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Profitability | It's Sink-or-Swim Time: Leakage Reports

There’s a Chinese proverb, “When the boat reaches midstream, it’s too late to mend the leaks.” Fortunately, the same is not true of law firms. Any time is the right time to look at your financial information, determine if your firm is leaking money, and stop the leaks that can drain your profits and sink your practice. How about now?

FROM: July / August 2005, PAGE 51 BY: David Bilinksy and Laura Calloway

Law firms leak money in lots of ways. When lawyers hear the term “leakage,” they usually think first about inflated expenses and other firm members’ salaries. But the type of leakage we’re talking about is the failure of a law practice to recoup the maximum return from the efforts of each of the firm’s fee-billers—whether they be partners, associates or paralegals.

In this issue, we’ll show you how to use “leakage reports” to gather more information about your profitability and that of your fellow lawyers. To start, let’s dive in and see how you look for leaks.

Calculate What Billings to Expect for the Year

First, determine each fee-biller’s standard hourly rate. You say you don’t have standard hourly rates? Then your homework assignment is to establish what each lawyer in your firm should be charging by the hour. This rate sets a baseline you can use to determine how each biller is doing in any financial period—be it a day, month, quarter or year.

Standard hourly rates should be set with regard to several factors, such as the biller’s compensation and the number of hours billed each year.

This can be a maddeningly circular exercise, so for now let’s just start with your usual hourly billing rate for most of the matters you handle.

Multiply your standard hourly rate—say, $250—by your budgeted billable hour expectation—say, 1,500 billable hours. This determines your ceiling or maximum expected billings for the year, which in this example is $375,000 per year, or $31,250 per month.

Once you have your maximum expected billings, divide it by 231—the approximate number of billable days per year—to determine your daily billable hours expectation (which we’ll use a little later). For example, if you expect to bill 1,500 hours this year, that works out to 6.5 billable hours per day. (Did we hear you say you don’t have an annual hourly billable expectation? Then you have a second homework assignment: Determine how many standard billable hours you should be producing each year.)

When you total the maximum fees expected from each of your firm’s fee-billers in a given year, the sum is the highest expected annual gross revenue for the firm (not accounting for windfalls). For example, if you have five fee-billers and each has a $250 standard hourly rate, then your highest expected annual revenues (HEAR) will be: 5 x $375,000 = $1,875,000.

Locate the Leaks in the Boat

Now, the search for leaks in the boat begins.

In virtually every firm, the annual revenue actually collected rarely equals the HEAR. In each step of the process of converting time worked into revenues received, there are almost always one or more leaks that reduce the HEAR. The good news is that there are some easy-to-reach places you can look to:

  1. Determine the total amount of leakage your firm is experiencing.
  2. Identify the individual leaks.
  3. Create strategies to plug the leaks.

Billable time. The first leak is failing either to produce or to record billable time. In our example, a yearly goal of 1,500 billable hours works out to a daily goal of 6.5 hours. If you fail to work at least that number of billable hours each day, you have a leak. If you put in the time but fail to record all of it, you have a leak. This is why it’s so important to keep accurate time records, to record your time as soon as possible after the work is done, and to create a system for capturing time if you work outside the office.

Many lawyers, particularly those who work on contingency, say they don’t need to account for their time since they don’t bill on that basis. This is true as far as it goes, but firm management then has no basis on which to judge how effective these contingency-fee lawyers really are—unless you can capture the true number of hours put into a case and compare it with the fees generated from that case.

Written-off time. A second leak is write-downs and write-offs when preparing the client bill. The total value of time recorded but never billed is the measure of this leak. The write-off leak is particularly acute when it comes to associate time. Partners are notorious for writing off associate time to boost their own fees, particularly where salaries and bonuses are based on collected billings.

However, associate time is not the only time that is written off. All lawyers write off time when they feel that the client will balk at the fee. This leak is usually an indication that too much time was put into the file based on its value to the client—resulting in the firm “eating” the written-off time.

Fee and disbursement reductions. A related leak is writing off fees and disbursements, long after the bill has been sent, as a compromise made to receive partial payment. Knowing that forcing collection can result in discipline or a malpractice action, many firms will take a percentage of the original fee just to bring the matter, and the relationship, to a quick, if not happy, end. Unfortunately, this results in another chink in the bottom of the billable-hour boat.

Bad debt. Yet another leak occurs when an invoice is finally written off as a bad debt. Many firms fail to deal effectively with their accounts receivable, leaving them to pile up in the “over 120 days” category. As we all know, accounts receivable that are older than 120 days stand very little chance of ever being collected, yet we often won’t allow these old accounts to be removed from the books in the vain hope that someday, somehow, this money will fall from heaven.

Unfortunately, this “ostrich” approach only leads to distortion of the firm’s financial records and to salary and bonus decisions that frequently are not justified.

Patch Up the Money Holes

By collecting the data we’ve just described, you’ve prepared yourself for your leakage-mending work. You can now compare actual receipts to the firm’s HEAR, quantify the total cost of the leaks at your firm, and take action to plug them.

One effective “stopper” is to implement a time-recording system that clocks billable time by electronic timers, as do most automated case management and time-and-billing programs.

You can also establish a budget for each new file and have triggers in your accounting system to warn you when you are approaching a fixed percentage of your billable hourly budget for the file. For example, you can be warned when a file reaches 25 percent, 50 percent, 75 percent and 90 percent of its estimated billable hourly budget. Implementing such a system forces you to be realistic about the fee potential of a file and whether or not the case can be handled economically.

After all, billable time is an investment of the firm’s resources. Shouldn’t there be a determination, at the outset, whether this case will be a profitable one for the firm? And shouldn’t there be a process in place to examine, once the case is over, whether the initial determination was correct?

When you undertake this analysis, a couple of things will naturally occur.

  • First, you will gain experience and get better at forecasting which cases are winners and which are losers from a financial as well as a legal perspective.
  • Second, by focusing attention from the beginning on the expected fees to come from a file, you will consciously aim to bring each file to a conclusion within the established billable-hours budget—which is much better than writing off uncollectible time after the case is over.

Be a Lawyer, Not a Lender

There is one final leak, not caught by these calculations, that results from waiting for payment. If you send a bill on January 1 and don’t receive payment until April 30, you have financed this invoice for your client for a third of a year (unless your invoices carry a financing charge that is at least equal to the firm’s working capital cost—and the client pays the charge).

Many lawyers dislike charging their clients interest, but a stiff finance charge on unpaid bills can be a good way to encourage your clients with good credit ratings to borrow from professional lenders, such as banks, rather than from your firm.

There are numerous profitability reports yet to discuss. Next time we’ll look at some others that you can easily generate from your financial system. Until then, we say, “Hi ho, hi ho, it’s off to record my billable time I go….”

David J. Bilinsky ( daveb@lsbc.org) is the Practice Management Advisor and staff lawyer for the Law Society of British Columbia. Laura A. Calloway ( lcalloway@alabar.org) is Director of the Alabama State Bar's Law Office Management Assistance Program.