A Primer on Law Firm Profit Maximization ~ Thriving Amidst a Global Pandemic
Updated: Apr 21, 2021
. . . even for the same timekeeper, billable hours are not all created equally and do not contribute equally to profits. . . . Stated differently, the hypothetical law firm achieved 90% realization of its targeted annual profit, not by raising hourly rates, but by discounting 25% of its billed hours production. How?
The ongoing COVID 19 pandemic has imposed unusual strains on the legal industry over the past year, compelling law firm managers to rethink the structures and timekeeper compositions of their firms. Many responded by reducing firm headcounts and implementing various cost controlling actions such as reducing leased office space. See, e.g., Dylan Jackson, Firms Will Continue to ‘Clean House’ Next Year, Lawyers Included, Law.com (December 3, 2020).
Those cost-containing measures were rewarded at several firms with dramatic per-partner profitability increases in the lofty ranges of 15% to 25.6 % at the end of 2020. See Dan Roe, At More than a Dozen Firms, 2020 Layoffs Were Followed by Partner Profit Windfalls, Law.com (March 4, 2021). Although increased profitability is always welcome news, it appears that many of these same firms reported mostly flat or slightly elevated annual revenues. Id. As shown in the following analysis, increased profitability in the face of cost-cutting measures does not necessarily translate into future increased profitability.
Year-over-year increases in profitability require not only sustained efficiencies in firm overhead, but also year-over-year increases in revenue and an optimal mix of firm timekeepers. The following analysis employs hourly cost rate and hourly profit rate accounting in the context of a hypothetical law firm to illustrate the origin of profit generation within law firms generally and to challenge the orthodoxies of billing rate realization, partner-to-associate leverage, hourly billing rate escalation, and other industry maxims typically espoused to urge on law firm profit maximization.
The practice of law has changed dramatically over the past several decades—changes propelled by technological revolutions in the ways that lawyers work, manage cases, and communicate with clients and each other. These technologies spawned the creation of “global” firms with thousands of lawyers, and in contrast, enabled lawyers to profitably and productively work in smaller and even solo practices. (For a more thorough discussion of the impact of technology on the business of law, see York Faulkner, The Escalating Role of Information Technology & Artificial Intelligence in the Practice of Law, YMF Law Tokyo (2021).)
Despite these rapid changes, the billable hour remains the primary unit for billing clients and measuring law firm performance. Most law firms distribute periodic reports to their partnerships that provide multiple metrics based on billable and billed hours production, e.g., average billed hours per attorney and per various groups within the firm, average billed hours over time, billable hour “realization” rates, etc. Few firms, however, combine the billable hour metrics with their cost accounting and, as a result, operate somewhat blindly in understanding the interaction between expenses and billed hour production. Hourly cost rate and profit rate accounting sheds considerable light on how and why some firms are profitable and others are not, optimization of attorney head counts and billing rates, and the calibration of many other law firm management metrics.
This article discusses hourly cost rate and hourly profit rate accounting in the context of a hypothetical law firm. The assumptions of this hypothetical are intentionally simplified in order to demonstrate the key concepts related to hourly cost rate and profit rate accounting. (For a more formal and alternative discussion of law firm cost and profitability accounting, see James D. Cotterman, Calculating Profitability, Altman Weil, Inc. (2019).)
Here, an annual accounting period is used for ease of conceptualizing the hourly cost and profit rate accounting principles. These principles apply equally to any accounting period, e.g., daily, weekly, monthly, quarterly, etc.
The hourly cost rate and profit rate metrics provide unique perspectives into how law firm profits (or losses) are generated—not only on a firm wide basis, but also by individual attorneys and groups of attorneys, e.g., partners and associates. These broadened perspectives enable greater insights into the optimization of headcounts, hourly billing rates, partner-to-associate “leverage,” and other aspects of law firm management. Hourly cost rate and profit rate accounting further enables the analysis of various “what if?” scenarios while altering such variables as headcount, hourly billing rates, etc. The examples in this article show how the hypothetical law firm dramatically increases profits, not by raising hourly billing rates but by discounting rates.
The hypothetical law firm analyzed here has two classes of attorneys—partners and associates.
