Lloyd’s of Lawyers (or, If only insurance companies would learn how to price)

There is a fascinating article in the June 29, 2006 edition of Lawyers Weekly, out of Australia, entitled “A time honoured debate: how should law firms charge?” You can read the entire article here.

Basically, the article predicts that even with the substantial criticisms of time billing, it “seems destined to remain.” Some of the justifications given are as follows:

In the opinion of Ian Roberts, managing partner of Holding Redlich’s Sydney office, nobody, whether clients or law firms, likes hourly rates very much. “It’s just that for a lot of work there isn’t a better way to charge,” he says.

“If the client can specify with considerable accuracy exactly what has to be done, the law firm should be able to do that work for a fixed price. But it’s a bit like going to a tennis court without knowing who your opponent is going to be.” On major acquisitions, it is difficult to predict what the other parties are going to do, and how much work will be required.

“We have all been caught in situations where what appeared to be a quite straightforward transaction was anything but. In those circumstances, I haven’t been able to think of a better way [to charge] than an hourly rate basis.”

Likewise, John O’Sullivan, general counsel of the Commonwealth Bank of Australia, does not believe that
fixed fee arrangements are a ‘silver bullet’ solution. “To ask law firms to accept billing methods other than
hourly rate billing in matters where the quantity of work is not itself fixed is simply a means of asking law
firms to share the risk on the cost.”

Maybe Ian Roberts and John O’Sullivan are right. Maybe 135 years of economic theory and laws, along
with centuries of customer buying habits are wrong. Customers really do like cost-plus pricing. In fact,
I had an interesting conversation today with my homeowner insurance company, which I thought you might
find enlightening. It certainly was an epiphany for me. I am now renouncing the VeraSage Quest to rid the professions of cost-plus billing.

Insurance Company Agent (ICA): “Good afternoon, CSAA, how may I help you.”

Ron: “Hello, this is Ron Baker and I am interested in earthquake coverage for my home.”

ICA: “Excellent, Mr. Baker. I see you’ve been a customer with us for nearly 30 years. We will take
excellent care of you, as we have in the past.”

Ron: “Great. How much would the standard earthquake coverage premium be for my home?”

ICA: “Before I answer, Mr. Baker, I need to ask you if you are aware of the fact that our company was
recently acquired by a consortium of lawyers and CPAs?”

Ron: “Uh, no, I wasn’t aware of that. Congratulations, I think.”

ICA: “Thank you. You see, at their recent partnership retreat they had
what’s known as a BFO (Blinding Flash of the Obvious). You see, Mr. Baker, we really don’t know how much
it is going to cost to insure your home against an earthquake. There are far too many risks and
uncertainties in this line of business. We don’t know how big the next quake will be, where it will hit, or
what the damage will be to our policyholders homes. How could we possibly give you a fixed price under
these conditions, which is what our new owners asked themselves during the retreat. I think you agree
that is certainly a conundrum, no?”

Ron: “I guess, but how I am suppose to know if I can even afford this extra coverage? How can I make a
prudent and informed buying decision on the value of the coverage if I don’t know the price?”

ICA: “I understand the question, Mr. Baker, and it’s a good one. In fact, I’ve been getting it all week from
our policyholders. Our new owners answer is that it would not be fair to charge you a premium that
exceeded the actual damages, plus a normal rate of profit of course, including the time value of money.
Nor would it be fair to charge you a premium that did not cover the actual damages, plus a normal
rate of profit, of course. So you see, we simply can’t give you a price for your earthquake insurance.
There are just too many variables. Does that answer your question?”

Ron: “Not really. I can’t really make a decision about this until I know the price.”

ICA: “Well, Mr. Baker, I understand your dilemma, but I don’t think you’re viewing this from our perspective.
The new way it works is as follows: We put your name on the earthquake insurance list, along with the date
you decided to opt for coverage. Heaven forbid, if an earthquake were to strike, and your home is
damaged beyond the deductible, you will submit a claim. We will aggregate all the claims we receive,
tally them up, then divide by the number of policyholders on the list, adjusted by a complicated equation for time. We will then simply send you a bill for the retroactive costs since you’ve been
covered, adding a normal profit and the time value of money, of course.”

Ron: “How do I know that your costs will be accurate?”

