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."

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.

Break-even hourly rate or cost per
billable hour (Expenses/ realized hours)

$175 per hour

Total revenue (Realized hours x
hourly rate)

$350,000

Profit (loss) for end of year
bonus or correction

$0

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.)

Projected expenses and revenue

Salary

$250,000

Number of hours worked

2500

Salary per hour

$100

Direct labor ($100 salary per hour
x 2000 realized hours)

$200,000

Indirect labor overhead ($100
salary per hour x 500 unrealized hours for administration, marketing and
unpaid bills)

$ 50,000

Other overhead expenses
(malpractice insurance, health insurance, fringe benefits, taxes, rent, phone
etc.)

$100,000

Total expenses

$350,000

Overhead rate ((Indirect labor +
other overhead)/ Direct labor)

75%

Break-even hourly rate or cost per
billable hour (Expenses/ realized hours)

$175

Actual hourly rate

$200

Total revenue (Realized hours x
hourly rate)

$400,000

Profit (loss) for end of year
bonus or correction

$ 50,000

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.)

Actual expenses and revenue

Salary

$250,000

Number of hours worked

2050

Salary per hour

$121.95

Direct labor ($121,95 salary per
hour x 1500 realized hours)

$182,925

Indirect labor overhead ($121.95
salary per hour x 550 unrealized hours for administration, marketing and
unpaid bills)

$ 67,073

Other overhead expenses
(malpractice insurance, health insurance, fringe benefits, taxes, rent, phone
etc.)

$85,642

Total expenses

$335,640

Overhead rate ((Indirect labor +
other overhead)/ Direct labor)

83.48%

Break-even hourly rate or cost per
billable hour (Expenses/ realized hours)

$223.76

Actual hourly rate

$200

Total revenue (Realized hours x
actual hourly rate)

$300,000

Profit (loss) for end of year
bonus or correction

(35,640)

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.