Pricing is not at all a rational process
Updated: Mar 12, 2020
Oscar Wilde, the famous Irish poet and playwright (1854-1900), is credited with the quote “The cynic knows the price of everything and the value of nothing.” This article is not about Oscar Wilde, nor is it about cynics. It is to bust the myth that buying is a rational process. It is a common misconception that given a choice, people and companies will go for the cheapest option. Typically not.
When talking with law firms, we frequently can feel the frustration that the only thing clients seem to care about is price. Countless are the experiences of partners having to jump through many hoops of procurement, having to provide all sorts of information with no clear purpose, only to be told at the end of the process that some other law firms had a cheaper offer. The process of panel selection can be extremely disheartening and frustrating.
For a company only 1% of all costs is legal costs
We have many conversations with CEOs, CFO’s and GCs. Do you know what percentage of the total cost of a big international company would be legal costs? Obviously, it varies between sectors and companies, but typically it would hover around 1% of total costs. How happy do you think the board would be if the GC could reduce this 1% to 0,95%? In all honesty, they wouldn’t care. Nor would the shareholders. In reality it would be very unusual for a GC to be under pressure from the board to negotiate lower rates with the law firms. GCs however are constantly under pressure to reduce headcount, as this is a metric that CFOs and shareholders monitor.
As is shown in the TGO Value Matrix© there is a direct relationship between the value perception and the return on investment. Companies do not mind spending money on lawyers as long as it helps them make a profit or prevent a loss. That is why companies are prepared to pay 10 million to the lawyers that help them to close the deal. In a 40 billion takeover, 10 million is not a big deal. The client would not be more happy if the legal cost was 9 million or unhappy if it was 11 million. It is simply part of the investment to get the M&A done and increase shareholder value. However, as we all know, the same GC who did not care about one million more or less during the M&A could be on the phone for 15 minutes complaining about a €5000 invoice for a simple employment matter. It is about the lawyer’s contribution to the bottom-line. Not about the absolute price.
People hardly ever go for the cheapest alternative
When at school you were probably taught that capitalism encourages competition and that competition will lead to lower prices. Governments rely on this doctrine when they decide to privatize energy companies, health care, railways and so on. History has learned that competition on the long run does not lead to lower prices. Also, in the legal market, competition between law firms does not lead to lower prices. There are no ‘undersellers’ among business law firms. Ever since the 2008 financial crisis, GCs have tried to get the prices down. Statistics clearly show that despite these efforts, they ended up paying more as there is no real competition on price between firms.
In part it is the clients who are to blame. It is deeply rooted in human nature to make irrational decisions as it comes to the things we buy. Have a look at the picture above. As you can see, it shows 6 hammers that vary in price between €4,98 and €31,90. The shape, weight and functionality of all hammers are exactly the same. They will all do the job equally well with no difference whatsoever. Even buying something as basic and simple as a hammer is not a rational process. If it was, there would only be one hammer: the one that costs €4,98, because no one would buy any of the others.
This example illustrates on the one hand that competition does not lead to lower prices and on the other hand that most people do not go for the cheapest alternative. This holds true for almost any product or service you could think of. The vast majority does not buy the cheapest car, shirt, pasta and so on.
People pay irrationally for brands
There is a great example involving a humble cookie. Oreo cookies are popular, cheap and readily available worldwide in supermarkets. The typical price of a package of 14 Oreo cookies is around €1,25.
On 18 February 2020 a fashion brand named Supreme launched its own version of the Oreo cookie at a price of €8,00 for a package of 3. That is 3000% more expensive than the normal Oreo. Despite the red color the taste and composition is exactly the same. It is literally the same cookie in a different color.
Further to my argument: these Supreme Oreo cookies have since been offered on eBay for prices as high as $4000. Who will now still insist that prices are a rational thing?
It is not about price, it’s about value
So, what is the big picture? For companies in general the legal costs are insignificant, and it makes little sense to go through great lengths to bring these costs down. Yet it is a fact that companies are complaining about the costs of lawyers. In most cases this has less to do with the absolute costs than it has to do with the value perception. As long as the company has the feeling that the legal costs are contributing to their bottom-line, there is rarely any complaint. This changes if legal is just cost and does not contribute to profitability.
Even is the most rigorous procurement processes clients do not only look at costs. When crunching the numbers that lead to the TGO Value Matrix© we found a 10% plus or minus deviation depending on the strength and quality of an existing relationship. This means that a law firm which had a very strong existing relationship with the client could be up to 10% more expensive than an average firm with a neutral relationship. A firm without any previous relationship would have to charge 10% in order to be perceived as good value.
On top of that we found a second deviation. Law firms with an extremely strong brand reputation (quality, not name recognition) could also charge up to 10% more for the same mandate (compared with an equally experienced and capable law firm with a not so strong brand). This resembles the example with Supreme and the Oreo cookies.
Our book Data & Dialogue, a relationship redefined (worldwide available on Amazon) contains a lot of valuable information and insights on this topic. TGO Consulting also offers one-day pricing workshops to law firm partners and a workshop on buying legal services for in-house departments.
Should you be interested, send an email to Lisa at firstname.lastname@example.org