A Better Approach to Flat Fees
I’m a big fan of flat fees. They do a much better job (than hourly billing) at aligning the interests of the client and her legal team. And, when done correctly, they can simultaneously improve profitability of the work and allow the legal team to scale-up to serve more clients (at that improved profitability).
One of the
dumbest less informed comments I hear from lawyers when I talk about flat fees is “We’ve flat fee’d a few matters, but we got killed on one of them so I’m suspicious of using them again.”
Here’s why that attitude is a problem:You shouldn’t “flat fee” a matter, you should develop a legal product and sell it for a fixed price.
Individual matters are complex. Even when you’ve done a lot of them, any lawyer knows that there can be quite a bit of variation. If you decide to offer a fixed fee on a one-off piece of work—maybe because the client’s asked for it or maybe because you’ve been reading, albeit skeptically, about how cool alternative fees are—you’re essentially gambling that you’ll be able to work fewer hours than the quote you give divided by your hourly rate.
This has a few problems. For one, even us conservative, skeptical lawyers fall prey to the planning fallacy and the optimism bias. The Freakonomics team hit on this in their podcast episode: Here’s Why All Your Projects Are Always Late — and What to Do About It.
Even if you estimate correctly, you (and your team) are not likely to change the way you work for a single matter. And it turns out the way of working is key to a successful flat rate paradigm.
When you bill by the hour your profit margin is capped: profitability is the gap between your hourly rate and the sum of your hourly cost and your fixed costs. Sure you can (try to) raise rates or (try to) control costs, but these will only generate marginal improvements. At risk of sounding crass, the formula for maximizing your revenue on an hourly matter is to work your highest-price resource for as many hours as the client will let you get away with.
This means you’re primed to put in the hours, and working extra hours doesn’t have much downside (up to that point where you piss off the client), because every hour is profitable.
When you charge a flat rate, your potential profit margin becomes variable. Here, profitability is the gap between the price you charged for the work and the total cost. As before you can raise prices and/or control costs, but cost control becomes a different animal. Whereas with hourly work you know that every hour you put in will be profitable, on a flat-rate matter it is pure cost. That means (again, being crass), that the formula for profitability is now to give the work to your lowest-cost resource for as few hours as you can get away with and still deliver a quality product.
Now some of you may cringe and say that’s a recipe for cutting corners, and it can be. But you still have to deliver a quality product, which means you have to know what quality looks like. When you’re billing hourly, that’s not a problem; you can just do the typical lawyer’s version of quality control and say “Well, I guess I’ll read this thing a fifth time to make sure I haven’t missed anything.” When you fix your fee, you need to define your quality standard up-front and do your darnedest to hit it on the first try.
Which gets back to the problem of dabbling with fixed fees. When you have a mix of matters some hourly and some fixed-fee, you create a real conundrum from a process improvement standpoint. Optimize for hourly work (which is very likely how your systems are already set up) and you’ll have a heckuva time keeping your costs down on the flat-fee cases. But optimize for flat-fee (by improving quality standards and the processes that deliver them) and you’ll risk working fewer hours on those hourly-rate matters, ergo lower revenue.
This is why you need to think about your hourly rate offerings as products, not just one-offs.
A product (including a productized service—that link is to a Harvard Business Review article that gives concrete examples for law practices) is something you sell for a price. For a services-as-a-product that offering typically has a scope, probably some features, and at least one deliverable. Through market research or plain ol’ experimentation, you can figure out a reasonable fee to charge for the package you’re offering.
When mature businesses gauge the profitability of a product, they don’t put too much weight on the sale of any single unit. Instead, they take the total sales, divide it by the total costs, and calculate profitability for the capital-P Product (over the relevant time period). (This is actually a great way to calculate the profitability of your hourly-rate product offerings too, and I wrote an article for Lawyerist awhile back showing you how.)
This is my second criticism when a lawyer tells me they “took a beating” on some individual flat fee matter. Ok, so maybe your profitability wasn’t where you wanted it to be for that particular unit sold, but that doesn’t mean the whole regime is suspect. Say you work 10 flat rate matters and your profitability is 65% for four of them, 40% for three, 25% for two, and just 5% for one. That’s still a 43.5% profitability for the product itself.
From a process improvement standpoint, this is a great opportunity for improvement. We can analyze why different matters performed the way they did, and then optimize around the higher-margin work. If we do nothing more than eliminate that low-end outlier on the next 10 you sell, your total profitability jumps by 2%. Then, on the next 10, we figure out how to get those 25 percenters up to the 40% range, and so on. Even if you don’t have those highly-profitable unit sales at first, the process of process improvement can help you build a clear path for getting there.
Which leads to the last big mistake I see attorneys make when comparing hourly matters to flat-rate ones: they relate apples to oranges. Here’s what typically happens: Because of the cognitive biases I mentioned above, you probably under-estimated the amount of time you’d work on that one-off flat rate matter. And of course you’re still tracking time because it’s a good idea, and because it is how you get paid on your other matters.
At the end of the matter, you add up all the hours you worked on the flat rate matter and divide it by the fee you charged, and when that number is smaller than your hourly rate you say “I lost money on this matter.” Wrong. You may have left money on the table, but you didn’t lose any (unless you were truly terrible at estimating, but I rarely see it get to that). You were just less profitable than you would have been had you charged by the hour.
Now you have a sample-size of one, which, when it falls short of expectation can certainly feel bad, but that doesn’t make it statistically significant. Especially when you ran that single example through a services-delivery process that is optimized for hourly pricing.
The key word in all of this is optimization. If you’ve been billing hourly your whole career, or you work for a firm that has, then all of your systems, habits, incentives, probably your very culture is built around hourly billing. That’s a lot of inertia to overcome.
And, of course, it has been a wildly successful formula for lawyers to make money over the past 50+ years. But just because it is successful doesn’t make it optimal. There’s the aforementioned cap on your potential profit margin, combined with changing client attitudes and expectations and that pesky competition (some of it from *gasp* non-lawyers). Still, it works reasonably well for a lot of people, even if somewhat less well than it used to.
If you’re one of those people for whom it’s working, I probably don’t want to talk to you (seriously, how did you even read this far?). I’m not trying to convert everyone, at least not yet.
But if you’ve grown frustrated with hourly work, either because it is soul-sucking or because you’re not making as much money as you’d like or, if you’re like me, because you want to figure out how to help more people by delivering legal services at scale (and start to lower that A2J gap), then we should talk.
Maybe you’ve already got a flat fee or some other alternative fee program in place but you don’t have the background in process improvement to take it to the next level. (If that’s the case, we really should talk—that’s my favorite thing to do). Or maybe you’re looking to convert some of your current services to productized offerings (even litigation; it really is possible!).
I’m always happy to talk about legal products and pricing (a whole other topic, but a fun one!). If you have questions about how flat fees can work for you, you can always contact me to set up a time to chat, or drop in on one of my open office hours and ask away.