ICA: “Mr. Baker, I’m not sure I appreciate the tone of that question. We here at CSAA are very fastidious
and ethical. Our costs accountants are excellent CPAs, who will carefully, and accurately, keep
track of all outflows. I really think you must put yourself in our shoes. There is simply no other way to give
you a fair price, wouldn’t you agree?”

Ron: “But I know the price of everything else I purchase before I buy for it.”

ICA: “Well that may be true for commodities like groceries and clothing, but it’s certaintly not true for law,
accounting, and other professional services, is it now, Mr. Baker?”

Ron: “Touche.”

ICA: “In fact, the new owners tell us they are consulting with the airline industry as well, and are
transitionining them to an hourly model, since flying planes is also fraught with innumerable risks and
uncertainties. In fact, our new owners inform us that the airlines are unprofitable because they do not
price like we do now. It makes imminent sense when you really stop and think about it, doesn’t it?”

Ron: “Alright, you’ve convinced me. Put me on the list for earthquake coverage.”

ICA: “Consider it done, Mr. Baker. And thank you for selecting CSAA for this very important coverage. We
look forward to continuing our relationship for at least another 30 years. You will be receiving your policies
shortly, please read them carefully, sign them in triplicate, and return two copies to our offices. We
appreciate your business. Good day.”

Comments

  1. Ron–Another compelling illustration of the problem of hourly billing. I have struggled mightily to understand why clients have not revolted against hourly billing for precisely the reasons your illustration highlights. The best I can come up with is that while the idea of “value” billing sounds good in theory, it is not an easy concept to put into practice. When a company is sued for breaching an acquisition agreement, how does it determine the value of the defense of the lawsuit? The knee jerk reaction is to estimate how much the defense of the suit is likely to cost under an hourly billing arrangement. Which, of course, reflects unacceptable circuity in the analysis. I hope future posts will focus on the “hows” in addition to the “whys” of the value billing.

  2. Thank you, Pat. Clients won’t revolt against hourly billing for a simple reason: It’s not their job. In the history of price changes, it’s almost always done by the seller, not the buyer. Why? Because the seller has the most interest in getting pricing right, since they sell hundreds (or millions) of times, while customers buy much less frequently.

    No customer asked the airlines, hotels, car rental agencies or cruise lines to shift to Yield Management. Some large companies have demanded their law firms to offer fixed prices, but it’s far and few between. Bottome line: It’s your responsibility to change your pricing, not your customers. As for the “hows” versus the “whys,” much has been written on this, by me, and others, but let me say this: One way we know how not to value the defense in a lawsuit is by the hour.

    I couldn’t agree more with Tracy, who doesn’t want to be paid like a union employee. If customers only wanted to buy your time, they would certainly find someone cheaper than lawyers to buy it from. They are not buying time, they are buying results, reduction in risk and uncertainty, and intellectual capital. Pricing these characteristics by the hour is ludicrous. No doubt fixed pricing can work for lawyers, since they are subject to the same laws of economics as any other business, and all businesses must price before the customer buys.

    Chris, I think you believe the insurance analogy is not fair because you can’t intellectually answer how they can quote a fixed price under conditions far more uncertain and riskier than lawyers operate with, or merchant bankers for that matter. I’m not aware of any contractor who would quote a price for building a house without detailed blueprints, nor am I advocating you quote a price without a defined scope of work.

    The fact that your client may not know what they want only puts more burden on you, the expert, to offer the options and probabilities. If your customer is that unsure of their goals, than what they are trying to accomplish must be high risk. How do you think they feel when you, the expert, look at them and say, “I have no idea what’s involved.” A customer’s lack of ability to specify exactly what they want does not obviate the need for you to fix a price on what you know they do want, or at least, need. As Tracy says, use the phasing approach, it does work.

    If your client doesn’t want to sit down and discuss objectives, goals and expectations with you, that’s a client you probably shouldn’t have in the first place.

    Most customers are happy to pay a premium if you reduce risk and uncertainty–look at the mortgage market, where most customers opt for a fixed rate, even though it costs more. Prices from professional service providers are no different. If you didn’t track hours, customers would have no way of knowing if you “lose out” or not. You are not selling time. I don’t agree with your statement “The fear of being criticised for over paying often outweighs the benefits of a fixed fee.” If this was true, most people wouldn’t have fixed rate mortgages.