The partners are pure “equity” partners who are compensated solely from law firm profits. As will be seen, this assumption is a key factor in several of the conclusions that follow. This assumption does not preclude the possibility that the partners in this hypothetical law firm receive monthly or some other periodic fixed “draws” as part of their compensation. However, the accounting and analysis in this article does not attribute partner draws to each partner’s share of overhead expense. This treatment of partner draws reflects the legal and economic reality that partners ultimately are paid only after obligations to third parties, hourly wage earners, and salaried employees have been satisfied. In reality, partner “draws” are what the name implies—a draw from the partner’s paid-in capital account that must be covered or paid back by a subtraction from the partner’s share of firm profits. Nonetheless, the purpose of this article is not to suggest rigorous accounting methodology, but instead to demonstrate the real economic consequences that flow from law firm management strategies and individual attorney decision making.
As shown in the table below, there are 50 partners in this firm who, as a group, have an average hourly billing rate of $900 per hour. At the conclusion of the calendar year, the 50 partners had each billed an average of 1,500 hours totaling 75,000 hours and generating $67,500,000 in revenue.
There are 120 associates in the firm who, as a group, have an average hourly billing rate of $500 per hour. At the conclusion of the calendar year, the 120 associates had each billed an average of 1,500 hours totaling 180,000 hours and generating $90,000,000 in revenue.
Overall, the firm’s 170 lawyers billed 255,000 hours and generated $157,500,000 in revenue.
Following is a representation of the typical year-end, profit/loss law firm accounting:
Based on the operating expense data assumed in the table, the firm generated annual profits equaling $77,500,000. The following table further breaks down profits by attorney group.
Firm overhead is allocated on a simple per capita basis. After subtracting associate compensation and their share of firm overhead from the associates’ revenue, the statement shows that associates contributed $24,705,882 of profit to the firm. On an hourly basis, the associates produced an average of $137 of profit per hour.
Partner profit contribution is computed by subtracting the partners’ share of firm overhead from their revenue—resulting in $52,794,118 of profit to the firm. On an hourly basis, the partners produced an average of $704 of profit per hour.
As a first observation, the partners of this firm contribute significantly more to firm profits than associates—both in gross terms and on an hourly basis. The reason for that disparity is due, in part, to the partners’ greater hourly billing rates. However, the difference in hourly billing rates is only one factor for that disparity. In fact, as shown by the hourly cost rate accounting discussed below, the difference in hourly billing rates is the least significant factor in explaining disparities between partner and associate profitability.
Hourly Cost Rates & Hourly Profit Rates
As shown below, the first step in computing hourly cost rates is determining (1) firm overhead expense per attorney and (2) salary expense per attorney. Firm overhead is borne by all 170 firm attorneys, both partners and associates. When firm overhead is divided by 170 attorneys, the per-attorney overhead expense equals $294,118. Non-staff salary expense, however, arises only in connection with the employment of associates. When associate salary expense is divided by the 120 associates, the average per-associate salary expense is $250,000. These computations are used to determine “average attorney cost” on an annual basis for partners and associates.
As shown above, the average attorney cost for partners is $294,118—their per capita share of firm overhead. The average attorney cost for associates is $544,118—their per capita share of firm overhead plus their individual salaries.
Immediately apparent from this computation is that partners and associates have vastly different cost structures. That cost structure difference is reflected in the “average hourly cost rate” computations. Here, although both partners and associates each billed an average of 1,500 hours, the hourly cost rates for each group are quite different. The hourly cost rate for partners ($294,118÷1,500) equals $196 of cost per hour.
In contrast, the hourly cost rate for associates ($544,118÷1,500) equals $363 of cost per hour. This divergence in hourly cost rates has nothing to do with differences between the partners’ and associates’ respective billing rates. Rather, due to the salary expense incurred in hiring associates (relative to partners) each associate has a much steeper and taller hill to climb along the way to generating profits for the firm.
Compounding the associates’ difficulty in generating profit is their typically lower hourly billing rates relative to partners. The “average hourly profit rate” shown in the table above demonstrates the disparities in profitability between partners and associates. Here, the hourly cost rate computations are confirmed by the traditional accounting methodology, showing that on average, partners generated $704 of profit per hour and associates generated only $137 of profit per hour.
The hourly cost rate and profit rate accounting metrics provide an alternative method for presenting the law firm’s Annual Profit/Loss Statement.
