ALL PROFESSIONALS STRUGGLE with answering the client’s question of how much a service will cost. The usual answer is, “I don’t know because I don’t know how much time it will take. I don’t know how the other side will respond. I can’t tell how much research is required, nor can I predict how you will respond to the alternatives…”
So how do we better predict fees? How do we establish an appropriate fee, whether hourly or some alternative? Both are good questions, but we need to ask another first: How do we determine the cost of delivering our services? Cost is an integral part of establishing a delivery price for legal services, whether using hourly billing or an alternative fee arrangement.
Few law offices base individual billing rates exclusively on costs. Rather, the new associate billing rate is often set by using the “rule of three” (i.e., salary multiplied by three, divided by the minimum required billable hours, equals billing rate) or some modification thereof. Other timekeeper rates are usually based on some percentage increase over the previous year, the years of experience, what each partner thinks about his or her own rate and some “Kentucky windage” based on what is heard on the street or from clients, as well as what is known about rates that other firms charge for similar services. Cash collections are then estimated based on hours to be worked and cash collection percentages. Estimated costs are deducted. And if resulting profits are reasonably acceptable, rates are adopted.
The good news is that this approach has worked in the past. The bad news is that it does not work as well today and will work less well in the future for several reasons:
- Not all costs of doing business are usually tracked. Those that are omitted may include rate adjustments to client bills, money costs, partner costs and event costs.
- Individual client or matter profitability is difficult to determine with this approach.
- Costs are not matched with related revenues.
- Utilization and leverage cost differences are not highlighted at the matter level.
- The value to the client isn’t anywhere in the picture (unless there is a problem)!
What is needed to establish appropriate fees and to guide the billing process is a much broadened view, finding an alternative to the hourly rate multiplied by the hours worked. That view should include all items affecting the cost of providing a service to a client and the value to the client, as well as the economics of supply and demand.
COST OF SERVICE VERSUS VALUE TO THE CLIENT
Lawyers need to remember that the time they spend on a matter is not always the measure of the value received by the client. The true value of legal services is determined by the client and may have little relation to the hours worked or the cost of the service.
In my book Winning Alternatives to the Billable Hour: Strategies That Work (Third Ed.), co-authored with Jim Calloway, a litigation example is included to illustrate this point. A very narrow and specialized medical malpractice case might require dozens of hours of research, consultation with experts and careful drafting just to prepare a set of interrogatories. After the lawyer has prepared and tried four or five of these types of cases, preparing the interrogatories based on the prior work product might take less than an hour or two for some customization based on the specific facts of the new case. Would anyone doubt that, based on the experience of the lawyer, the interrogatories in the fifth case were superior—and had greater value to the client—than those propounded in the first case, even though they took less time to draft? Experience improves the lawyer’s work product and the lawyer’s abilities. As experience allowed one to perform tasks more efficiently and quickly, the traditional response was to raise the lawyer’s hourly billing rate. Therefore, associates charge one rate, while junior and senior partners have higher rates.
Yet, as many lawyers have come to realize, upward hourly rate adjustments are not always possible. If the medical malpractice lawyer mentioned above charged $3,000 for the first interrogatories prepared (10 hours at $300 per hour), can he raise his hourly rate to $1,500 per hour for the two hours it took him to do the interrogatories in the fifth case? Is it ethical for him to “pad” his time to reflect 10 hours of work when he only had two? The value to the client in the fifth case is as great or greater than in the first case, so why wouldn’t the fee be the same or greater?
UNDERSTANDING COSTS WHEN DEVELOPING FEES
The medical malpractice example is an excellent illustration of why hourly rates should not be used to determine true value. Further, a fee arrangement should be related to the cost of providing a service as well as the willingness or desire of the lawyer to bill an appropriate amount. This is what converts the billing process from a mechanical step to an “art.” This is often lacking in straight hourly billing.
In the past, lawyers could increase hourly rates with little resistance from clients, meaning that the cost of delivering legal services was not very important. This has changed, and more and more legal professionals are discovering that having an understanding of the following costs of delivery is essential in managing profitability.
Revenue adjustment costs. The term revenue adjustment costs means those adjustments made by the lawyer to billings—either before (rate and billing adjustments or write-ups and write-downs) or after (write-offs) bills are sent to clients. There are three types of revenue adjustment costs:
- Rate adjustments. The difference between the “value” of timekeepers’ time (based on time spent and “standard” hourly rates) and the value based on front-end agreements made with the client. Rate adjustments can be either premiums or discounts.
- Billing adjustments. The difference between an agreed upon billing amount (hourly rate, premium, discount, etc.) and the amount billed to the client. These may be due to inefficiencies or efficiencies that are not passed on to the client.
- Write-offs. Typically adjustments to billed amounts when a client objects to a portion of the bill or for bad debts.
Timekeeper costs. Timekeeper costs are the direct costs of people serving clients on a particular matter.
Overhead costs. The firm’s overhead costs are the various indirect costs associated with keeping the doors of the law office open: support staff, rent, supplies, depreciation, continuing education, etc.
Event costs. Event costs include the cost of nontimekeeper services provided directly to a matter. These include such internal services as document creation, copying, computerized research and long-distance telephone charges.
Money costs. Money costs represent the cost of borrowed funds or partner capital related to the investments made in a matter from the time incurred until ultimately collected: timekeeper, overhead and event costs, plus out-of-pocket costs paid by the firm.
PUTTING IT TOGETHER, PUTTING IT TO WORK
Both lawyers and law firms should be able to take the costs outlined above and determine exactly what the cost is to deliver either one hour of legal services for a partner or paralegal, or one completed simple estate plan to a client. If an hourly rate is going to be charged, will it be sufficient to pay the costs and deliver an appropriate profit for the work? If a fixed fee is appropriate, will it cover the costs and be sufficiently valuable to the client so he or she will pay the fee?
Conduct a cost analysis for the work you do most frequently. Data mine your old bills for efficiencies in delivering better services and identifying opportunities for using an alternative fee arrangement. Spend an hour at the end of each engagement to review the process and see how it can be improved the next time.