Wage Growth Is Dependent on Revenue/Profit Growth

The National Law Journal 2010 Law Firm Billing Survey reports a 2.7% increase in average firm-wide billing rates over 2009 in the 250 largest U.S. law firms. This is a significant departure from larger annual, pre-recession increases. Nevertheless, it is roughly consistent with inflation, which may offer some measure of solace.

If the slowdown in annual rate increases marks a turning point in the pricing profile of the legal profession, it could lead to some serious wage growth challenges for law firms. Wage growth is dependent on both per-timekeeper revenue and profit growth.

Per-timekeeper revenue is a function of pricing (mostly hourly rates), utilization (billable hours) and realization (what is collected as a percentage of the value of the time recorded). In the last 25 years, annual billing rate increases (typically close to twice the annual rate of inflation) have been the key driver of per-timekeeper revenue growth in excess of inflation (see Chart 1, below).

[IMGCAP(1)]

From 1985 to 2009, associate utilization was extremely consistent ' rising only about 1% total between 1985 and 2007, and then dipping through 2009 for a net 1% total decline over the 25-year period. Partner billable hours fluctuated more, growing by 12% in the pre-recession years, and ending with a net 6% increase in 2009.

Realization actually decreased slightly (about 10% overall), reflecting increased use of pricing discounts, greater write-downs of time value at the point of billing and increased write-offs of receivables. The recession accounted for three of the 10 percentage points given up. Thus, per-timekeeper revenue has been largely dependent upon pricing increases (changes in stated hourly rates).

Overhead

Profit growth is also an important element in the wage growth equation ' which leads to a brief word on overhead. Overhead is the total cost of operating the law firm, excluding timekeeper compensation. In this regard, we examine overhead on per-lawyer and per-fee earner bases. The profit in this instance represents what is available to pay timekeepers after all operating costs have been covered.

Per-timekeeper overhead has followed predictable patterns over the past 25 years (see Chart 2, below). In good economic times, it rose faster than inflation. In recessions, it held steady or declined. This pattern repeats itself outside of the legal profession as well. Very few business managers have the discipline or resolve to run an operation on a full “lean and mean” basis in perpetuity. When opportunities exist to boost the top line, cost structures get fat. During recessions, attention is focused on what is controllable ' expenses. And in this author's opinion, this round of cost control declarations will wane as the economy recovers, just like so many New Year's resolutions.

[IMGCAP(2)]

The good news is that while overhead growth has exceeded inflation since 1985, it only consumed a portion of the billing rate increases. This yielded the opportunity for rather impressive, sustained wage growth for timekeepers, at least up through 2007. Interestingly, competition to acquire and retain associates resulted in more of that gain being allocated to them than to partners (see Table 1, below).

[IMGCAP(3)]

Perpetuating Strong Wage Growth

If this year marks a turning point in the pricing profile (which is largely dependent on how aggressive clients are ' keep in mind my earlier admonition regarding cost control declarations) how then does one perpetuate strong wage growth?

Absent traditional billing rate increases, lawyers might work harder (more billable hours), work more efficiently (better realization), or discount less (also better realization) to fund equivalent pay hikes. How likely is each of these? And how effective?

Peak billable hours for lawyers occur during the sixth or seventh year of practice and exhibit a steady decline for the remainder of their careers. Note that those historic rate increases largely fueled the ever-rising revenue curve of a lawyer over a career. Add to that hours profile an aging lawyer population and the increased effort required to develop business, and the likelihood of partners working harder is low. It is also unlikely that associates can sustain a much more aggressive work routine. Many would argue that the job already has extreme hour expectations at all levels. Working harder also requires not only the desire to do so, but also sufficient work to warrant the additional time.

The next tactic ' working more efficiently ' is an opposing factor to higher billable hours. Some experts have postulated that 15% greater efficiency is achievable over time through improved practice skills and methods, legal project management and more aggressive technology utilization. If you charge on an hourly basis this benefit inures to the client, unless you can raise rates sufficiently to compensate.

Alternative fee arrangements may offer the provider some means to retain a portion of that benefit without an obvious rate increase. Otherwise, the full revenue loss from efficiency gains must come from more work volume. At least in the short run, many firms seem focused on taking market share from their competitors, not opening new untapped markets. So the opportunities for increased work volume are diminished compared with what is typical in a period of economic recovery.