Here, the hourly billing rate, cost rate, and profit rate figures for partners and associates are used together with average per attorney hours to compute revenues and profits for each group of attorneys and total firm profit. The partners generated $67,500,000 of revenue (75,000 hours x $900 average hourly billing rate), resulting in $52,794,118 of profit (75,000 hours x $704 average hourly profit rate) (decimal values of the $704 per hour profit rate are not shown). By comparison, the associates produced $90,000,000 of revenue (180,000 hours x $500 average hourly billing rate), resulting in $24,705,882 of profit (180,000 hours x $137 average hourly profit rate) (decimal values of the $137 per hour profit rate are not shown). Combining the profits of both groups results in a total of $77,500,000 profit for the firm.
This presentation of the firm’s Annual Profit/Loss Statement enables year-to-year comparison of the cost structures and profitability on an hourly basis as well as an assessment of the profit contribution of attorney groups (and individual attorneys).
A point deserving emphasis here is that although the hourly billing rates for partners and associates are static, i.e., they apply equally to each hour billed, hourly cost rates are not fixed. Instead, hourly cost rates are dynamic and change with each hour billed.
In the computation above, the $196 hourly cost rate for partners, for example, is a function of the number of hours billed by the partners. Because “hours billed” is in the denominator of the equation, as the number of hours billed increases, the hourly cost rate decreases. That inverse relationship between hours billed and hourly cost rates is illustrated in the following table:
The table shows that the hourly cost rate applicable to the first hour billed by a partner in the firm is $294,118 and for associates, the hourly cost rate of the first hour billed is $544,118. However, by the time that partners bill their 1500th hour, the hourly cost rate has fallen to $196. Associates achieve an average hourly cost rate of $363 upon billing their 1500th hour.
The “hourly cost rate” alternatively can be thought of as a “break even hourly billing rate”—the hourly rate at which for a specific number of hours billed, the timekeeper breaks even or just covers his or her share of annual attorney cost.
The following table combines hourly billing rates with hourly cost rates over the course of 2000 hours of billings for both partners and associates—demonstrating the impact of declining cost rates on timekeeper profitability.
Here, for example, the first hour billed by a partner generates a loss of $293,218. However, as shown in the table, the partners’ billings begin generating profits at some point after 300 billed hours.
In contrast, associates in the firm do not begin generating profits until after they have billed 1,000 hours. Again, this disparity results from both differences between partner and associate hourly billing rates AND hourly cost rates.
Because partners have smaller hour-by-hour hourly cost rates, partners will, at any given hourly billing rate, generate more profit (or less loss) than an associate at the same number of hours billed.
The following table illustrates this point:
This table adds a column to the partners’ hourly profit/loss computations, demonstrating the profit/loss that partners would generate if they billed their hours at $500 per hour, i.e., associate billing rates.
The table shows that even at $500 per hour, partners would become profitable at some point after billing just 500 hours and at 2000 hours would generate profits of $353 per hour—compared to just $228 per hour for associates at the same hourly billing rate.
The hourly cost/profit rate accounting can also be used to compute the firm’s average hourly cost rate and average hourly profit rate across all timekeepers—as well as the firm’s total profit/loss at any cumulative average hours billed by the firm’s timekeepers. To do that analysis, we first compute the firm’s average hourly billing rate across all timekeepers as follows:
Additionally, we compute the average operating expense per timekeeper as follows:
Having computed these two averages, we can now make the following firm overall computations where the firm’s actual profits of $77,500,000 at an average of 1500 hours per attorney are bracketed:
One important observation here is that the average hourly billing rate across all attorneys was just $618 per hour.
Stated differently, if all 170 attorneys had billed all of their time at $618 per hour, then the firm’s year-end financial results would have been the same.
Here is what the firm’s Profit/Loss Statement would have looked like if all attorneys billed their time at a standard hourly rate of $618:
Here, despite greater hourly cost rates and smaller hourly profit rates, the associates outperform the partners in profit production—due to their greater headcount number. This indicates a role for leverage in law firm profit maximization. But, as discussed further below, the benefits of leverage quickly evaporate when headcounts are not optimized in view of billable hours production.
There are potentially innumerable ways to structure the firm’s billing rates to arrive at an average of $618 per hour across timekeepers—e.g., a broadly distributed curve with wide divergence between minimum and maximum billing rates (likely similar to most law firms) or a taller more sharply peaked curve with billing rates clustered more closely among the mean of $618 per hour (higher minimum rates and lower maximum rates).
