Cost of Production
Price is critical to profit. Price determines your client mix. Price determines how hard you have to work. Price is a critical part of your marketing strategy. Many aspects of success are determined by price.
In our training and consulting work we encounter many firms who have become comfortable with the strategic elements of the pricing decision. The most significant tactical element of the pricing decision however, is overlooked more often than not. This element is the cost of production.
When a group of lawyers are asked “who knows how much it costs to produce an hour of legal work?” Usually, one in ten will have thought about it. Half of this select group will have guessed intuitively and the other half will have worked it out.
We allow lawyers to price their own work quite early in their career with little or no knowledge of the cost of production.
The Cost of Production Usually Relates to an Individual not an Activity
In knowledge based businesses people are the stock in trade. There are three critical components to cost. Firstly, direct employment expenses. These include salaries, on costs and the cost of any direct support labour. Any training, knowledge maintenance or improvement costs should also be added.
The second component of cost is non-salary overhead, the ongoing costs of running a business.
The third component of cost is productivity. This will either be measured as events completed or time recorded, depending on the way you conduct your practice.
Salaries will be determined by market forces there is not much we can do about this in the short term.
Overheads can be managed through budgeting, benchmarking and thrift. This is relatively straight forward. In the management of the cost of production the big kahuna is productivity.
Overheads, including salaries are usually fixed, they do not vary with volume of production. Costs can only be recovered on chargeable time (total time spent at work is irrelevant to the cost of production). It follows that maximizing individual chargeable time minimizes the cost of production.
A lawyer with a fixed salary, fixed levels of support, fixed non salaried overheads and a limited quantity of chargeable time will have the same hourly cost of production no matter what he or she does.
A written explanation of how to calculate the cost of production is somewhat cumbersome. Should you wish to calculate the cost of production for your team, practice group or firm please email email@example.com and we will forward an Excel document that does all the tricky calculations for you.
The Current Management Conundrum
There is constant client pressure on legal fees at all levels in the Australian legal services market. The most direct way to decrease fees, without decreasing total staff and partner compensation is to increase productivity by working longer, more productively (as measured by chargeable time) or both. At the same time we know that our talented staff wants to be valued for more than chargeable hours (In some cases this may mean doing less of them), workmore flexibly, be more mobile, for less hours and for increasing rewards. The dreaded cost price squeeze is upon us. This is a huge conundrum; I will talk about it in the next issue.
The Case for Volume
Increasing the volume of a homogeneous activity does not in itself reduce the cost of production. This is particularly the case if the same lawyer time per file is required regardless of the amount of files you have.
We often see firms who loss lead below their cost of production to win volume business. Unless one can achieve significant economies of scale through repetitive precedents and comparatively cheaper non-lawyer labour, volume will only hasten ones decline.
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