An argument exists for using increased efficiency as a means for the provider to hold the line on discounts. However, this is a market populated with aggressive clients eager to negotiate discounted rates ' at least in the short term. If clients revert to long-term patterns (a statistical expectation) and the economy recovers, then much of the discounting pressures may recede. This would be good if it happened, but it is probably not a good primary planning assumption.

For those law firms that operate in areas of the law dominated by third-party payers (insurance carriers), the pricing challenges are not likely to improve. This is an anomaly. There exists a mismatched relationship between buyer and seller, with buyer having a far greater bargaining position in the pricing discussion. Rate structures have been and will continue to be depressed relative to other venues with similar work, and/or the gap between stated and actual rates will remain exaggerated compared with the rest of the profession. Unfortunately, there is not much likelihood of relaxed discounting for those practitioners.

So we come back to the basic equation; to increase compensation, revenue must increase or costs must decrease. Revenue increases are going to be harder to obtain when the primary revenue driver ' rate increases ' is constrained, and the remaining drivers are significantly more difficult to improve.

Cost reductions, beyond the belt-tightening undertaken during the recession, are also going to be harder to realize. Much of what is left to exploit will likely primarily benefit clients ' the outsourcing of certain legal services, the deployment of technology ' which could have the perverse consequence of driving up capital investment for law firms, while simultaneously driving down fee revenue and reducing the cost to service clients.

A Holistic View

If I were planning how to approach the new decade, I would take a holistic view of revamping the law firm: pushing forward initiatives in alternative fee arrangements, extensive deployment of intelligent technology tools and restructuring of the service delivery model. Starting with pilot programs within practice groups and with specific clients will be necessary to build confidence, competencies and skills in these areas. Even if the market is slow to embrace such measures, there is likely a tipping point where expectations will accelerate. That tipping point may very well occur in this decade. Those law firms that undertake this effort early will be the ones positioned to capitalize when the tipping point arrives.

James D. Cotterman, a member of this newsletter's Board of Editors, is a principal of Altman Weil, Inc., a legal management consultancy headquartered in suburban Philadelphia. Contact Cotterman at 407-381-2426 or e-mail [email protected]. Copyright ' 2011, Altman Weil, Inc., Newtown Square, PA, USA

The National Law Journal 2010 Law Firm Billing Survey reports a 2.7% increase in average firm-wide billing rates over 2009 in the 250 largest U.S. law firms. This is a significant departure from larger annual, pre-recession increases. Nevertheless, it is roughly consistent with inflation, which may offer some measure of solace.

If the slowdown in annual rate increases marks a turning point in the pricing profile of the legal profession, it could lead to some serious wage growth challenges for law firms. Wage growth is dependent on both per-timekeeper revenue and profit growth.

Per-timekeeper revenue is a function of pricing (mostly hourly rates), utilization (billable hours) and realization (what is collected as a percentage of the value of the time recorded). In the last 25 years, annual billing rate increases (typically close to twice the annual rate of inflation) have been the key driver of per-timekeeper revenue growth in excess of inflation (see Chart 1, below).

[IMGCAP(1)]

From 1985 to 2009, associate utilization was extremely consistent ' rising only about 1% total between 1985 and 2007, and then dipping through 2009 for a net 1% total decline over the 25-year period. Partner billable hours fluctuated more, growing by 12% in the pre-recession years, and ending with a net 6% increase in 2009.

Realization actually decreased slightly (about 10% overall), reflecting increased use of pricing discounts, greater write-downs of time value at the point of billing and increased write-offs of receivables. The recession accounted for three of the 10 percentage points given up. Thus, per-timekeeper revenue has been largely dependent upon pricing increases (changes in stated hourly rates).

Overhead

Profit growth is also an important element in the wage growth equation ' which leads to a brief word on overhead. Overhead is the total cost of operating the law firm, excluding timekeeper compensation. In this regard, we examine overhead on per-lawyer and per-fee earner bases. The profit in this instance represents what is available to pay timekeepers after all operating costs have been covered.

Per-timekeeper overhead has followed predictable patterns over the past 25 years (see Chart 2, below). In good economic times, it rose faster than inflation. In recessions, it held steady or declined. This pattern repeats itself outside of the legal profession as well. Very few business managers have the discipline or resolve to run an operation on a full “lean and mean” basis in perpetuity. When opportunities exist to boost the top line, cost structures get fat. During recessions, attention is focused on what is controllable ' expenses. And in this author's opinion, this round of cost control declarations will wane as the economy recovers, just like so many New Year's resolutions.

