Why Understanding Economics is the Key to Law Firm Profitability

Why Understanding Economics is the Key to Law Firm Profitability

“One of the biggest flaws with alternative fee arrangements (AFAs) not succeeding in law firms, is most law firms don’t understand their economics,” says Frederick J. Esposito, Jr., CLM, executive director of Long Island, New York and New Jersey based regional law firm, Rivkin Radler, LLP.

Mr. Esposito believes law firms focus too heavily on rate setting. By contrast he suggests, firms need to take into account law firm expenses. In other words, focus not just how much the firm charges clients, but how much it costs the firm to produce the work and keep clients happy.

“Right now it’s a client’s market, cautions Mr. Esposito, clients want focus and value, they want their law firms to work more efficiently and they want to pay less.”

To address this, firms need to understand their data, he says.

“You have to read and understand your data and you have to look at billable hours and monitor those hours and ask the questions. Are the hours increasing or decreasing?  Are the billing numbers low, are they high?” What is the realization for billing and collections?

The goal, he says, is to bring that information forward to answer important business questions, such as:

What can we do ensure the work an attorney brings into the firm will actually make the firm money?

To answer this question accurately, he recommends law firms consider the following profit/loss formula:

  • An attorney’s total compensation. This figure not only includes how much an attorney is paid in salary, but also the attorney’s compensation benefits, taxes and any expenses allocated to the attorney such as administrative support staff. Essentially, this figure needs to include the total overall direct expense allocation to that attorney.
  • Work cash versus actual direct expenses. This figure gives a profit & loss for the attorney based on the hours they’ve worked against their total overall direct expenses.

“Just because an attorney brings $3 million in work, adds Mr. Esposito, doesn’t necessarily mean it’s a win for the firm, especially if it costs the firm $4 million to service the business.”

“It really comes down to how much it costs to produce the work,” he adds.

Once this information becomes realized, it benefit law firms in several important ways:

  • Creates value
  • Covers Cost
  • Assumes Risk
  • Makes Money

The only trouble is only a small percentage of firms are actually proactively adapting their practices to meet the changing demands of the business. Instead, too many firms approach their clients in a reactionary way.

“Law firms need to view the profession as a business,” he adds.

In addition, to understanding their economics and how the firm produces revenue, another important aspect of managing the firm more like a business, involves weeding out the good clients from the bad. Some attorneys know their value and turn clients away, he says, but astonishingly, some attorneys still discount their fees by up to 30 percent, in an attempt to succumb to client demands.

This is approach isn’t helping them, he adds.

“Just ask yourself, do I really want to cut my fees?” If the answer is no, then the firm most likely doesn’t need to keep that type of client in the firm.”

While there’s still a fundamental resistance to change by some law firms, Mr. Esposito believes those firms that proactively look at their business models, understand their economics to better address pricing issues and work more efficiently to adapt to evolving client demands, will be those poised to succeed in today’s highly competitive legal market.

This post is by Carla Del Bove, who provides support to the business of law software product line based in the LexisNexis Raleigh Technology Center.

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