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Hourly Billing and AI: The Perfect Pricing Storm

Posted by Richard Burcher on Nov 20, 2018 10:00:00 AM


It’s time to relearn what value pricing looks like.

Law firms face overwhelming pressure from current and potential clients to do “more for less,” resulting in rapidly growing interest in technology-augmented offerings. Firms are now focused on leveraging technology for process-oriented work, applied at scale, to produce effective solutions that support the general counsel’s evolving role as manager of legal spend and supply chain risk.

Many firms are adopting artificial intelligence (AI) in order to complete more work in far less time. But, while this exponential increase in efficiency can be exciting and represent a great opportunity (particularly for early AI adopters), it can have a vicious sting in the tail. Before identifying that sting, however, it is worth recapping the three main pricing paradigms used by law firms today:

  • Cost-plus: The firm calculates the cost of providing the services and then adds a somewhat arbitrary profit margin.
  • Demand- or market-based price strategy: The firm sets prices based on what they perceive their competitors to be doing or a determination of the range of prices acceptable to the target market. We sometimes refer to this as the zone of tolerance.
  • Value-based pricing: The firm sets prices primarily, but not exclusively, according to the perceived or estimated value of the service to the client.

Current law firm pricing practice is dominated by the first two paradigms: cost-plus and demand- or market-based price strategy. When looking to run a technology-assisted firm, however, there is a fundamental problem with these two pricing models.

Without careful thought regarding pricing strategy, firms that rush headlong into new technology run the risk of a double whammy: managing both the cost associated with investing in new technology and the fact that fewer hours are spent working (which means fewer hours spent earning).

For example, if AI will allow document review to be completed in a fraction of the time it used to take, that's often a significant number of billable hours out the window. What firms are then left with is more expense (i.e., technology) and potentially less revenue (i.e., fewer billable hours), which is not something to get particularly excited about on the face of it.

Something will have to change with traditional legal pricing models for AI to be the genuine boon to firms it can be and for firms to remain profitable.

Move Beyond the Pricing Catch-22

To maintain — and even increase — firm revenue in this competitive landscape, firms may need to invert the traditional staffing pyramid. This isn't necessarily a bad thing (unless you are in the early stages of your career), as firms are going to need comparatively more senior lawyers and business professionals in order to deliver what clients regard as real value.

From the firm's perspective, this should be recognized as both a problem and an opportunity. The opportunity is that firms can offer cost savings and efficiency on procedural work, while simultaneously upselling work being undertaken by senior lawyers and business professionals. In so doing, there is the potential to achieve some set-off.

When considering this change, we should be cognizant of typical revenue projections of a product, which runs in tandem with the traditional technology adoption lifecycle. A product typically is test driven first by a limited number of innovators with an increasing number of users as early adopters and the early majority, followed by the late majority of users, and, finally, the laggards.

The revenue and profit curves changes over the lifecycle of a product — following a similar pattern to the product adoption lifecycle — typically defined as introduction, growth, maturity and then decline.

In applying these projections to technology adoption by law firms, there is an opportunity for firms that are innovators and early adopters to preserve reasonable margins while the use of the technology remains relatively novel and sparsely distributed.

Find New Opportunities and Reimagine the Old

There is an important distinction between doing the same thing more efficiently and using technology to do new things. In other words, simply doing the same jobs that have always been done but doing them more quickly and efficiently can result in a substantial reduction in revenue. One way to address this is to move from “low volume, high margin” to “high volume, low margin” to sustain profitability and find new revenue streams.

For an example of a technology-driven, new revenue stream, the largest employment and labor law firm in the world, Littler & Mendelson, collaborated with legal AI platform Neota to develop a subscription-based cloud software that any employer (including those that are not clients of the firm) can log into. Employers enter various information and are then able to automatically produce a report that advises whether the client is, technically speaking, an employee or an independent contractor with all the associated income tax, pensions and related implications. Since the software was made available, it has been accessed (and paid for) thousands of times — mostly by companies that are not (yet) clients of the firm in the traditional sense — providing increased brand visibility for Littler & Mendelson.

There are many other initiatives firms can deploy in both the short and medium term to achieve greater efficiencies and cost savings from the client's point of view through technology. However, if those firms retain hourly billing as the predominant pricing model, they will be financially harmed. Evolution through technology requires evolution in a firm’s strategy and pricing model.

Unfortunately, the pervasiveness of the hourly billing regime has dulled any sense we might have had of what “value” looks like from the client's perspective. Paradoxically, a 1975 English Court of Appeal decision (Property and Reversionary Investment Corporation v Secretary of State for the Environment) simply yet eloquently illustrates a truism we would do well to remind ourselves of in 2018 and beyond:

“The business of determining a fair and reasonable fee is an exercise in assessment, an exercise in balanced judgement, not merely an arithmetical calculation.”

As technology replaces more procedural, time-consuming billable work, firms will have one of two choices: 1) focus on higher-value work being completed by senior lawyers and business professionals that is priced based on perceived value to the client or 2) focus on facilitating lower-value procedural work at a much higher volume. This is, in effect, a decision between a “low volume, high margin” business strategy and a “high volume, low margin” strategy — each requiring different pricing models. Having said that, it is not necessary for firms to treat that as a binary choice if they do not wish to do so. It is quite feasible to deploy “low volume, high margin” and “high volume, low margin” offerings under the one brand — think airlines with business class and coach on the same flight. However, the delivery model, pricing strategy and communications strategy will need to be completely reimagined.

After relying for so long on hourly billing, though, many firms are going to have to relearn what value pricing looks like very quickly and how to best communicate that shift to their longstanding clients.

Richard Burcher headshot croppedRichard Burcher is a former law firm managing partner, and for the last 10 years, has served as the Managing Director of New York- and London-based leading global legal services pricing experts Validatum®.

Topics: Business of Law

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