Market Insight: Guest Articles
Law Firm Leverage and Profitability
by Michael Koehne
March 2005
Profitability vs. Volume
Many law firms confuse growth and business success with volume. These firms focus exclusively on securing high numbers of revenue-producing clients, at lower rates, hoping to keep a constantly full pipeline-leveraging with an increasing number of associates. But these same practices often fail to do the financial analysis necessary to determine that these same clients, though producing revenue, are failing to produce profits. Failure to capture and analyze key cost accounting data, together with heavily discounted realization rates and coupled with poor overall planning lead many firms into the mode of treading water economically. At best they attain bare profitability-and this despite all their lawyers seemingly working at full capacity. And, other firms faced with this anomaly and desperate for greater profits walk a dubious ethical line by encouraging its professionals, through subtle institutional custom, to over-bill.
Success in business comes to those who gather as much data and information as possible both from their internal accounting systems and from outside sources-and use it to improve both internal processes and financial results. Law firm leaders should regularly review data on their clients and make the difficult decisions: high volume clients who yield low margins become likely candidates for a wave goodbye.
A volume leverage strategy, however, can create a profitable “commodity” practice. Witness the success of many insurance defense firms. But partners in these practices realize that leveraging many timekeepers at lower rates to produce bottom line results comes at a price. Time consuming vigilance and management acumen becomes a necessity. Watching the economic and financial fundamentals must become the norm. What once penciled out nicely on the back of a napkin at the firm’s inception must become a developed set of institutionalized firm processes and actions based on review of reported results.
The Unhappy Scenario
Law firms are unique service businesses with high cash flow characteristics. And, absent good management, high cash flow can often hide deeper economic and financial troubles. Smaller highly leveraged firms often start out optimistically with what appear to be “unbeatable” odds, having secured the right clients with the right-sized internal team. Though over time the work still comes in, more lawyers are employed to increase leverage and significant amounts of cash regularly arrive at the door, the partners begin to perceive that fewer and fewer dollars are actually reaching their pockets. An unhappy scenario begins to unfold: cost cutting, declining associate and staff morale, associate defections, partner defections and so forth. All of this is avoidable.
It doesn’t have to be that way--Some Practice Tips
Here are some basic business accounting and financial practices utilizing easily obtained internal data that can help any small practice, highly leveraged or not, to find their way towards growth and profitability:
Watch the numbers-but watch them on an accrual as well as the cash basis
Many small firms run their operations as though from a checkbook -with daily cash receipts driving financial decision making. Many firms are mislead when they confuse cash flow with profit and loss. Though most small firms file their income taxes on the cash basis and keep their books accordingly, the underlying trends of any business are to be found when accrual basis accounting is followed. The real goal of looking at a firm’s financial picture is to see how well the value of hours produced are translated into bottom line results-not just how much cash is received. Accrual accounting matches expenses to revenue in the period in which the revenue was produced: expensed dollars are incurred to support billing activity and profits-expensed dollars are not incurred to support collections. Even if partners only look at a Profit and Loss statement, they’ll know far more about their firm if that statement is produced on an accrual basis.
Know the real cost of keeping the doors open by applying cost analysis
One of the most important bits of information a firm must know is the price it must charge to cover the cost of its service. Many small firms rely solely on “the market” or “custom” or “what sounds right” for determining the rates they charge their clients. A more thorough analysis however can reveal the firm’s real costs that underlie that hourly rate. This analysis, performed on prior period data (last year or last quarter), can provide a gauge for setting future rate adjustments more in keeping with the firm’s needs.
