Hourly billing: the end of the beginning

Over the past day and a half, I've gotten bunches of emails and tweets all asking the same questions: Had I read the Wall Street Journal story? What about the Corporate Counsel piece? Is the billable hour really dead? What do you have to say?

Here's what I have to say:

Come on in. The water's fine. What took you so long?

(Our firm, Shepherd Law Group, completely abandoned hourly billing nearly three years ago. We haven't billed — or even tracked — a single hour since 2006.)

In fact, the billable hour isn't dead (yet), but you're forgiven if you thought this had happened based on what you read Monday. Quick recap: The front page of The Wall Street Journal had a story called "'Billable Hour' Under Attack" (subscription possibly required). The story was written by Nathan Koppel and Ashby Jones, who wonderfully cover the Journal's legal beat. It's a great piece (although I have no idea why "billable hour" is in quotes in the headline). They report on the efforts of companies like Pfizer, Cisco Systems, and American Express to rein in legal spending by moving work away from hourly billing and into fixed-price arrangements. They write:

The companies are ditching the hourly structure — which critics complain offers law firms an incentive to rack up bigger bills — in favor of flat-fee contracts. One survey found an increase of more than 50% this year in corporate spending on alternatives to the traditional hourly-fee model.

Make sure you also watch the video sidebar with an interview of Amy Schulman, Pfizer's general counsel (it's about three minutes):

Also Monday, Corporate Counsel magazine ran a piece called "Two Veteran Lawyers Say Now Is the Time for Fixed Fees." WilmerHale lawyers William Lee and Benjamin Heineman wrote it (I hope they didn't suggest the title). In it, the veteran lawyers decry the billable hour and trumpet the benefits of fixed prices:

For in-house counsel facing tremendous budgetary pressures, the fixed fee addresses the problems caused by the hourly rate, such as unpredictability, high costs divorced from actual value and, most importantly, the maddening law firm definition of "productivity" — defined as more lawyers and more hours per matter.

Both articles are steps forward in the war on the legacy systems and guild mentality entrenched in most law firms and reflected in the billable-hour business model. But don't think for a moment that this is the end of the billable hour, or even the beginning of the end. But it is — to paraphrase Churchill — perhaps, the end of the beginning.

As I've often said, the issue is not about invoicing methods. It's much deeper than that. We're talking about changing the dominant business model of an entire industry, and that's not going to be done with a couple of articles. In fact, these two articles show how far we have to go.

Let me explain: There are three basic concepts that are at the root of misunderstanding about how the law-firm model works. They are cost, profit, and price.

• Cost. No customer anywhere gives a flying something through a rolling doughnut what a law firm's costs are. That's the firm's problem. Think about it: have you ever gone to a store to buy something and wondered about the retailer's costs? Of course not. Yet when you read the veteran lawyers' article in Corporate Counsel, costs are about the only thing they talk about. Clients don't care about whether you can reduce your costs, boys.
• Profit. Profit is what's left for a firm after you subtract cost from revenue. A customer shouldn't really care about your profits, other than having a vague understanding that a vendor needs to make profits (eventually) to justify being in business in the first place. Beyond that, though, the customer doesn't care. In fact, there's no earthly reason why the customer should even know what your profits are. It might be different if you were publicly traded, but no American law firms are. It's ironic that large law firms voluntarily self-report their profits (and more importantly, their profits per partner) and then have clients complain about the firms' profit margins. When you listen to the Journal's video of Pfizer's Schulman, notice how many times she refers disparagingly to law firms' profit margins. ("You're going to have to get used to making less money.")
  


• Price. And what is price? Get ready to write this down: Price is simply the measurement of something's value to a customer. It's as simple as that. It has nothing to do with profit. It has nothing to do with cost. The price of anything is the value that thing has to a particular customer at a particular time. Anyone who tells you otherwise needs to go audit Economics 101 at the local community college.

Nearly all law firms practice cost-led (or more accurately, cost-plus) pricing. In other words, they base their prices on their costs. WilmerHale does. Pfizer's "legal alliance" firms do. All these firms track their lawyers time on timesheets, and base their associates' performance and pay at least partly on hours billed.

Read what the Wilmer veterans have to say about cost:

As in all business, a total price for a matter or a book of business is built up from costs (and, at times, also derived from the significance of the matter). One of the most important issues in setting fixed fees is distinguishing between a law firm's actual costs (which firms see), and the actual costs, plus profit margins for the partners (which is what clients see in a firm's bills). A second, related problem is that the history of costs to the company may be an imperfect guide. Past bills are an aggregation of hourly rates (plus out-of-pocket costs), which may reflect inefficiencies.

Huh? No, fellas. The price depends on only one thing: the amount the customer will pay at that time. You can prattle on all you want about costs and budgets and efficiencies and inefficiencies, but it doesn't matter a whit. It's up to you to set a price that is less than or equal to the value the client places on your service. If you do, you'll be hired for the job. If the value to the client is high enough, you should be able to charge enough so that your revenue exceeds your costs, giving you a profit. But don't expect your client to care about your costs or your profits — that's not their job.

