What is driving law firm profit in 2021?
(AND A FEW TIPS TO HELP ON YOUR PRICING JOURNEY…)
I have had several discussions recently around what is likely to drive profit in law firms in 2021 in light of Covid-19. Notwithstanding the extreme uncertainty of the Covid-19 crisis and current economic environment, the answer is the same as it would have been six months ago, this time last year, or even ten years ago. Pricing is your biggest profit driver.
Every law firm, big or small, makes decisions about pricing their legal services. For most law firms, these decisions are made regularly – weekly, even daily. Anecdotally, there are various levels of sophistication that go into the decision-making process. Those larger firms with ample resources often have pricing managers employed which is highly advantageous. Some firms will map out a piece of work by breaking it into stages and apply fixed or value pricing (smart). Others work out how much it costs them to do the work and add a margin. Some base their pricing decisions off what they think the client will pay. Some look at what way the wind is blowing and put down a figure.
Whatever the level of sophistication, the pricing of your legal services also happens to be your biggest driver of profit. So, if increasing profit is something that is important to your firm, then you must get your pricing right.
Below are a few pricing ‘tips’ to help you on your pricing journey:
1. Understand the impact of increasing your prices.
Increasing rates does not increase profit proportionately. There is a positive flow-on effect on profit. Consider the following example:
10 hours work x $400 per hour = $4000 fees
Assume cost of production (CoP) is $300 per hour
10 hours work x $300 per hour = $3000
$4000 fees - $3000 CoP = $1000 profit
If rates increase by 5%, then:
10 hours work x $420 per hour = $4200 fees
Cost of production remains the same:
10 hours work x $300 per hour = $3000
$4200 fees - $3000 CoP = $1200 profit
The example shows a 5% increase in rates results in a 20% increase in profit because cost of production does not change with a rate increase.
2. Perception is reality.
Even a small increase in rates is great for profit. Aim to increase rates annually unless there is a very good reason not to. I guarantee your expenses will increase annually. If you are contemplating a rate increase and are unsure how your client will respond, remember these three points:
a. Your clients do not contemplate your rates anywhere near as much as you do;
b. If a client will not accept a small rate increase, there is likely something fundamentally wrong with the client relationship; and
c. The amount a client will pay hinges on the perceived value they are receiving.
Any pricing conversation with a client should always be about value, not price. If the conversation is about price, then there will always be a competitor who will do the work for less than you and the lowest price will usually win out. You have be able to clearly and succinctly communicate the value you can provide to a client.
3. Know how much it costs you.
Whether you price your legal services by hourly rates, fixed fees, value pricing, or otherwise, you must understand the cost of production to properly price your legal services. Otherwise, margin will not be known.
There are many ways cost of production can be calculated (which could be a whole other blog topic!). It is typically going to involve allocating direct expenses (those which can be directly applied to a fee earner) and indirect expenses (essentially all others) to fee earners. If you consider who uses what resources and in what amounts, then allocation of expenses can be complicated!
When going through the process remember it is not an exact science so there is no need to get too ‘granular’ with expense allocation. Be as fair as you can. Also, find a fair method that works for your firm which is precise yet is not too difficult to administer.
4. It’s not all about profit.
How you price your legal services will also impact how clients perceive your firm brand. Remember, this is how your clients perceive your firm, not what you say your firm does on your website! It is important because a positive brand perception means your firm is likely to get new work and/or a referral over a competitor.
If your pricing is too high, then there is an issue with the perceived value that the client is expecting. Clients will pay more for your legal services if they perceive the necessary value is present. If your pricing is too low and you are prepared to except requests for price decreases and discounts without negotiation, then it suggests to your client you do not value your own services.
Obviously, you can never price at a rate which is more than what a client will pay. But how do you know? The answer is easy - talk to your clients!
Pricing your legal services correctly is not just about increasing your profit margins. It impacts your brand, your reputation and what type of client you want to work with.
5. Don’t discount!
We saw in the calculation above in 1. that there is a positive effect on profit by increasing rates. The reverse applies to discounting! As the cost of production remains the same, the discount flows straight through to reduce your bottom line.
If you absolutely must discount, then do not do it for nothing. Scale your services back by, for example, removing a process from a matter, shorten the length of a standard report, or perhaps provide the report less frequently.
Next time a client asks you for a discount, ask yourself “Will this matter go ahead anyway?”
Discounting has a severe impact on your profit margin not to mention your brand perception.