Three separate calculations are required, using data from the firm’s accounting and time/billing systems:
- Calculate the firm’s overhead per timekeeper
On an accrual basis run a profit and loss statement from last period. From total expense subtract all timekeeper compensation expense (and, don’t forget benefits and firm payroll tax)-but leave support staff compensation in. Subtract out any accountant originated “book entries,” such as depreciation and amortization. Now take the resulting number-net expenses-and allocate it among the timekeepers. For associates assign a full time equivalent (FTE) number of 1 to them. For partners, assign them 1.5-partners tend to consume a greater share of overhead in their role as case managers and owners. Paralegals get a value of 0.5-they tend not to have offices or secretaries. Add up the number of FTEs and divide it into the net expenses and then multiply, for each timekeeper, that result times their respective FTE number. This number represents overhead per timekeeper. For example, the overhead cost for an associate in a firm with two partners, two associates and a paralegal would look like this: (net expenses/5.5) x1.0 = overhead per associate. - Calculate the total breakeven per timekeeper
Add each individual timekeeper’s total compensation, including the firm’s payroll tax, any bonuses or profit sharing to their respective allocated overhead cost from the previous analysis. The sum will represent the firm’s breakeven number-the gross dollars this individual must produce to keep the lights on and the doors open.
But, where’s the profit? - Calculate the firm’s margin per timekeeper
From your time-billing system obtain the gross dollars generated (not just billed) by the individual timekeeper for the same period. Subtract the breakeven number from the gross dollars. The resulting net number is the profit per timekeeper (assuming it is a positive number). Dividing the gross dollars generated per timekeeper by this number will yield the firm’s margin per timekeeper.
Margin per timekeeper is a valuable statistic. When combined with a review of total individual billable hours produced and when compared with other timekeeper statistics, underperforming associates and partners can be readily identified. This analysis may also lead management to a more significant discovery-underperforming clients. Where margins are consistently thin and timekeepers are logging reasonable (if not heavy) amounts of billable hours, are paid appropriately (according to their “specialty market”), and assuming the firm’s overhead costs is under control-hourly rates may become suspect.
Discussion must then inevitably lead the firm to either increasing leverage (adding more associates-and more overhead) or increasing rates. If clients are rate resistant, the time may have come to examine the firm’s commitment to either that client or the firm’s growth strategy.
Watch discounting at billing
What is the actual out-the-door hourly rate? Little understood by many small firms is the role realization rates can play in determining profitability. For all professionals the work becomes all-and, once the work is done, billing issues can be fast forgotten. But this is done at the firm’s peril. Unmonitored, extensive discounting before billing will sharply erode established billing rates, insidiously ravaging a firm’s bottom line. The market strategy of selling services at lower rates becomes the no-win reality of selling services below cost. Most time/billing systems can produce a report showing realization rates. When regularly compared with budgeted, or book, rates, partners can readily see trouble areas-mark-downs applied for overworked files, associate under-supervision, ineligible task billing guideline requirements and so forth.
Obviously, most clients at one time or another will seek some discounting for any number of reasons-and, generally it must be granted. However, some clients strategically target a firm’s book rates. They know that their lawyers, having completed the work, will not risk client displeasure by denying them a requested discount. When such a client, perhaps representing a large percentage of a firm’s business, makes a continuing custom of discounting requests, a firm needs to either rein in that client, often a difficult, if not impossible task, or seek greener fields.
Keep your eyes on the prize-plan strategically
Develop a 3-5 year plan and establish a yearly budget process. One would not think of risking valuable savings to build a house without developing an architectural plan. Yet many small firms think nothing of starting a practice with the hope of producing many years of income stream for its partners with the barest of income projection planning and then running that practice without any reference to yearly income goals, expense caps and cash flow projections.
Firms must have a set of goals or objectives together with a method of getting there and a timeline in which these goals are to be accomplished. Without such a plan, drift is the result.
The wrong focus prevails, leverage gets out of hand, obsessions with cost containment and unrealistic income expectations follow.
Firms should invest in the process of projecting, on an accrual basis, yearly income objectives. Expenses should be analyzed in relation to income needs and projected realistically. A cash conversion should be made, using historical accounts receivable data-projecting from previous periods how and when billings were converted to cash.
During the fiscal year all monthly, quarterly and yearly reports should be then referenced to the budget model so financial and operational adjustments can be timely made to achieve expected profits.
Financial plans have the advantage of putting the firm’s wish lists on the table together with analysis performed. Even if a firm only produces a yearly income and expense budget, that firm, at the least, is able to compare actual results with a base-perspective is gained. Longer term plans are better-strategy over time gives a bigger picture-whole practices can be shaped, trends can be integrated, clients can be chosen to match the firms own schemes and the odds for sustained profitability increase.
