Finance: Profitability—Know the Rules and Get in the Game

The biggest question on the minds of most managing partners and administrators today is “What’s ahead for 2023?” Law firms are working in a roller coaster economy, and 2023 is looking to be a year when firms will need to regroup and adapt to not only a post-pandemic world, but one that is leaning toward a recession. 2022 was not necessarily a bad year for most firms, but the economic climate remains uncertain. The positive aspect is that many law firms are starting to get more in tune with their economics. They are introducing process improvement/ project management methodologies to assist in streamlining costs for producing legal services and, more importantly, using this information to create more strategic pricing options for clients in their business development initiatives. In short, law firms are now officially in the “revenue game.”

Clients continue to push back on fees. They want more predictability, which has moved the profession toward more creative pricing/fee arrangements. While there are arguments about the pros and cons of these arrangements, the issue comes down to clients continuing to perceive a widening gap between the amounts they are charged for legal services and the value of the services provided. This has created a client need for reconciliation of rates to value. 

Accordingly, law firms collaborate with institutional client-designated third parties to “reconcile differences.” These differences, or time write-offs, while not significant on average, have a cumulative effect on a law firm’s profitability. This becomes further exacerbated because law firms file appeals in hopes of reversing write-offs. But in most cases the appeals are denied or clients pay pennies on the dollar—unfortunately, resulting in an investment of additional nonbillable time in what would seem, in most cases, to be an unsuccessful appeal which further reduces profitability.

When speaking with general counsel (GC), institutional clients are open to fee arrangements instead of a billable hour arrangement. I recall one GC mentioning that law firms make earnest efforts to meet the billing guidelines set forth to avoid the write-off/appeal process and make the effort to provide the client with what they need, but seldom make the ask as to what the client would like. Law firms should explore this avenue that could potentially take the firm away from hourly billing and lead to improved fee arrangements that work for the firm and the institutional client.

Hourly clients can be more of a challenge with pricing, and the key is to make sure value perception is one of the rules of the game. As discussed in other columns, discounts are not the answer, but creating value is the game changer. This may require additional client hand-holding and education, but the key is ongoing communication and the ability to demonstrate to the client a result that is commensurate with the fees billed. It will not happen overnight, but the investment of time can potentially increase revenues and profitability.

Whether institutional or hourly, the collective voice of the client is being heard and law firms are now taking steps to provide more creative fee arrangements that work for clients and benefit the law firm. There is less focus on billable hours, while providing more cost predictability with less risk for clients. Law firms that understand their economics and profitability metrics are in a better position to be initiative-taking in sharing risk on fees with clients because there is more empirical certainty, allowing the law firms more flexibility to assume risk.

In 2023, law firms will continue to deal with the realities of client expectations and focus on delivery of legal services in an efficient and cost-effective manner—and delivering those services while generating profit. Understanding how much it costs the firm to produce a billable hour per task and per lawyer, as well as other productivity and cost-related metrics, is essential for successful pricing/fee arrangements and profitability.

The second big question many law firms are asking is “How many other law firms are actually ‘playing the revenue game’ using fee arrangements to the point of achieving profitability?” The short answer is that many firms are beginning to learn the value/metrics game and generate more profit, but many continue to make the same mistakes that significantly reduce profits. This is usually attributed to a lack of monitoring of performance metrics throughout the life of a matter and is compounded by a lack of ongoing management. Law firms cannot ignore matter performance management if the expectation is to have a successful and profitable fee arrangement. There are already many firms engaged in large-scale fee arrangements and doing so profitably. However, many of those firms made costly mistakes and learned from those mistakes.

Firms that have been successful with fee arrangements understand the need to monitor the mechanics of their practices through better planning and managing of their firms and engagements. Law is a business, and every firm functions as an economic model. When they plan and organize engagements and leverage efficiently, firms can become more profitable. In 2023, firms will need to get serious about the proper leveraging of attorneys to maximize client value, provide more predictability and minimize firm costs.

In addition to the usual profitability metrics such as fee collections, fee write-offs, and attorney time write-downs and write-offs, the most essential ingredient to maximize profitability is to maintain and enforce contemporaneous timekeeping. Whether firms stay with the billable hour or move to fee arrangements, timekeeping will continue to play a critical role in profitability. Clients can perceive the value of fee arrangements, but law firms must continue to track the time it takes to accomplish tasks. Timekeeping data will become a powerful planning tool, rather than something that gets passed on to the client in the form of a monthly bill. Better timekeeping practices will allow firms to better estimate fees to be charged for services and get a better handle on firm investment and generating profit.

At the end of the day, law firm profitability will hinge a great deal on the law firm’s ability to create value for the client, completing matters in an efficient and cost-effective manner, and the firm’s ability to learn new skills to improve internal behaviors and build success and profits.

The game is afoot, but the rules have not changed—performance metrics impacting client focus, client value and firm efficiency will continue to drive profitability. For our purposes, process improvement–driven profitability will take the lead in 2023. Fee arrangements developed based on process improvement-driven pricing strategies are not going away, despite the billable hour versus nonbillable hour debate. The billable hour as defined is here to stay, but it will serve multiple purposes, mostly as a planning tool. Law firms struggle with the balance of making the practice of law both satisfying and financially rewarding. In 2023, law firm profitability will be a balancing act that includes a composite of client expectations of efficiency, reduced legal fees and added value. The balancing act will become more complicated, but not insurmountable.

Law firms that can learn the rules of the game by setting goals and developing processes to keep matters on track, understanding their economics, and delivering more value to their clients in a timely manner, at a lower cost, will increase profitability and will have the competitive advantage in 2023.