The first week, we started down the path of evaluating the cost of process improvement for a law department. The second week, we finished that analysis and started to looked at process improvement from the law firm’s perspective. This week, we continue our look at the value of process improvement from the law firm’s perspective.
When we did the ROI calculation for the law firm’s process improvement event, we got an ROI of -$35,927. As I noted, however, that is how it looks at first blush. We should dig deeper.
It turns out that what seems to be a disastrous event from the law firm’s perspective really is an opportunity. Ask lawyers, and they say the opportunity is to use the “saved” time to do more work for the same client or do work for a different or even new client. In other words, if a lawyer bills 40 hours per week she sees the time saved from the process improvement event as an opportunity to keep billing 40 hours per week, just with a different mix of clients and matters. That is an opportunity, but not the one I see and not one that would drive a rational investor to use the process improvement event.
Rethinking Law Firm Pricing
The opportunity I focus on offers much more to the lawyer and her client. It starts with the value model. Process improvement supports the lawyer moving from the billable hour to an alternative fee structure which can be more profitable for the law firm while costing the client less. We used the assumption that the lawyer bills at $500 per hour, so the lawyer was charging $2,500 for five hours work. After the first process improvement event, it takes the lawyer three hours to do the work, so everyone assumes the price will drop from $2,500 to $1,000. That is a bad assumption.
The value the client received has not changed. The only thing that changed was the input volume to produce that value. The lawyer could switch from charging by the hour to charging a fixed fee based on the value. On a fixed fee model, the lawyer can choose one of several paths including charge the original price, reduce the price a little, reduce the price a lot, or keep the price the same but offer additional services. The demand for the lawyer’s services will play an important role in the decision. The value of the services is determined by what clients will pay, not by the time it takes to provide the service. For example, even though it only took five hours to perform the service, clients may have been willing to pay $5,000. Of, while it still takes two hours to perform the service, clients may be willing to pay only $250.
Lawyers often think about revenue, but not about profit margin. Firms compensate lawyers based on revenue and often pay little attention to profit margin. Lawyers focus on revenue over profit because they are rewarded for doing so. Most large firms still have some partners generating millions of dollars of revenue on which the firms lose money. For example, the firm may have decided to support a practice area as part of the firm’s mix of services even though that practice area does not make moneyIf that is a conscious decision. In that case, the firm has made a rational decision.
Unfortunately, firms often maintain these money-losing practices for the wrong reasons. They may not want to have the firm’s overall revenue drop, the partner who owns the book of business could b politically powerful in the firm, or the firm simply does not know what it makes or loses on the business.
I am going to assume you want every revenue stream to generate a positive profit margin. Firm-wide profit margins vary at large firms, so I will pick 50% for this example to keep the numbers simple (large firm profit margins more typically range from the low 30s to the 40s, though individual practices can go much lower and higher). Our lawyer was billing (and we will assume collecting) $2,500 for five hours work. At a 50% profit margin, the firm made 0.50 x $2,500 = $1,250. What can the firm do when it takes only three hours to do the work under the various options I listed above:
1. Keep price the same. Profit margin increases to 70% ($2,500 – $750 cost = $1,750 profit, $1,750 / $2,500 = 70% profit margin).
2. Reduce the price a little. Our lawyer charges $2,000, and the profit margin still increases to 62.5% ($2,000-$750 cost = $1,250 profit, $1,250 / $2,000 = 62.5% profit margin).
3. Reduce the price a lot. Our lawyer charges $1,500, and the profit margin stays at 50% ($1,500 – $750 = $750 profit, $750 / $1,500 = 50% profit margin).
4. Keep the price the same but offer additional services. The profit margin will be somewhere between 50% and 70%, depending on the services the firm provides and assuming those services are not too costly so they push the profit margin below 50%.
The price our lawyer uses as the fixed fee will depend on many factors. They include the relationship with the client, the competitive market generally, competition for this particular matter, and the firm’s pricing philosophy.
But, one additional factor the lawyer should consider is the ROI on the investment to reduce the time on the matter from five to three hours. Ignoring the investment means the law firm will not recoup the investment, which is just bad business. There is an exception. If market prices are dropping drastically, then investing in process improvement may be a way to reduce costs while keeping pace with the drop in market prices. In that event, the law firm’s profit margin could get squeezed (from 50% to, say, 35%). Practitioners serving individuals and small businesses may be experiencing some of that with technology-driven competitors entering the market.
