Discounts are eating away your Margins

Have you ever had a client calling you and complaining about the latest invoice? Did you end up giving them some sort of discount, thinking that it was only a small piece of the pie? Well, it probably was a much larger piece than you thought – at least if you are an equity partner.

Key words: discounts, profit margin, equity partner

Image: cottonbro/pexels

Law Firms are high-margin Businesses

Law firms are generally considered to be among the businesses with the highest profit margins (why this, however, is not the whole truth will be addressed in a different article). According to the latest AmLaw100 rankings, the average profit margin amounts to 44%, whereas the most profitable firm (Cahill Gordon & Reindel) showcased a stunning 70% profit margin.

The profit margin refers to the firm’s revenue minus its cost, divided by the revenue, or: (revenue – cost)/revenue. So, if you sold services for 100K $ and your cost amounted to 70K $, it means that your profit margin is 30%; (100K-70K)/100K = 30%. At this point, it is important to mention that a law firm’s profits is commonly distributed among its equity partners as (part of) their compensation. Simply put and referring to the above example from the latest AmLaw100 list, an average equity partner of an average AmLaw100 firm therefore earns 44 cents on every dollar that is collected on the bills sent out by said equity partner.

Discounts kill your Margins

A 2021 report from Thomson Reuters suggested that law firms billed about 17% less than they would have if they had invoiced their clients in accordance with their standard fees, and almost 10% less than if they had billed their clients according to the fees actually agreed upon. In other words, law firms offered discounts on their standard fees before the work was done, only to cut their rates even further (or strike hours) on the final bill.

Now you might say that a 17% discount is not so bad after all. It’s not great but it’s only about one sixth of the total revenue, which means you still end up with a staggering 83% of the revenue, right? Right, but…

Let’s go back to the profit margin = (revenue – cost)/revenue, a formula containing two different variables: revenue and cost. When a law firm or lawyer offers a discount on their fees, the revenue will be smaller as a consequence, whereas cost won’t be affected.

Let’s look at the following made-up example of three equal law firms with four equity partners each: Law Firm X, Y and Z have equal standard rates of an average of 500 $/h. Each firm bills 20’000 hours and incurs costs of 6’000’000 $.

Law Firm X offers no discounts at all to their clients:

Profit margin: (20’000 h x 500 $/h – 6’000’000 $)/(20’000 h x 500 $/h) = 40%

Revenue: 10’000’000 $

Profit: 4’000’000 $

Profit per Equity Partner: 1’000’000 $

Law Firm Y agrees to lower their standard rates by 10% to 450 $/h:

Profit margin: (20’000 h x 450 $/h – 6’000’000 $)/(20’000 h x 450 $/h) = 33%

Revenue: 9’000’000 $

Profit: 3’000’000 $

Profit per Equity Partner: 750’000 $

Law Firm Z agrees to lower their standard rates by 10% to 450 $/h as well as another 10% to a billed rate of 400 $/h:

Profit margin: (20’000 h x 400 $/h – 6’000’000 $)/(20’000 h x 400 $/h) = 25%

Revenue: 8’000’000 $

Profit: 2’000’000 $

Profit per Equity Partner: 500’000 $

What this example shows, is that while a 10% discount only amounts to a 10% decrease in revenue, it leads to a 16.7% decrease in the profit margin and a staggering 25% decrease in profits, whereas a 20% discount leads to a 37.5% decrease in the profit margin and cuts the profits in half.

Discounts make the pie smaller. And it’s equity partners who take a disproportionately large hit when discounts are offered to clients.

But what if the Client insists on a Discount?

Financial planning is important in every business venture. And oftentimes assumptions have to be made about future earnings. Therefore, try to set rational assumptions. Have you been giving discounts more often than not? Face the hard truth and don’t use your standard rate in your calculations, but rather the agreed or billed rates.

Or even better: don’t go down the discount road. Once discounts have been offered to a client, it is very hard to take them away. If some sort of reduction is unavoidable or in the firm’s long-term interest (e.g. because the client might switch to another firm if not offered any sort of reduction) reduce the final number on the final bill – by a real number instead of a percentage. While this might be semantics, the latter will be perceived as a one-time gift and is therefore both more tangible for the client and less likely to be demanded the next time a bill is sent out. Or maybe try something new to begin with and introduce fixed fee packages?