Tuesday, March 23, 2010

Why Standardize?

This blog focuses on empirical contract analysis and the identification of contract standards. The main themes will be: change; economics and metrics.

This is my first foray into the blogosphere. I plan to write at least weekly on the forces driving change in the legal industry and how lawyers can best respond and adapt.

I'm speaking on the
Future of KM at ABA TechShow this week with Toby Brown from Fulbright & Jaworski. Many of you will know Toby through his well known 3 Geeks and a Law Blog. As I get ready for TechShow, it seems appropriate to start this blog on the topic of the economic factors driving change.

Paul Lippe of the
Legal OnRamp in "Embracing the New Normal" highlights the power of the current economic forces. Paul reports:

"• The general counsel of a major company explained that he had shifted his legal spending from 50 percent internal and 50 percent external to 70-30, thus reducing outside spending by 40 percent.

• The General Counsel Roundtable presented data showing that outside legal spending by the S&P 500 was dropping from $16.7B in 2007 to an estimated $13.8BB in 2010, a 17 percent decline."

These numbers are astounding. When working for larger companies, I began to get a sense of the degree of change needed to meet changing circumstances. Where for example, the corporation was challenged to reduce expenses by less than 10%, it could typically meet its goal by active expense control. When the business was challenged to reduce expenses by 10 to 15%, then expense control was not enough, and it would be forced to lay people off. In this circumstance, staff reductions would likely come from lower paid categories. However, when the goal ranged from 15-20%, then staff reductions would have to include senior staff. Each level of cost control has escalating impacts on the ability of the organization to meet its client's needs. But, where the expense goals rose to 20% or more, trimming expenses probably would not suffice. The business model would need to change.

Those of us involved in legal technology for many years have long debated what will it take for lawyers to fully embrace technology—not just generic technology for communication and word processing—but technology that automates the practice of law? If Paul's numbers are correct and this approach is widely adopted by US businesses, then change is not nigh: its here. And the change is not just incremental: it's a sea change.

The impacts and appropriate responses can be illustrated by a sliding bar chart—an idea I've adapted from Jeff Rovner. In this example, I pose the example of a law firm engaged to draft and negotiate an outsourcing agreement in each of the last three years.

In 2008, the firm bills 71.5 hours at a blended rate of $350 per hour. The total bill is $25,000. The firm, like many successful law firms in the pre-recessionary period enjoyed a profit margin of 40% and so we can calculate the cost of services was $15,000 and the firm's profit was $10,000.

In 2009, due to soft demand for legal services, the firm agreed to a discount of 20%. Nothing changed at the firm; the work was still performed in the traditional manner and it still took 71.5 hours. The cost of services therefore remained $15,000 and the discount "comes off the top" reducing profit by 50% to $5,000.

As the economy slowly comes out of recession, many hope to return to the good 'ole days. But this appears unlikely. Why would clients pay $25,000 this year for the same service for which they paid $20,000 last year?

The bottom line is that it is now easy to see how law firms can quickly bankrupt themselves through discounting because profit margins are quickly eroding. For this reason, law firms are seeing the importance and value of Alternative Fee Arrangements (AFA's).

In 2010 and beyond, firms may agree to a fixed price of $20,000 and adjust the internal cost lever "to the left." While it may take some investment, if firm's can reduce their costs by 20% and take 57 hours to draft and negotiate the agreement, their profit margin would be restored to 40%.

The chart shows there are two key determinates of profit: market price and internal costs. This is, of course, no different from any other business.

The market price is primarily set by macroeconomic trends and firm brand. Firm's have little control over macro trends. They can control their brand. It can take years to establish or improve brand quality. But, as Toyota has shown, a business can quickly tarnish its image.

Internal costs are entirely in the control of the firm. However, I get the sense from law firm leaders that they do not see the cost slider as being so fluid. For most lawyers, shifting the cost slider left is fraught with danger and uncertainty. This is where the legal technologists and knowledge management experts can help.

The better approach is maintain (or improve quality) while reducing costs. And, this will be the topic of the next post.

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