If the firm were to move closer to the latter structure of billing rates (more tightly clustered rates with the highest rates close to the average of $618 per hour), then the question becomes whether the firm’s partners could sell/bill more hours? In other words, could a partner, for example, with a billing rate reduced from $900/hour to $750/hour (on all or some fraction of his/her time) bill more time?
If so, even at the same average hourly billing rate, then the firm’s financial results (all else equal) would be dramatically different due to declining hourly cost rates and commensurately increasing hourly profit rates.
The table above demonstrates this point. If, for example, the firm’s attorneys had produced an average of 1600 billed hours for the year (all else equal), then the firm’s profits, at an average hourly rate of $618/hour, would have been $88,000,000. In other words, increasing billed hours production by just 100 hours per attorney would add $10,500,000 of profits to the firm—$150,000 per partner.
Thus, the table can be used as a “back of the napkin” computation to predict the firm’s results based on average billed hours production within a reasonable range of actual results. The table also can be used to compute the firm’s “break even” point in terms of overall hours billed (assuming all else equal).
The table above as well as the following chart show that the firm breaks even somewhere between an average of 700 and 800 hours billed per timekeeper:
Moreover, the hourly cost/profit rate data can be used to show the contributions of partners and associates to firm losses/profits along the continuum of hours billed.
Here, partners begin contributing to firm profitability after billing 300 hours. Associates, however, do not begin contributing to firm profits until after billing 1,000 hours. And, even thereafter, their contribution to profits remains small relative to partners.
The following chart shows the relationship between the partners’ falling hourly cost rates and corresponding rising hourly profit rates. The transition from loss to profitability appears quick and dramatic in this example.
In contrast, the relationship between associate hourly cost rates and hourly profit rates are much less dramatic. In fact, whereas the partners’ hourly profit rates accelerate above the hourly cost rates at some point between 600 and 700 hours billed, the associates' hourly profit rates do not “crossover” their hourly cost rates until sometime after 2000 hours billed.
One takeaway from this analysis is that there is no one-to-one correlation between hours billed and profitability. In other words, even for the same timekeeper, billable hours are not all created equally and do not contribute equally to profits.
For example, the following table compares what would have happened if each of the firm’s attorneys (partners and associates alike) had increased their average billed hours from 1500 hours to 2000 hours.
Increasing billed hours by an average of 25% (500 hours per attorney) resulted in a 40% increase in firm profits ($52,520,000 increase over $77,500,000 of actual profits).
Stated differently, the last 500 hours billed by each attorney were far more profitable than the prior 500 billed hours—and so on and so forth.
The hourly cost rate and profit rate metrics can be further used to analyze the decisions/results of individual attorneys (subject to the ceteris paribus assumption).
In the first scenario, Partner A bills 1,000 hours for the year, resulting in an hourly cost rate of $294 dollars, an hourly profit rate of $606, and $606,000 of profit to the firm. Although Partner A had opportunities to work on “associate level projects,” he would have needed to bill his time at a reduced rate. Because he had heard consultants say that maintaining a 100% “realization rate” was critical to firm profitability, Partner A took a pass on the projects and did not bill any additional hours.
In Scenario 2, Partner B also bills 1,000 hours at her ordinary billing rate of $900 per hour. However, unlike Partner A, Partner B worked on several “paralegal level projects” for a total of 1,000 hours—billing her time at such a low billing rate that each hour billed generated exactly “zero” dollars of profit each hour.
However, in contrast to Partner A, Partner B generated $753,000 of profit to the firm—$147,000 more profit than Partner A. The reason for this may not be readily apparent. By billing 2,000 hours, Partner B’s hourly cost rate fell to $147, making her overall production of hours more profitable. In other words, by billing 1,000 hours at $147 per hour, Partner B covered an additional $147,000 of her annual attorney cost.
In Scenario 2.1, Partner B bills the additional 1,000 hours at just $100 per hour, generating a loss of $47,000 with respect to those hours billed. Yet, Partner B still generated $100,000 more profit to the firm than Partner A.
In Scenario 3, Partner C bills 1,000 hours at his ordinary hourly billing rate of $900 per hour. Partner C bills an additional 1,000 hours of “associate level work” at the associate billing rate of $500 per hour. The result is that Partner C generates $1,106,000 of profits to the firm.
