I recently had a conversation with one of my clients, a law firm managing partner, about profitability. He had attended a seminar put on by a management consultant who talked about profitability and the use of alternative or fixed fees, claiming that in order to determine whether a particular matter was profitable, the firm should keep track of time spent on that matter, multiply that by the hourly rate of the attorney(s) doing the work, and then compare that amount to the amount of the fixed fee received on that matter.
Unfortunately, this is how many lawyers try to determine whether they should use fixed fees and whether those matters are profitable. But in my view (and thankfully, in my client's), this approach is all wrong for a number of reasons:
- Any attorney's hourly rate is, to some degree, a fiction
- It is unproductive to calculate the profitability of a single matter
- Even on hourly billed cases, hourly rates may differ depending on what the market will bear
- This calculation only compares revenues, not profits
- Comparing a real number (money actually received) to a fantasy number (what may have been billed using hourly billing) is an exercise in futility
Hourly rate vs. Cost
As my client pointed out, he could make the flat fee matters look more profitable by lowering the attorney's hourly rate, which is already a somewhat arbitrary number which firms derive from some calcluation of overhead costs, hoped for profit and anticipated number of hours lawyers are expected to bill per year. But in most firms, there are different billable rates for different practice areas and different types of matters depending on what the market will bear in a particular case or practice area. And some clients negotiate for or set their own hourly rates.
The hourly rate calculation assumes an attorney will bill a certain number of hours per year, but does it really 'cost' the firm more if the attorney works more or less hours, if the attorney is paid on a yearly salary and generates revenue for the firm over and above their costs (their salary and the portion of overhead they use) to the firm? The 'cost' of the hour is the individual attorney's 'cost,' not the firm's cost, as I noted in this 2011 article written for Law Practice Today.
Profitability of individual matters
It's difficult to determine the "profitability" of individual matters, because these calculations don't take into account things like the potential for new business or referrals from the client or the costs associated with providing that particular service on that particular matter. An attorney's hourly rate - at least in theory - encompasses not only payment for the services rendered, but also some portion of overhead. But how do you carve that up to determine how much overhead should be allocated to individual flat or alternative fee matters?
This analysis also fails to take into account the simple fact that in most firms, some matters may be more profitable than others, but that isn't necessarily a bad thing. Yet making this comparison automatically makes the firm thing something is 'wrong' if a particular matter "could have" made more money if it were billed hourly.
Sometimes, an individiual matter is 'unprofitable' or less profitable than other matters, but taken as a whole the practice area or group of services provided is profitable. Every firm has some matters which pay for other matters, or which make taking other matters possible. Some matters provide less profitability but more consistent cash flow. Others provide the ability for less seasoned attorneys to gain experience, or provide services to the same clients who bring in larger or more lucrative matters (who might go elsewhere if the firm refused to provide the 'less profitable' services). Deciding the value of these matters to the firm based on this kind of hourly vs. fixed fee "profitability" comparison loses sight of these facts.
It may be helpful for firms to look at profitability of an attorney, a practice area or service provided (or of a client, if the firm receives multiple matters from a client) as a whole, but the only way to do that is to know the costs associated with providing those services which - once again - have nothing to do with the hours the lawyers spend on those matters. Costs include things like salaries, allocated staff, equipment, office space and other overhead, etc.
Even where a firm looks at the profitability of a specific client, practice area, industry or lawyer, the overall profitability of the firm must be taken into account, since there will be several factors that are not considered in those smaller profitability calculations, including things like business development, mentoring, staff management and administrative tasks, which are even more difficult to allocate per matter or per practice area.
Real Money vs. 'Hoped For' Money
Comparing a fictitious amount which might have been to the actual fee collected makes no sense. It assumes not only that the hours refelcted on the timesheet would all have been billed to the client, but also that the entire bill would have been paid.
The reaility is that hourly bills are often adjusted by the firm before being sent to the client. Even then, many clients do not simply accept the firm's bills, and not all clients pay in full and on time. Other factors not taken into account here include:Would there have been costs associated with collecting those fees? Would there be costs associated with the billing process or preparing hourly bills that do not exist with alternative or fixed fee arrangements?
Would the same client have even accepted an hourly billed arrangement at those rates?
Making a calculation based on what the firm may have billed, without knowing what would actually have been collected is inherently faulty - you're simply comparing income actually received to a fantasy - what good is that?
The comparison of what 'would have been' under an hourly rate and what actually was received under a fixed or other alternative fee arrangement not only fails to recognize that the client may not have actually paid the full hourly rate for any number of reasons, but it also doesn't actually measure profitability - it only measures revenue; it only takes part of the equation into account.
The problem with doing a real profitability calclulation (and the reason why many firms avoid it) is that it isn't easy to do; what part of overhead gets allocated to which matters or practice areas? If some services or employees are shared among groups or practice areas, this allocation makes a real difference in determining profitability.
This model also fails to take into account the potential upside to increased efficiencies which are more likely to emerge with alternative or fixed fee arrangements; hourly billing fails to encourage these efficiencies because more hours mean higher fees, which creates a disincentive to look for efficiencies. These efficiencies can increase profitability overall. They may also increase client satisfaction and referrals, neither of which is taken into account in the hourly vs. flat fee analysis.
The Bottom Line
Profit = Revenue - Costs
The only way to determine profitability is to know your costs (hours are not costs) and to subtract that number from revenue actually received. Sure, it's more difficult than simply comparing hours and hourly rates, but it's more accurate, too.