Improving the Law Firm ROI
Looking back at our law department example, we recall that the in-house lawyer repeated the process once a month. Over five years, the lawyer would iterate the process 60 times. That may sound like a lot of iterations, but when you break down what lawyers do, it is easy to find tasks that lawyers do hundreds of times each year. Time adds up across those tasks, which makes it easy to find ways to generate large ROIs on process improvement events.
We can translate the effect of repetition to the law firm setting. Again, to keep our example simple, we will assume our lawyer in the firm also does the five hour task once a month, though she performs the task for various clients (one month for Client A, the next for Client B, and so on). The initial cost to do the process improvement event stays the same at $15,000. Now we will look at the ROI for the law firm under a few scenarios.
First, we will assume that our lawyer decides to reduce the price for the matter from $2,500 to $2,000. In the first year, the firm will spend $15,000 during the first month. In the second month, the firm will spend $750 (versus $1,250 before improvement) to do the work, but it will collect $2,000 (versus $2,500 before the price drop). In other words, it will spend $500 less but it will collect $500 less, so the net change in cash flow (before the event to after) is $0. It will remain the same throughout the five years for an ROI of -$13,636.
If the firm spent $15,000 and saved $0 why is the ROI only -$13,636? The firm will have spent $15,000 to get no change in net cash flow, but a profit margin increase from 50% to 62.5% (plus whatever benefits they get from reducing the price to clients). The basic ROI formula assumes the $15,000 is spent at the end of the year, not the beginning. It discounts the amount to the present, which is why the ROI is less than $15,000. For those who want to be very precise, you can tweak the formula to address the timing issue.
The ROI went to -$13,636 from -$35,927, which is good, but we still don’t have a compelling argument for process improvement. Before we abandon this process improvement event, we should ask again whether we have considered in our calculations all of the benefits the firm will get from the event.
The answer is no. In our calculation, we assume no value to the two hours per iteration that were picked up from the event. In the first year, the firm picked up 11 x 2 = 22 hours and in years 2 through 5 it picked up 24 hours per year, for a total over five years of 118 hours. If the firm cannot do anything with those hours (they have 0 value to the firm), then our calculation was correct. But, if the firm can use those hours (do work and charge clients for the work), they have value.
Currently, each hour has $250 of value to the firm ($500 billed rate – $250 cost). If we add that value to our ROI calculation, we get a new ROI of $6,154. If the firm can use those hours at the 62.5% profit margin (for example, do the same task for more clients using only three hours and charging $2,000), the ROI increases to $11,101.
We can do a quick summary of process improvement from the firm’s perspective:
1. If a firm does a process improvement event and it sticks with the billable hour for its pricing model, it will be hard to justify doing process improvement. Firms that are comfortable billing by the hour and who have sufficient clients willing to pay by the hour may not benefit by becoming more efficient (at least not using this simple ROI analysis).
2. If a firm does a process improvement event and changes to an alternative fee pricing model, it is easy to justify doing process improvement, provided the firm sees value in the time saved by becoming more efficient. I showed one value—using the time saved to do work for other clients on an alternative fee schedule. There are other measures of value that could be used, such as lower employee turnover, higher client attraction and retention rates, and higher employee satisfaction from doing less wasteful work. Always remember time is the one thing we cannot replace, so saving time has value.
3. Process improvement events have value beyond the obvious. We did not talk about the value to the client of reducing the work time from five to three hours. The client may value getting the work product more quickly. That value may express itself as client satisfaction. Some clients may be willing to pay more for a faster resolution.
We have seen how process improvement events can generate positive ROIs within a law department and a law firm. But process improvement does not live alone today, like it did back when companies first started using it. In the 1970s when Toyota put more structure around its corporate process improvement program, and in the 1980s and 1990s when U.S. companies adopted process improvement, the question was often binary—do process improvement or stick with the current method. Today, another alternative frequently pops up, and that is technology and more specifically computer systems.
It makes sense for us to look at process improvement and ask whether the ROI method of valuing an event has anything to offer when we consider using computers as an alternative to labor. Next week, in the final installment of this four-part post, I will look at technology, the ROI analysis, and add some closing thoughts.