In Scenario 3.1, Partner C had attended the same consultant meetings as Partner A and decided to give the additional “associate level work” to an associate to bill at the associate billing rate of $500 per hour—“because associates are cheaper.” However, Partner C’s 1,000 hours plus the associate’s 1,000 hours generated only $743,000 of profit to the firm—and the firm is $363,000 worse off than if Partner C had billed the additional 1,000 hours at $500 per hour. The associate may have been “cheaper” from a client-facing perspective but not from a firm profit generation perspective.
In Scenario 4, Partner D bills 2,000 hours at $900 per hour—generating $1,506,000 of profit to the firm.
Partner D produced $400,000 more profit than Partner C in Scenario 3 where Partner C billed half of his time at an associate’s rate. And, Partner D produced $763,000 more profit than the combined profits produced by Partner C and the associate in Scenario 3.1, where Partner C delegated 1,000 hours to an associate instead of billing the hours himself.
In Scenario 5, Partner E bills 2,000 total hours for the year. However, Partner E purposefully established three different billing rates for her work. She informed her clients that she would bill her time at a premium rate of $1,100 per hour whenever she takes depositions or appears in court on the clients' cases.
Partner E billed her clients $900 per hour for legal research, brief drafting, and other strategy-related work. She also told her clients that she would discount her fee to $700 per hour for client consultations and for intraoffice conferences, hoping to encourage her clients to contact her more frequently for consultation.
In this scenario, coincidentally, Partner E produced $1,506,000 of profits—the same as Partner D who charged the standard $900 per hour rate for all hours billed.
Partner E reasoned that although her clients might value her expertise and time, the clients might feel that some of her work, such as in court appearances, might be more valuable than other work and feel more comfortable paying a higher fee for that time.
Partner E explained to her partners that BMW, for example, makes 700, 500, and 300 series cars. They are all luxury BMW sedans, but they are different cars and priced accordingly. She reasoned that the same principle applies equally to her work.
She therefore decided that instead of presenting clients with a single hourly rate, she would bill time using a “menu” of hourly rates, allowing her to spend more time on her cases and add greater value to the work she performed for her clients—in other words, tasks rather than lawyers are assigned billing rates. This, coincidentally, is an example of what economists call “capturing the full value of the demand curve,” and this is why most manufacturers make optionally priced models of their products.
Dealing with Excess Capacity
The partners concluded from the data that the firm had significant “excess capacity” in its attorney headcount. The firm analyzed two approaches to dealing with the excess capacity.
Reduced Headcount Scenario
Based on a target of 2,000 billed hours per attorney, the firm made the following computations—determining that the firm’s optimal attorney headcount was 128 attorneys. In other words, the firm concluded that it had 43 more attorneys than it needed to produce 255,000 billed hours.
The firm wanted to know how profits might be affected if it reduced its associate headcount from 120 to 78 (less 43 associates). The firm realized that the partners would need to “cover” the work that would have been done by the associates—billing part of their time at associate rates. In the computation above, the firm determined that the partners had a total of 25,000 hours of excess capacity that could be used to cover the missing associates’ work.
The firm ran the following scenario to determine the impact on profits by reducing associate headcount:
This adjusted headcount scenario shows that the firm would increase profits by $23,140,000 (from $77,500,000 to $100,640,000) by reducing associate headcount to 78 and by transferring 25,000 hours of “associate work” to the partners to bill at discounted associate rates.
Significantly, the $23,140,000 increase in profits was produced without increasing a single hourly billing rate on any billed hour. Moreover, whereas 120 associates had produced $24,705,882 of profit in the original scenario, in the reduced headcount scenario, just 78 associates produced $35,340,000 of profit.
Also, the profitability of the partners’ original production of 75,000 hours increased by $3,680,882. Combined with the $8,825,000 of profit generated from billing the 25,000 hours originally billed by associates at associate billing rates, the partners produced a total of $12,505,882 additional profit—by billing 25% of their hours at almost a 50% discount.
Where did the additional profits come from?
The additional profits were realized by reducing the scale of the firm by 43 associates and their corresponding firm overhead. The hourly cost rate computation earlier in the article showed that each associate has a corresponding average salary/overhead expense of $544,118.