[IMGCAP(2)]

The good news is that while overhead growth has exceeded inflation since 1985, it only consumed a portion of the billing rate increases. This yielded the opportunity for rather impressive, sustained wage growth for timekeepers, at least up through 2007. Interestingly, competition to acquire and retain associates resulted in more of that gain being allocated to them than to partners (see Table 1, below).

[IMGCAP(3)]

Perpetuating Strong Wage Growth

If this year marks a turning point in the pricing profile (which is largely dependent on how aggressive clients are ' keep in mind my earlier admonition regarding cost control declarations) how then does one perpetuate strong wage growth?

Absent traditional billing rate increases, lawyers might work harder (more billable hours), work more efficiently (better realization), or discount less (also better realization) to fund equivalent pay hikes. How likely is each of these? And how effective?

Peak billable hours for lawyers occur during the sixth or seventh year of practice and exhibit a steady decline for the remainder of their careers. Note that those historic rate increases largely fueled the ever-rising revenue curve of a lawyer over a career. Add to that hours profile an aging lawyer population and the increased effort required to develop business, and the likelihood of partners working harder is low. It is also unlikely that associates can sustain a much more aggressive work routine. Many would argue that the job already has extreme hour expectations at all levels. Working harder also requires not only the desire to do so, but also sufficient work to warrant the additional time.

The next tactic ' working more efficiently ' is an opposing factor to higher billable hours. Some experts have postulated that 15% greater efficiency is achievable over time through improved practice skills and methods, legal project management and more aggressive technology utilization. If you charge on an hourly basis this benefit inures to the client, unless you can raise rates sufficiently to compensate.

Alternative fee arrangements may offer the provider some means to retain a portion of that benefit without an obvious rate increase. Otherwise, the full revenue loss from efficiency gains must come from more work volume. At least in the short run, many firms seem focused on taking market share from their competitors, not opening new untapped markets. So the opportunities for increased work volume are diminished compared with what is typical in a period of economic recovery.

An argument exists for using increased efficiency as a means for the provider to hold the line on discounts. However, this is a market populated with aggressive clients eager to negotiate discounted rates ' at least in the short term. If clients revert to long-term patterns (a statistical expectation) and the economy recovers, then much of the discounting pressures may recede. This would be good if it happened, but it is probably not a good primary planning assumption.

For those law firms that operate in areas of the law dominated by third-party payers (insurance carriers), the pricing challenges are not likely to improve. This is an anomaly. There exists a mismatched relationship between buyer and seller, with buyer having a far greater bargaining position in the pricing discussion. Rate structures have been and will continue to be depressed relative to other venues with similar work, and/or the gap between stated and actual rates will remain exaggerated compared with the rest of the profession. Unfortunately, there is not much likelihood of relaxed discounting for those practitioners.

So we come back to the basic equation; to increase compensation, revenue must increase or costs must decrease. Revenue increases are going to be harder to obtain when the primary revenue driver ' rate increases ' is constrained, and the remaining drivers are significantly more difficult to improve.

Cost reductions, beyond the belt-tightening undertaken during the recession, are also going to be harder to realize. Much of what is left to exploit will likely primarily benefit clients ' the outsourcing of certain legal services, the deployment of technology ' which could have the perverse consequence of driving up capital investment for law firms, while simultaneously driving down fee revenue and reducing the cost to service clients.

A Holistic View

If I were planning how to approach the new decade, I would take a holistic view of revamping the law firm: pushing forward initiatives in alternative fee arrangements, extensive deployment of intelligent technology tools and restructuring of the service delivery model. Starting with pilot programs within practice groups and with specific clients will be necessary to build confidence, competencies and skills in these areas. Even if the market is slow to embrace such measures, there is likely a tipping point where expectations will accelerate. That tipping point may very well occur in this decade. Those law firms that undertake this effort early will be the ones positioned to capitalize when the tipping point arrives.

James D. Cotterman, a member of this newsletter's Board of Editors, is a principal of Altman Weil, Inc., a legal management consultancy headquartered in suburban Philadelphia. Contact Cotterman at 407-381-2426 or e-mail [email protected]. Copyright ' 2011, Altman Weil, Inc., Newtown Square, PA, USA