Although the discipline of pricing and the field of microeconomics have their roots in the bartering system–where value is king–most would agree that today’s pricing discussions are highly influenced by numbers. This is especially true in the legal industry, as we continue to debate the relevance of the billable hour and, more importantly, its replacements.
For many reasons, law firms have been very slow to embrace a non-hourly rate reality. Instead, the industry seems to believe the better solution is discounting. Because clients push the practice, law firms perpetuate this misguided approach. As Peter Zeughauser has noted, “The Achilles heel of many firms is that they use discounting to achieve high levels of client satisfaction…without focusing their partners on improving profit margin.” There is a disconnect between discounts and profitability.
Dodds’ 1-3-4 Rule
One of the clearest descriptions of the effects of discounting I’ve encountered comes from Stuart Dodds, our industry’s first professional pricer. Originally the Global Head of Pricing at Linklaters, Dodds currently serves as Director, Global Pricing and Legal Project Management at Baker & McKenzie. The illustrations below appear in Dodds’ forthcoming book, Smarter Pricing, Smarter Profit (ABA, 2014).
Dodds discovered the reality of a discount results in a disproportionate decline in profit.
Scenario
An attorney accepts a new matter at the hourly rate of $400, a 54% markup above the firm’s $260/hour cost. Working 100 hours on the matter gives the firm $40k in revenue. Subtracting the firm’s cost, $26k, from the matter’s revenue, $40k, yields the firm’s profit: $14k.
Now let’s pretend we’re in a post-Great Recession business climate, where discounting is ubiquitous. If the relationship partner agrees to a 10% discount (sound familiar?), the attorney’s new billing rate is $360. Let’s run through the scenario again.
Working 100 hours on the matter now gives the firm $36k in revenue. The firm’s costs don’t change just because the hourly rate changes, so the same $26k is subtracted from the matter’s revenue, $36k, yields the firm’s revised profit: $10k. That’s nearly a 30% drop!
More importantly, how much extra effort (i.e., hours) must the partner work to earn back that profit loss? According to Dodds’ chart, at the new rate of $360/hour, the partner would need an additional 40% more hours at the discounted rate to recover the lost profit of a 10% discount. (N.B. This calculation presumes 100% realization!)
The numbers are eye-opening: a 10% discount reduces profit by 30%, which in turn requires 40% more hours at the discounted rate to maintain the original profit. 1-3-4.
The effect is more devastating with tighter margins. For example, if your firm’s cost was $300, then a 10% discount triggers a 40% drop in profits (from $10k to $6k) and volume skyrockets to a 67% increase.
Lawyers didn’t go to law school because they like math. But I’m betting they would understand, appreciate and even embrace Dodds’ 1-3-4 Rule. We all should. Thanks, Stuart.
I think a lot of this material was originally developed about 10 years ago by Beaton Consulting in Australia, and indeed Mr Beaton is still posting on the subject. 1-3-4 is a nice heuristic though. Those guys in Oz seem to have figured out a lot of this stuff already; luckily for us the rest of the legal world isn’t in Oz. (And I won’t continue that as a fun metaphor).