Therefore, when the firm makes a scale reduction of 43 associates (and corresponding real estate, staff, IT licenses, etc.), there is a net savings of approximately $23,000,000. Those reductions and headcount optimization further suggest a substantial decrease in share partner fixed expense risk, engendering more favorable lending terms to the firm or even reductions in the partnership’s required minimum paid-in hard capital.
The firm compared the reduced headcount results with the “ideal” result of retaining its full attorney headcount and having all attorneys bill 2,000 hours at full realization. They found that although the reduced headcount scenario significantly improved profits, the firm was still $29,380,000 away from achieving its “ideal” target of $130,020,000 total firm profit.
Moreover, the partnership was concerned about the long-term effects on associate recruitment, client relationships, etc. that would result from making drastic reductions in associate and staff headcounts. Also, although the partnership knew the firm had excess hours capacity, it was not certain that the partners and remaining associates could substantively “cover” the work of the departed associates. If the firm were a boutique in a single practice area, there might be a better chance of the remaining attorneys absorbing the work. But the firm had several practice areas, and the partners recognized that reducing associate headcount would also mean reducing many of the firm’s expertise and abilities.
Finally, the partners appreciated that their firm is in the business of selling billable hours. Reducing headcount by 43 associates might improve profits in the short run, but it also would significantly constrain billable hours production moving forward into the future—reducing the firm’s overall capacity for producing revenue and profits. The partners further understood that they would incur significant hiring, training, and other expenses to once again expand their workforce at a later time. Absent exigent circumstances, the partners wished to explore other profit maximizing options.
“Unsold Inventory” Approach
The partners began thinking that selling legal services in hourly units might not be so different from other businesses that sell physical product units. They realized that their problem of “excess capacity” might be analogous to the problem that many businesses face with unsold inventory.
They further realized that the firm might be analogous to businesses with “expiring inventory” problems, such as auto dealers—when new models arrive, the value of current models falls precipitously. Those businesses routinely deal with the unsold inventory problem by selling the unsold units at heavy discounts—attempting to capture as much value from the inventory as possible before it loses further value. In the law firm scenario, unbilled hours in inventory “expire” or are forever lost if not billed—at any hourly rate.
The partners in the hypothetical firm, of course, would prefer to sell all of the firm’s hours at full realization, but decided to analyze the impact on profitability of selling the firm’s excess capacity at discounted hourly billing rates.
The partners calculated that there were 25,000 hours of excess capacity in the partnership, and 60,000 hours of excess capacity among the associates.
The following table shows the impact on profitability of discounting the partners’ 25,000 hours of excess capacity to an average of $700 per hour, and the associates’ 60,000 hours of excess capacity to an average of $350 per hour.
The table shows that by selling the excess hours at a discount, the firm would increase profits to $116,020,000. The table below compares that result to the firm’s actual results, showing a 33% ($38,520,000) increase in profits, achieved—not by raising hourly billing rates—but instead by discounting 25% of the firm’s billed hours.
When compared to the “ideal” scenario of billing all partner and associate hours at full realization, this scenario falls short of the ideal billing scenario by only $14,000,000—approximately $15,000,000 closer to the ideal level of profits than the reduced headcount scenario.
Stated differently, the hypothetical law firm achieved 90% realization of its targeted annual profit, not by raising hourly billing rates, but instead by discounting 25% of its billed hours. How?
The hourly cost rate accounting demonstrates that billed hours production is the predominate force in generating law firm profits (or losses). Hourly billing rates are, of course, relevant and play a role in generating firm profits. However, as discussed above, hourly billing rates are “static” in that they apply equally to each hour billed. Hourly cost rates, on the other hand, dynamically decrease as hours billed increase—dramatically increasing profitability as each timekeeper bills more and more time.
Economists refer to this phenomenon as “scale effects.” That is why producing a single semiconductor chip might cost millions of dollars. However, producing mass quantities of the same chip allows the chips to be sold profitably for only a few dollars. That is also why FedEx can profitably provide next-day airmail service at very reasonable rates—fixed costs are spread over vast quantities of parcels.
Businesses cannot realize favorable scale effects unless and until all units are sold, either at or above unit cost. Law firm businesses are no different. But, because we sell time, we somehow lack the same business instincts and instead create rigid hourly billing rate structures. Here, the hypothetical law firm had 85,000 units of unsold inventory, and the firm took a loss on it—valued in the 10s of millions of dollars.
