Pricing (Part 2 of 6): The cost-plus approach

A few weeks ago, when I gave a speech at the retreat of a 1,000 lawyer firm, a senior partner asked:  "In your experience, how do large firms determine costs?"  I replied:  "Mostly, they don't.  Until recently, most firms were making so much money they didn't need to precisely calculate their costs."

Many lawyers seem to think of their standard hourly rates as being equal to the firm's costs.  But traditionally, rates have actually been based on "cost plus a lot" and no one was quite sure which part was the cost and which part was the "plus a lot."

One underlying problem is that compensation of equity partners typically is based on dividing the firm's profits at the end of the year.  To cite an extreme example, consider Wachtel, which had the highest profits per partner in the AmLaw 100 last year:  $4,350,000.  Some equity partners were paid more than this average, some were paid less.  But let's consider a lawyer who was paid exactly that amount. 

He may think of his $4,350,000 annual draw as a cost of doing business.  But the chances are Wachtel could stay in business if he were forced to scrape by on $3 million, or even $2 million.  What fraction of his draw is a true cost and what part is his share of the profits?  Until the day that Wachtel guarantees equity partners a baseline salary, and identifies the rest as a discretionary profit-sharing bonus, the line between cost and plus will remain arbitrary.

Despite this lack of precision, most law firm pricing has traditionally been based on the cost-plus model.  As Ron Baker points out in his influential book Pricing on Purpose (p. 88), it seems fair to start from costs and add a reasonable markup for profit.  But Baker strongly favors value pricing over cost plus.  After listing twelve bullet points that people use in arguing in favor of the cost-plus approach, he notes "It is amazing how many businesses still cling to the cost-plus pricing method... Doing something stupid once is just stupid.  Doing it twice is a philosophy." 

The authors of the fifth edition of The Strategy and Tactics of Pricing (p. 2-3) are a bit gentler when they say:

Cost-plus pricing is... in theory, a simple guide to profitability; in practice, it is a blueprint for mediocre financial performance. The problem with cost-driven pricing is fundamental:  In most industries it is impossible to determine a product's unit cost before determining its price.  Why?  Because unit costs change with volume.

In traditional legal work, the "unit" you are selling is the billable hour.  To see how its cost changes with volume, consider the case of Beth, an AmLaw 200 senior associate who specializes in labor law, and is considering going out on her own.

Last year Beth billed 2000 hours at an average rate of $300 per hour.  Since the firm charged $600,000 for her time, and Beth was paid a salary of $250,000, the firm's share of her billings was $350,000.  It seems obvious to Beth that if she hung her own shingle, she should be able to charge less, and make more. 

Her first question is what she should charge per hour.  She goes on the web, and finds this cost plus formula: 

Average Billing Rate = (Expenses + Desired Profit)/ Realized Hours.

Realized hours, of course, are the hours which are not only billed but also paid.  Since she will be a solo practitioner, the "desired profit" equals the amount she would realistically expect to take home in addition to her salary at the end of the year. 

Beth is not a numbers person, so she asks her math-loving sister to do the calculations which appear in the table below.

At the beginning of the year, Beth's salary is only an estimate, since she will be her own boss, and what she earns will depend on her revenue and expenses.

Although her calculations suggested an hourly rate of $175, Beth decides to start by charging $200 per hour to leave a safety margin in cases expenses are higher than predicted, her billable hours are lower and/or some clients fail to pay their bills.

Beth asks a CPA friend to review her sister's thinking.  He says that he would like to see more details about exactly what she will spend on rent, insurance, payroll taxes, and everything else, but the analysis is basically sound.  However, he says that Beth needs to factor in one more thing:  the non-billable hours (indirect labor) that she has to work to set up the office, send out her bills, and find new clients. 

Consultants often don't track the unbilled time they spend on marketing and administration.  But from a CPA's point of view, that time has a value, and is a cost of doing business, so it should be included in the cost analysis.  This may seem like hairsplitting to a new solo, but as Beth's firm grows it will be extremely important to track.  

After talking to the CPA, Beth does not change her projection for the bottom line, but her sister does add a few lines to her chart as follows.  (Note to readers:  Feel free to skip this chart, and all the rest.  The text summarizes the main conclusions.)

The point is that she has used the cost-plus equation. She raised her hourly billing rate so as to add to her expenses an amount for desired profit - and she had to know what her expenses were and do the math.

So Beth goes out, rents an office, and gets started.  At the end of the year, her big picture projections turn out to be close, but of course many details turn out to be different.  On the negative side, her clients don't give her quite as much work as she expected, one client fails to pay a small bill, and it takes more time than she predicted to start the business.  She ends up with only 1500 realized hours instead of 2000, and worked 550 unrealized hours instead of 500. On the positive side, she controls other expenses like a hawk, and is able to spend 14% below her initial budget.  At the end of the year, her figures look like the next table. (Again, feel free to skip to the text after the table.)

All in all, a reasonable first year.  She "lost" $35,640 (that is, she had to reduce her desired salary) instead of making a profit of $50,000, but she also worked 450 hours less than planned and covered most of her salary while working independently.  Most new solos would be happy with this result.

In terms of our example, however, the point is that the only way to truly know her costs was to wait until the end of the year, see what she actually spent, see how many hours were actually billed and paid, and then do the math. When her sales volume changed, her unit costs changed as well.

It could have turned out very differently.  If she had been able to bill the full 2000 hours and all were paid (realized) as originally planned, her cost per direct labor hour would have been $167.82.  If her billable hours had declined to 1000, the same expenses would have led to a cost per direct labor hour of $335.84.

Now take these uncertainties, and multiply them by 100 lawyers or 1000, with laterals coming and going, and client needs constantly changing, and you will begin to get an appreciation for how difficult it would be to accurately predict a large firms's cost per hour at the beginning of the year.  Any cost estimate at the beginning of the year will depend on a number of assumptions.  And when some of those assumptions inevitably turn out to be incorrect, the cost numbers will need to change.

However, it can be done.  Government contractors who work under cost-plus contracts are required to estimate their costs at the beginning of each year, bill the government all year long at the estimated rate, and then do a reconciliation at the end of the year to determine actual reimbursable costs.  If actual costs exceed the original estimate, contractors typically must request permission to exceed the contract limit, giving the government 90 days advance notice.  If costs are lower than the original estimate, at the end of the year the government gets a refund.

To make money within these rules, contractors set up elaborate financial reporting systems to provide early warning of variance from their projections, and they change their spending at the first sign of a problem.  So it is certainly possible to run a company within narrow cost limits, but it requires a degree of financial analysis and control that would be a revolutionary change for law firms.

These days, many partners in large firms do not understand even the rough costs of each billable hour.  Does it matter?  Yes it does.  As one AmLaw 100 decision maker put it in the LegalBizDev Survey of Alternative Fees:

Our partners are the salesmen as well as the producing managers on a lot of this work, so they've got to be armed with our own internal costs and how we can adjust those internal costs. If somebody comes back and says [that they'd] like to do this work, and [they know] what [they] need, but [that they] can only get $150,000 for the project, then we have to say [whether we can make it work, or] if we're doing it with no profit margin or as a loss leader. There need to be people in the organization that can sit down with the partners and talk to them about costs and [then] arm them to talk to the general counsels.

Cost-plus may or may not be a good basis for setting prices.  But if law firms want to stay in business in an ever more competitive world, they must ultimately charge at least as much as they spend.  And that starts with understanding their costs.  In future posts, we will discuss how this relates to value billing and more.

This post was written by Jim Hassett and Matt Hassett. 

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