delivery methods and focusing on practice areas and geographies experiencing the most growth will also be crucial.
Demand to Remain Sluggish in 2011
The Bureau of Economic Analysis estimates that revenues in the Legal Services industry, after growing at a compound annual rate of 6.5% per year between 2001 and 2007, grew at only 4.8% in 2008 and then fell by 2.9% in 2009.
The deterioration in revenue in 2009 was due to declines in billable hours, inability to raise fees and a decline in realization rates for billing and collection of fees.
- First, survey data from Hildebrandt Baker Robinson and Citi Private Bank show billable hours down in 2009 by 4%, after growing at a compound rate of 4% per year between 2001 and 2007.1
- Second, data from the 2010 ACC/Sergengeti Managing Outside Counsel Survey on fees paid by corporations for outside counsel show, after growing at a compound rate of 6% per year from 2000 to 2008, fees growing at only 1.48% in 2009.2
While this data only represents one sector of the legal services market, it seems to be indicative of the softness that many firms are experiencing in their ability to raise fees. Indeed, the HBR/Citi survey data show that collection realization rates, or the percentage of standard fees that firms have been able to collect from clients, have fallen 4.3% from the third quarter of 2007 to the third quarter of 2010, to about 87%.3
Recovery in the demand for services across the broader economy suggests that legal services demand should have grown by 1% to 6% in 2010 and should grow even faster in 2011 (see chart at right). However, survey data suggests that the Legal Services sector has been underperforming the broader recovery and the underperformance will likely continue into 2011. HBR/Citi data show that billable hours have continued to decline in 2010, though at a rate of less than 1% and the ACC/Serengeti data suggest that fees may only have grown in the 1.5% range in 2010, tempered by the weak realization rates highlighted above. With regards to 2011, the HBR Peer Monitor Economic Index, which tracks the health of law firms across several indicators, has been in modest decline over the past three quarters and the latest Citi Managing Partner Confidence Index shows neutral sentiment on recovery prospects in the industry for 2011.4
Cost Cutting Can Only Go So Far
Amid the industry-wide slowdown, firms have engaged in aggressive cost cutting to conserve cash and maintain a base-line level of profitability. The Bureau of Economic Analysis estimates that the Legal Services industry as a whole shed just under 50,000 jobs between 2007 and 2009, or roughly 4.5% of the workforce.
Despite continued weakness in the market, cost cutting will likely be less of a profit driver in 2011 given the deep cuts already made. Consultant Robert Denney, in the most recent edition of the ABA Law Practice magazine, writes that cost cuts “have gone as far as they can go” and that “firms must now focus on increasing revenues” in order to increase market share and profits.5
Steps that Firms are Taking to Prosper
In an environment of sluggish demand and weak pricing, firms must increasingly drive profits through growth strategies, such as taking market share from competitors and focusing resources and on pockets of growth. They must be innovative in areas such as efficient service delivery models, pricing and managing billing and receivables.
Innovative Pricing – Alternative Fee Arrangements
While it is still standard to use billable hours as a basis for pricing legal services pricing, value-based pricing structures, otherwise known as Alternative Fee Arrangements (AFAs) are catching on as a way to increase market share, penetrate new market segments and deliver additional value to clients.6
What are AFAs?
Billable-hour pricing is based on the cost of a lawyers’ time, firm overhead and a profit margin. Value-based pricing views markets in segments and creates pricing structures based on the firm’s cost to serve the segment, the value those customers in that segment receive and the prices that competitors charge to serve those customers.7 Common alternative fee arrangements include contractually fixed fees, portfolio pricing, results-based contingency fees, hourly rates blended with fee caps and incentive fees. All AFAs include the concept of firms segmenting the market and sharing some of the risk related to providing services.
What are the Trends in Use of AFAs?
Survey data from corporate legal departments suggests that almost half use alternative fee arrangements, such as fixed and contingency fees, for a portion of their outside legal work and that the use of AFAs is on the rise. Mirroring the corporate data, respondents to the 2010 Citi Leaders Council Survey of 48 large law firms projected using AFAs for 12.9% of their revenues in 2010, up from 10.6% in 2009, and that this percentage would grow to 15.4% in 2011.
While many law firms expect to increase their use of AFAs over the next several years, it is important to note that there still seems to be greater demand among clients for AFAs than there is willingness by law firms to engage in these innovative pricing structures. This mismatch in demand and supply of alternative fee arrangements is probably due to the increased risk that law firms must assume when they enter into an AFA with a client. However, risk, can be managed through effective planning and implementation of AFAs.
To aid in risk management, the ABA’s Law Practice magazine published an excellent self-assessment checklist for gauging the readiness of a practice or firm for implementing AFAs in their November/December 2010 issue.
