Cost recovery 101
17 Sep 2020
Do you know what cost recovery is?
According to the Strategic CFO, cost recovery is defined as “the method to recovering an expenditure which a business takes on. Generally, cost recovery is simply recovering the costs of any given expense. This can be the initial startup costs of the business by meeting and exceeding the break-even point, the cost of an investment through evaluating the return on investment, or even the cost of capital taken to finance the firm”. Explained simply, cost recovery can be seen as regaining the value of an expense incurred by doing business.
Let’s break this down a little.
What does cost recovery entail?
Historically, law firms have absorbed the cost of litigation and primarily bill for attorney hours as part of their representation on a per hour basis (which is referred to as cost absorption). Here, only costs reasonably related to the representation are passed through to the client. However, given changing pricing models and the evolving landscape of legal practice, many law firms are considering converting from a cost absorption model to a cost recovery or profit model. With a cost recovery model, law firms are turning expenses like legal research into potential revenue streams which could lead to an untapped profit model.
Importantly, cost recovery effects a law firms revenue, client relationships and the firm’s competitive strategy. Components which should be near and dear to every law firm’s heart. But according to Rob Mattern in the article Cost Recovery Strategies That Work for the New Legal Market, what the market has revealed, is that attorneys are writing off soft costs due to client pressure, or discomfort with the “price.” In addition, clients are refusing to pay or “pushing back” on soft cost recovery, saying things like “other law firms don’t charge this and this is not our payment policy”. Whilst attorneys, at the same time, will bill invoices received from a third party (hard costs), at a much higher percentage to make up for the carve out of the soft costs.
The balance is seemingly off, with there being a huge tug of war between definitively billing for hard costs and making “carve outs” for soft costs. But, why the differentiation?
What is a hard cost vs a soft cost?
According to CosmoLex, a hard cost (known as a direct cost), is one that is paid directly to a vendor on behalf of a client for services provided in association with a specific matter. Like track and trace fees for debtors. Good law firm practice management, through the use of a legal industry-specific accounting and billing programme, like AJS, ensures that these costs appear timeously on a client’s invoice and that the firm’s books reflect the repayment of the cost when it occurs.
Soft cost (known as an indirect costs), are general overhead expenses that can be easily attributed to a specific matter but are not paid directly to the vendor on behalf of the client. Soft costs typically include telephone, internet, legal research materials and copy costs. Some law firms bill clients for these soft costs (if the cost can be attributed easily to a specific client). For example, many copy machines or telephone systems allow a law firm to assign each client matter a number and then track the number of copies or the duration of all calls made under that number. Industry-specific accounting and billing programs like AJS Enterprise Legal Accounting & Practice Management allow firms to include these soft costs on the client invoice and recoup them from the client when the invoice is sent out.
Knowing the difference between these two costs allows one to better understand the reasoning behind attorneys being reluctant to bill for soft costs. Costs which clients have, historically, pushed back on paying. And yet, it is important that law firms get over this “hurdle” and make the most out of this cost recovery process.
What are some of the hurdles that law firms face when trying to bill for soft costs?
According to Daniel Pelc in the article Top Five Reasons Cost Recovery Plans Fail, there are 5 common reasons that can derail your cost recovery train before it has even had a chance of leaving the station.
These include –
- Attorney carve-outs: this essentially amounts to an attorney being reluctant to charge for a soft cost. This scenario plays out time and time again. However, much like a small crack in a dam, failure to account for these fees will invariably follow the initially small wound to a policy integrity flood. If a cost is removed for Client A, why not Client B or Client C? What has resulted from this demand is a carve-out, or removal of the line item from the client’s invoice. To prevent your cost recovery plan’s destruction “by a thousand cuts”, two things need to happen. First, billing attorneys must understand and appreciate the value of the services being offered to their clients. Second, for cost recovery to be successful, a carve-out must require process adherence. Requests for carve-outs are going to occur frequently. To account for this eventuality, a law firm should create a process around such requests. For example, when an attorney seeks to remove a billable item, the request must follow an approval path where objective decisions are made by comparing costs and future revenue potential. This process has the effect of limiting carve outs. If a carve-out does occur, it would benefit the firm to list the carved-out expense on the invoice and show that the amount was removed from the bill. By doing so, the firm is still able to demonstrate value to the client.
- Client pushback: reluctance by a client to pay for soft costs. There is no doubt that the legal market is becoming more competitive. Corporate clients are in the driver’s seat and they regularly place restrictions on what they will or will not pay for. However, if a client’s expenses are discussed prior to (or within a reasonable time after the beginning of the representation), the firm would begin representation with “eyes wide open” as to what the client will or will not pay for.