Both articles talk more about controlling costs and lowering law firms' profit margins. They don't talk about increasing value to the client. To really change the system, value — not costs — must lead pricing. Then firms won't have any use for timesheets.

As I said, it's the end of the beginning. But there's a long way to go.

Comments

[Justin]

It was taught to me years ago that the optimal model for marketing/advertising agencies is a replication of the law firm. And that one of the biggest mistakes that marketing firms made was going public, which puts significant pressure on revenue growth and cost control. This ultimately manifests itself in people working 80 hours a week for $30K so the holding companies can report 15% growth to the Street. Of course, that's a different issue (but I love the part about there being no publicly traded law firms). Selling value is something many marketing firms will struggle with, because we are finally being held accountable to performance - something that is relatively easy in law firms (you win or you don't). it's a fascinating trend and I look forward to it gaining momentum.

[Jeff G]

Nice one Jay! Glad to see that the idea is gaining traction in the mainstream!

I especially agree with the idea that price has nothing to do with the aggregated costs – it has completely to do with the value you are providing. Words for the wise, no matter what industry you work in!

[Greg George]

Exceptional article Jay - cutting-edge of how we all must think to sustain growth and remain progressive, not only lawyers, but most providing professional services. Your firm has been far ahead of the times.

We are not paid because of our credentials, experience, Hallowed references or expertise, we are paid because we provide a timely and cost effective solution to a clients problem.

[Jackie Hutter, IP Strategist]

This is an amazingly smart post. I would add that this is not the first time in history that it took an economic crisis to reveal the inherent failings of a longstanding business model. My experience as a law firm shareholder and senior in-house lawyer tells me that there were problems with the traditional law firm model, probably starting with the "salary bubble" of earlier in the decade. To react to this, law firms consolidated and cut back internally--all in an effort to perserve their profits. This "Great Recession" has hit clients so hard that it has become clear that the traditional law firm model is not sustainable over the long haul.

And, you are right, clients should (and will increasingly will) care only about the value provided by their law firms/lawyers. If they value the security provided by the perception of higher quality at large firms or the sheer "firepower" in terms of size provided by these firms, large firms will get the business. If clients don't see value in this "marble and mahogany" model, they will go elsewhere.

It will be tough going for a while, but I think innovative lawyers (such as those that appear to be at your firm) will come out on the other side in a far better position. Those lawyers/law firms that don't--well, remember how great it was to be a typewriter manufacturer? (cf. Wang Industries)

[nick White]

Great article Jay.

What’s true for the lawyers is equally true for other service providers such as those in my profession of patent attorney. We have the added issue in our profession of global norms in practice and behaviour to deal with and the service charge mentality. On your point about costs you know we still have people in our world who charge a service fee for sending a fax, whilst not charging at all for snail or e-mail! Amazing.

The hubris of large Law Firms is astonishing from a client perspective. I used to be a client before I jumped over the fence into the world of private practice. The point you make about firms volunteering their profitability just shows the contempt they have for their clients. The clients do complain but until now that has had little effect as the service providers were largely immune and indifferent to these complaints.

The key point made by Amy Schulman is the point about value in relation to all stakeholders. When it comes to client relationships and sustainability for any business, value is what it is all about. The problem with past behaviour is that legal service providers in the main had arms length relationships with their clients and had a short term focus on monthly billing targets almost to the exclusion of any other performance metrics. Whether or not they added value was not their problem or focus all that mattered was billable hours...today.

In our business model we have junked the billable hour and patent attorney service charges. It has been a liberating experience and not just for the clients! As an aside I have recently acquired Richard Susskind’s book “The End of Lawyers”. A very sobering read which covers the issues around this area and more.

[John L. Davidon]

Time based billing vs. fixed fee as a "business method?" Get serious. Billing methods are not business models.

Has no one read Coase? Does no one understand that time based billing may be cheaper because it is free from costs of negotiation of a fixed fee, or "project management," etc.

Has anyone looked at a chart on Pfizer's stock price over the last 5 years. If they had, who would listen to Amy Schulman?

The long term trend in the law is that clients are able to do their own legal work, as they learn more law, putting all kinds of pressures on law firms. Read Mark D. Suchman, who has been writing about this trend for 20 years.

Unlike medicine, where demand grows as patients learn, demand shrinks, as law firm clients learn.

Last, as to "business models," read Gary Hamel or Sam Walton or Drucker. Lawyers are smart people. For a long long time they have thought about how to change the model but, basically, the law business is the same today as it was at the start.

There is no new "business model" for defending a civil law suit, a federal criminal investigation, or an indictment. There is no new business model if someone is using your patent, sans royalty payments, or your trade secrets, contrary to an agreement not to compete after termination.

One can decide not to read a document or investigate a witness, but that isn't a business model, that's a cost/risk assessment. If one decides to read a document or interview a witness, a cost has been incurred and law firms will have to be paid that cost and a reasonable profit for doing such or they will go out of business. A fixed fee will not result in more documents being read or witnesses being interviewed. Instead, like new homebuilders--a notorious group of fixed fee suppliers---once the fee is fixed, the quality will be cut to the bone so as to maximize profit. That is how one profits in a fixed fee world--provide the service as cheaply as possible.