    ABA surveys have documented that clients are willing to pay more for the certainty of a price up-front, even if they believe it would be cheaper than hourly rates. You have to understand their side: they purchase in a world of risk and uncertainty, not certainty. As a customer, I want a fixed price.

    It’s your responsibility to help your client determine what they need. I didn’t go to law school, and neither did your client (unless they are GCs; in which case you can bet they have very clear objectives and expectations). The responsibility is yours, not your clients. Until you take responsibility, nothing will change.

    Sure, merchant bankers do share in the risk. But they are also paid more than lawyers because they know they are not selling time, but rather, intellectual capital. Until professionals stop acting like union employees–worrying about what they make each hour–the mentality of a merchant banker will remain a foreign concept.

    I totally agree with your last paragraph. If a client asks you to quote a price without you understanding what they expect, don’t take the job.

    One last question: can you name for me anything that you buy as a customer in your daily life that you don’t know the price before hand? Are lawyers not subject to the same laws of economics as every other business?

    Hourly billing defies those laws, at both your peril and your customers. There’s a reason all other businesses refuse to utilize it. As a recovering CPA, that intrigued me. Why were professionals the only ones blathering about time and hours, when all other businesses just quoted prices? Once you study economics, it’s impossible to conclude hourly billing makes sense, except as a way to shift risk from seller to buyer. But you are in a much better position to accept the risk, since you can spread it over hundreds (or more) clients, where the buyer only deals with one (or few) law firms. Merchant bankers also think like actuaries, and professionals need to as well.

  3. Take the example of the tax lawyer charging at $700/hour who, as a result of his expertise, his years of building up connections in the Tax Office, and his intellect, provides a solution for client in one hour which saves the client $1 million. Surely that is worth more than $700 to both lawyer and client?
    Scoping expectations at the commencement of a matter has the dual result of identifying value, and also enabling the client to assume some control over the conduct of the matter. The NSW State government in Australia is proposing to introduce legislation to compel lawyers to provide budgets for clients. A major problem is that it appears the lawyer will bear the whole cost of doing so, which does not provide an incentive to the lawyer to fully investigate client expectations.

  4. Patrick Lamb writes, ” I have struggled mightily to understand why clients have not revolted against hourly billing.”

    Patrick, the answer really is quite simple. The law business in the United States is as close as any business can get to perfect competition. There are no practical barriers to entry. Any bright person can obtain a law license for virtually no capital investment and, in contrast to other businesses, the capital investment to operate is minimal.

    If you had a strong economics background you would know that rent seeking starts to end as one approaches perfect competition, in large part due to the transparency of the market. Buyers know what it costs sellers to produce a service and will refuse to pay much above costs.

    The hourly bill reveals to the client what providing the service cost.

    The piece to which Ron links has the key observation, “The problem is that the legal profession has adopted the billable hour from the accountants. The accountants used it as a costing measure. We have used it as a charging measure. It is a very good costing measure.”

    There is your answer. Clients are paying what it costs to provide the service and no more.

    Clients need not even understand all of this. There is often wisdom in mimicking other–a heuristic, if one will.

    The very best clients in the world have openingly explained this, but lawyers, for their known defects, refuse to listen. Charlie Munger, and I assume you know who he is, has for years criticized bright people who go into law because the opportunities are so much better elsewhere. Implicitly, what Munger is saying is that there is less competition (and thus more to be earned)doing other work.

    Now I have posted earlier that Edwards Deming argues that this focus on cost is a poor business practice, which will actually lead to an increase in costs, but no one else has seen the connection.

    The more obvious flaw with cost based billing is that it means that a supplier can increase its income only by increasing costs.

    Clients realize this and use a number of tools, of which the long term relation is the most important, to control such impulses.

    As for the earth quake insurance analogy, it his so factually distinguishable that it has absolutely nothing to do with the law business. For starters, clients cannot cause earth quakes but that are totally irrational in most any legal matter. No lawyer can or should bear the risk of future conduct by either one’s client or one’s opposition.

    Beyond that, Chris makes a great number of very accurate points.

    As for Ron’s comments on seller lead pricing changes, the only sellers who can raise prices are members of Cartels.

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