The problems with AFAs run deeper than resistance to change

For at least the past ten years, alternative fee arrangements (AFAs) have appeared on the agenda of almost every law firm management seminar. Legal industry experts encouraged their use, clients incorporated them into requests for proposals (RFPs) and law firms scrambled to look progressive and be a part of an emerging trend.

Unfortunately (or fortunately), the legal industry changes very slowly. The most recent data suggests that less than 20 per cent of law firm billings last year were of the AFA variety. That does not mean that consultants, clients and law firms missed the mark. It just means that most firms remained more comfortable with their old ways of doing business.

Law firms historically resist change, but AFAs present bigger challenges than simply changing the business model. Many fee arrangements come under the AFA umbrella, but the fixed fee seems to be the simplest and easiest to implement. Clients desiring budget certainty embrace this model as being easy to understand and execute.

From large contractors to plumbers, people agree on fixed fees daily. Yet law firms still resist this alternative to the billable hour. In response to perceived demand from clients, why can’t law firms present a firm price for their product? Unfortunately, the answer is simple: most firms don’t know what it costs to produce that product.

Costs and margins

Historically, unlike most businesses, law firms rarely venture into the world of margins and costs. Most law firms only think in terms of gross revenues. The magic formula remains hours times billing rates. Firms don’t focus on what it costs to produce that hour.

Most compensation committees assess partner contribution based upon the gross revenue produced for the firm. “A million dollars in partner revenue is $1m in revenue for the firm,” they think. Rarely do firms delve into the profit margin on each of those million dollars.

Associates receive bonuses based on how many hours they work. Profitability? Margin? Those words rarely make it into the evaluation process. It’s all about gross. Firms reward people based on how hard they work, not how smart they work. As a result, few firms even know the margins made per lawyer or matter.

In these changing times, understanding the profitability of lawyers and the work they do is vital to a firm’s success and survival. Firms with no grasp of margins and profitability may find themselves looking at the same problem facing the bankrupt watermelon farmer. When asked what happened, he responded: “I was losing $3 per truck load of watermelons. I decided the answer was to sell more watermelons. It didn’t work.”

Firms will be forced to move away from straight hourly rates. Whether firms discount rates, agree to fixed fees or other AFAs, firms must understand their costs and margins. Otherwise, they may find that they have sold a lot of watermelons, but made very little profit.

To illustrate the utility of knowing costs and projecting margins, assume the firm bids on a matter based on partner rates of $250 per hour and associate rates of $150 per hour. The chosen associate works 2,000 hours, earns $150,000 with benefits of $30,000 and overheads of $140,000. The total cost for the associate is $320,000. Dividing this by 2,000 gives a per hour cost of $160.

Based on those figures, the firm will lose $10 per hour for the associate’s time on the engagement. This is not a recipe for financial success. The firm may still take the work, but it should at least know the financial implications. Optimally, a lower-priced associate should be chosen to work on the project. Almost any work can be done profitably if properly staffed.

Revisiting fixed fees

To propose a fixed fee, firms struggle to predict the number of hours that will be involved. Unfortunately, that should just be the beginning. Firms must know the cost of those hours to the firm – otherwise time estimates mean little. Staffing turns on cost. Profitability turns on cost.

To agree to a fixed fee, management must understand overheads, salaries and productivity. Fortunately, software can be purchased to analyse all facets of profitability, allowing management to look at just about any scenario. Firms can also use software to determine not just how much money partners and associates have brought in, but also how much the firm has made.

As firms begin to understand the importance of measuring profitability, fixed fee arrangements will become easier to understand and use. Although AFAs have taken a while to come into favour, they are here to stay. Well-run firms will embrace the opportunities they present, but only after understanding costs, margins and profitability.