For these reasons, law firm management would be wise to minimize any restraint on billed hours production, including aggressively priced hourly billing rates and inflexible billing rate structures preventing firm attorneys' work on certain projects or subject matters. The hypothetical law firm, therefore, began focusing on ways to remain competitive and commensurate in the marketplace with its stated/published hourly billing rates while focusing on increasing billed hours production and thereby increasing firm profits. In other words, the hypothetical law firm considered whether its hourly billing rates were unnecessarily constraining billed hours production and exercised both creativity and caution in pricing its services.
The firm also ran numerous “what if?” scenarios to evaluate the creative pricing structures and their impact on firm profitability. The firm concluded that maximizing profit required much more than simply raising hourly billing rates. The firm therefore focused on optimizing firm overhead and headcount while maximizing hours production through carefully priced legal services.
The legal services industry is undergoing significant changes. Among other things, time saving technological advances have greatly impacted the way that law firms provide legal services and the ways in which they staff and conduct litigations and other billable work. We now can do more with less—less people, less travel, less delay—with less time. Yet, the billable hour remains the primary unit for the sale of legal services. And if the full value of those legal services is to be reflected in increasingly efficient (declining) billed hours per project, then one can expect that hourly rates must necessarily go up.
However, it is not clear that firms are raising hourly billing rates as a result of “increasingly efficient (declining) billed hours per project.” Increasing per-project efficiencies suggest that each firm attorney should on average continue to bill full-time hours (e.g., 2000 hours annually) by completing more projects over the course of the calendar year. Yet, it seems that many law firms are raising hourly rates while experiencing declining average annual per-attorney billed hours and ostensibly maintaining “realization rates” in excess of 90%. There are, at least, two possible reasons for this:
Such a firm, although faithfully recording and efficiently billing all hours worked, may simply be bringing in less and less work—resulting in falling average annual per-attorney billed hours. (This, of course, may simply be an economic consequence of the well-accepted downward slope of demand curves—less output is sold as price increases in efficient markets.)
Alternatively, such a firm may be achieving target realization rates by controlling recorded hours, resulting in artificial realization rates. In other words, attorneys do not record all time spent on a project in order to meet budgets or client expectations. Such a practice introduces chaos into law firm accounting. Fewer recorded hours result in increased hourly cost rates. To remain profitable at those elevated hourly cost rates, therefore, the firm must raise hourly billing rates—which of course further incentivizes the constraining of recorded hours to meet budgets, client expectations, etc. And thus, such a firm becomes ensnared in the escalating hourly billing rate trap.
This is readily apparent in firms with declining average annual billed hours per attorney and increasing hourly billing rates (likely more the rule than the exception these days from reporting in the legal press). The result? Law firm partners are increasingly compelled to pursue work from smaller and smaller pools of clients who are willing and able to pay higher billing rates (e.g., Fortune 500 to Fortune 100 to Fortune 50 clients), leaving the firm dependent on a much smaller and less diversified client base and likely with a much narrower focus of client services. Some firms may seek to fill such a niche—elite services and correspondingly high hourly rates. There is certainly no problem with that type of business model, and it would likely result in a highly profitable practice, provided all hours worked are actually billed—otherwise, the published hourly billing rates will overstate the true value of the firm’s attorney time, and the firm’s accounting metrics will not provide accurate signals to firm management.
From the cost accounting discussed above, it should be clear that salaried attorneys, e.g., associates, are very expensive necessities (if not luxuries) and should be hired with strategic care for the firm’s bottom-line profitability. Industry consultants often advocate for “increased leverage” as a road to law firm profitability, especially in the sale of commodity services. The cost accounting, however, raises concerns about over reliance on “leverage” (especially for commodity services) due to the constraints on hourly profit rates for salaried employees. Consequently, the cost accounting suggests two “rules of thumb” for law firm hiring:
1. Partnerships (and practice groups) hire salaried attorneys if, and only when, the partners have more work than they themselves can do.
2. Partnerships (and practice groups) hire additional salaried attorneys if, and only when, the existing salaried attorneys have more work than they themselves can do.
Similarly, the cost accounting suggests that firms should price their services to avoid excess capacity in the sale of their hourly units. In other words, firms raise rates only when they are experiencing increases in average per-attorney hourly billings and clearly have more demand for their hourly units than supply.
When these rules of thumb are followed, the cost and profitability accounting discussed above has a way of taking care of itself without much worry or concern from management.