- Incompatible systems: policy begets process. Law firm structures have been built and maintained around the principle of cost absorption. It can be frustrating to alter these processes to match a new cost recovery strategy. Billable items under a cost recovery policy are often unfamiliar to both the law firm accounting team and the invoicing team. During the creation of the cost recovery plan, it’s critical to understand the flow of a billable item and to trace a typical cost recovery invoice through the process from beginning to end.
- Misunderstanding cost recovery: keeping in mind the fact that law firms traditionally treat hard and soft costs very differently (with soft costs being carved out more frequently), the decision on how to treat a soft cost often causes chaos within law firms. Smoothing this bump in the road is why it’s important to ensure all the right people are at the table as you craft your cost recovery strategy.
- Underestimating soft costs: with hard costs it can be much easier to differentiate between recoverable and non-recoverable costs, as the amount is a clear expense for the firm. In the case of soft costs (costs incurred because of work performed on a client’s behalf through in-house resources), the water can be a bit murkier. If a firm keeps an eye on the cost of their service and compares it against amounts that other firms may be charging for similar services, there is no reason why soft costs cannot be similarly recoverable.
Being aware of the hurdles law firms could potentially face when dealing with cost recovery enables the proper development of a cost recovery model… let’s take a closer look at this.
Developing a cost recovery model
Formulating a cost recovery plan is not easy. It needs buy-in from the entire law firm. And this will require alignment with support structures, approval processes and potential for deviations from the plan. There is little guidance on how to create and enact a policy of this type. For good reason. Each plan will differ based on the firm and particular situation. Which is why, according to Mattern, in their article 5 Ways to Improve Cost Recovery for Your Law Firm, to be successful law firms need to build their cost recovery strategy according to the culture of the law firm. Basically, a law firm should –
“examine their clients and what they are willing to reimburse; look at how their attorneys are working; and, lastly, examine the structure of their back and middle office operations and how they should be structured to minimize expense and increase recovery”.
There is not a “one size fits all” approach to cost recovery. Each law firm will be different and will therefore view their approach to cost recovery (and what soft costs they are willing to recover), differently.
So, how does one ensure that their cost recovery model is successful?
According to Mattern you can undertake the following –
- “Develop your strategy from data, not anecdotes: data is the core of an effective strategy; it helps you to build a strategy that is acceptable to the majority of clients because it is defensible (your recovery cost is in line with the market and based on your costs) and verifiable;
- Know your numbers and net realizations: nothing can be managed unless it is measured. Review your processes and develop firm answers to the following questions: What percentage of your recovery is billable? How much gets written off by your billing attorney? How much do your clients actually pay? Many firms mistakenly believe that what they capture (billable) is approximately what is paid by the client. Unfortunately, the average amount actually collected on soft costs is in the 40% to 50% range after you net out write-offs. Having a clear understanding of your net realization allows you to build from a strong foundation;
- Adapt your cost recovery strategy to your technology: litigation support, eDiscovery, prints and scans are all essential frontiers for cost recovery. In order to continue to invest in these areas the recovery of their costs will be critical.
- Educate your attorneys: many firms believe that the clients are the biggest source of write-offs, only to find that it is actually the billing attorneys who are responsible. Firms that are successful in the cost recovery area educate their attorneys on the whys and how’s of their cost recovery strategy. Some even have a cost recovery committee that involves the attorneys in overseeing the formulation of the strategy. You must dispel the myth that these services are part of overhead and it is not “fair” to recover these costs. It is critical that the billing attorneys know the impact of write-offs on the bottom line;
- Consider shifting to a hard cost model: soft costs generally net out to 40-50% whilst hard costs (costs substantiated by an outside third party), usually net in the 90% range. Why the difference? Attorneys and clients are less likely to write off a charge from a third party that is backed up by an invoice. With strategic thinking about where to recover costs, how to utilize and educate attorneys, and how to document costs, your firm can develop a successful approach to cost recovery that not only improves your bottom line – it improves how you do business”.
As can be seen from the above, the recovery of costs plays a crucial role for most law firms and will continue to have a significant financial impact on their bottom line. The flow of information begins with unbiased market data combined with an aligned strategy to address the unique culture that exists for each individual law firm. In so doing, law firms can address cost recovery through the right methodology that will simultaneously satisfy attorneys’ needs for justifiable and transparent billing and their clients’ needs for reasonable and justifiable fees.
Law firms should not underestimate the value of cost recovery. Balancing long standing client relationships with whether or not your law firm can stay afloat (amidst ongoing carving out of costs), is definitely a balancing act worth focusing on. Wouldn’t you say?
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