Benefits of AFAs:
Value-based pricing techniques, including market segmentation and construction of pricing arrangements based on cost to serve, value received and competitor pricing, have been used for years by airlines, hotel chains, financial services firms and others to help capture new market segments and maximize profits. Indeed, research has shown that improved pricing is significantly more effective at increasing profitability than managing cost or volume. One study, Marn and Rosiello, found that, for an average firm, value-based pricing improvements resulting in 1 percent increase in average price can result in an 11 percent increase in profitability.8
In addition to increasing profitability, AFAs may also have important positive effects on client acquisition and retention and operational efficiency. Shook, Hardy & Bacon, a large litigation defense practice and growing user of AFAs, notes that AFAs help to simplify their billing and tighten operations. Shook Hardy’s chairman, John Murphy, recently said, “It’s been clear to us for some time now that clients were looking for ways for their law firms to be more creative and innovative… We saw this as a real opportunity to use alternative fee arrangements as a means of aligning our interests with those of the client and to show a willingness to share the risk.”9
Payment processors, like Meracord , can help facilitate AFAs by tracking and executing recurring payments automatically, providing additional means for clients to pay the firm, and providing reporting to the firm’s financial software.
Tightening Billing and Collection of Work-In-Progress
Tightening Billing of Work-In-Progress:
Unbilled fees and expenses at many firms amount to 20 % to 25% of annual revenue, constituting an unnecessary and costly financing of client activites.10 In the article, “Finance Tips: 25 Quick Tips for a Healthier Bottom Line,” Janis Alexander, Ed Poll and Mark Robertson suggest several steps to improve billing, including:
- Entering time electronically and contemporaneously;
- Billing electronically;
- Evening out cash-flow by having different billing cycles within the month for different portions of the practice;
- Investigating alternative fee arrangements, which can bring more standardization and regularity to the billing process.11
Initiatives to improve billing must also be coupled with initiatives to gain the buy-in and support of partners, some of whom may not fully comprehend the impact these behaviors have on the firm’s bottom line.12
Improving Management of Accounts Receivable Collection:
According to HBR/Citi data, the gap between billing realization and collection realization has widened from under 1% in 2007 to almost 3% in September 2010, highlighting the increasing difficulty that firms are having in collecting billed fees.
In order to improve collections, Alexander, Poll and Robertson suggest:
- Billing regularly in order to limit the sticker shock from any one bill;
- Aging accounts-receivable once a week in order to identify and stay on top of delinquent accounts;
- Sending out past due reminders;
- Not taking on new clients without a retainer and not working for clients who don’t pay in order to limit the firms liability.13
Leadership consultant Karen MacKay suggests setting a strategic goal of shortening the typical number of collection days for accounts-receivable, both through new processes such as those mentioned above, as well as through “focused effort by the lawyer, his or her assistant and someone on the firm’s accounting team.”14
Payment processors, like Meracord , can help facilitate collections improvements by tracking delinquent payments, sending late notices and providing the reporting necessary to age accounts frequently and giving clients additional, electronic methods for paying the firm.
Conclusion
Following two years of declines, demand for legal services will likely remain sluggish in 2011, making growth in revenue and profitability hard to achieve. Opportunities exist, though, for firms willing to adopt innovative pricing structures and tighten their billing and collections of fees, as well as embrace new service delivery methods and focus on practice areas and geographies experiencing the most growth. A payment processor, like Meracord , can be a key partner in helping facilitate pricing innovation and implement improved collections practices.
Sources:
1 The 2011 Client Advisory. Hildebrandt Baker Robbins and Citi Private Bank, 12 Jan 2011 (www.hbrconsulting.com)
2 Bodine, Larry. “Clients Are Happier, But Offer Less Legal Work with a Tiny Fee Increase.” 24 Jan 2011 (www.lawmarketing.com/pages/articles.asp)
3 Supra x 1, HBR/Citi Private Bank, pg. 13
4 Supra x 1, HBR/Citi Private Bank, pg. 5
5 Denney, Robert. ”What’s Hot and What’s Not in the Legal Profession,” Law Practice January/February 2011, Volume 37 Number 1. 19 Jan 2011 www.abanet.org/lpm/magazine/articles/v27/is1/pg11.shtml
6 Taylor, Steven T. “Positioned to Profit: How Three Law Firms Are Riding High in Changing Tides.” Law Practice November/December 2010, Volume 36 Number 6. 22 Dec 2010 www.abanet.org/lpm/magazine/articles/v36/is6/pg26.shtml
7 Thomas T. Nagle and John E. Hogan. The Strategy and Tactics of Pricing, 4th Ed. Upper Saddle River, New Jersey: Pearson/Prentice Hall, 2006. Pgs. 54-80
8 Marn and Rosielo (1992) quoted in Miller, Scott, “Pricing power: Using price strategy road maps and tools to maximize bottom-line results,” in CMA Management; May2008, Vol. 82 Issue 3, p26-32
10 MacKay, Karen. “Tips to Help Demystify the Numbers.” Law Practice November/December 2010, Volume 36 Number 6. 22 Dec 2010 www.abanet.org/lpm/magazine/articles/v36/is6/p56.shtml
11 Janis Alexander, Ed Poll and Mark Robertson. “Finance Tips: 25 Quick Tips for a Healthier Bottom Line.” Law Practice November/December 2010, Volume 36 Number 6, Page 26. 22 Dec 2010 www.abanet.org/lpm/magazine/articles/v36/is6/pg42.shtml
12 Esposito, Frederick J. Jr. “A Step-by-Step Plan for Encouraging Partner Compliance with Administrative Tasks.” Law Practice November/December 2010, Volume 36 Number 6, Page 36. 22 Dec 2010 www.abanet.org/lpm/magazine/articles/v36/is6/pg36.shtml
