The New Normal: Restoring Profitability

Volume 38 Number 4

By

About the Author

Arthur G. Greene is a principal of Boyer Greene LLC, a law firm consultancy with locations in Michigan and New Hampshire. He has lectured, conducted workshops, and authored articles and books on a variety of law firm issues, including Lawyer’s Guide to Increasing Revenue and The Lawyer’s Guide to Governing Your Firm. Greene has served as chair of the ABA Law Practice Management Section as well as past chair of the ABA Standing Committee on Legal Assistants and liaison to the ABA Commission on the Billable Hour. He is a member of the Advisory Board of the Legal Assistant Management Association and is a Fellow of the College of Law Practice Management. 

Law Practice Magazine | July/August 2012 | The Law Firm Profitability IssueWHAT DOES IT MEAN TO PRACTICE LAW IN “THE NEW NORMAL”? Simply put, it means lawyers will no longer be able to achieve financial success while operating with sloppy or ineffective business practices. For years, too many law firms have gotten by with marginal or inadequate management practices.

The practice of law is both a profession and a business, but lawyers can no longer hide behind the professional aspect as an excuse for failing to create an organization with good business practices. They can no longer consider themselves the exception to the rules that apply to other commercial ventures.

With access to seemingly unlimited information on the Internet, our clients are more educated and sophisticated in shopping for legal services. Whether they are businesses or consumer clients, they have had to focus more on cost savings and efficiencies.

It has long been the case that law firms with the best management practices return the highest profits to their partners. While careful client intake, clear client expectations, timely billing, high realization rates and strong collection policies have always been the goal, under the new normal those aspects of good management have become essential to a firm’s survival. Law firms that are not able to conform to good business practices are becoming victims under Darwin’s theory of survival of the fittest.

Follow these strategies to assess your firm’s performance and compete in the new normal.

CONDUCT A REVENUE CAPACITY ANALYSIS.

Lawyers often ask how they are doing compared with other similar firms. Such comparisons are difficult, particularly for small and midsized firms, due to the variables involved and the lack of sufficient information to draw meaningful conclusions.

Comparisons with other firms put the focus in the wrong place. The better approach is a self-analysis, which involves comparing your firm’s actual revenue to its revenue capacity. The preferred analysis is started by determining the amount of revenue your firm should be able to generate with its lawyers and paralegals working at their highest and most efficient level, given the firm’s current support, systems and technology. Take the standard hourly rate of each timekeeper and multiply it by the anticipated number of billable hours. The hours used in the analysis should be realistic, based on the size and location of the firm, the type of work involved, the culture of the firm and, most importantly, historical information about each individual’s performance.

For example:
Lawyer A
Lawyer B
Paralegal
Revenue Capacity:
1,600 hours x $250 = $400,000
1,700 hours x $200 = $340,000
1,500 hours x $90 = $135,000
$875,000

The analysis assumes that the work performed is billed based on hourly rates or, if other billing methods are used, that the hourly rates provide the basis for estimating anticipated revenue. The analysis also assumes that each lawyer and paralegal has an adequate workload, all time gets recorded, all billable hours are billed to clients, and all bills to clients get paid. While these assumptions are probably unattainable, the analysis does provide a benchmark for comparing the firm’s actual revenue performance.

Let’s make the assumption that the firm’s actual revenue is $525,560. That would mean that the firm is operating at 60 percent of its revenue capacity ($525,560 ÷ $875,000). Such a result would be considered problematic and should lead to an analysis of the reason for the shortfall. A review of key financial indicators would disclose whether the shortfall is based on lack of business, a poor work ethic, flawed recording of time, write-downs, a collection problem or some other factor. Many firms that conduct a revenue capacity analysis for the first time are shocked by the result.

Law firms with a 60 or 70 percent revenue capacity ratio are unlikely to survive long term in the new normal. And law firms with an 80 to 85 percent revenue capacity ratio can improve their profits. Ironically, the lower the ratio, the greater the opportunity for improvement.

Here is the powerful concept: Adding revenue while holding expenses at about the same level will cause all the increased revenue to go to the bottom line. If your overhead is about 50 percent, a 10 percent increase in revenue capacity ratio will add 20 percent to the profits. Think about it.

DEVELOP FINANCIAL REPORTS.

The next step in the analysis is to identify the reasons for the shortfall between actual revenue and revenue capacity. The answer is likely to be a combination of factors. While some causes will be more obvious than others, today’s successful law practice requires that all aspects of the shortfall be identified and corrected.

Unfortunately, many small and mid-sized firms operate with inadequate financial reports. To conduct a complete analysis, the following financial reports should be produced on a monthly basis:

  • Revenue and expense budget
  • Profit & loss statement
  • Billable hours report
  • Billings report
  • Cash receipts report
  • Aged work-in-process report
  • Aged receivables report
  • Billing realization reports
  • Collection realization report
  • Balance sheet

If these financial reports are not available on a monthly basis, you are at a serious disadvantage in attempting to manage your firm. In most circumstances, there is either a lack of understanding as to what reports are necessary or how to configure the software to produce the required reports.

If you find yourself without the necessary reports, let your bookkeeper know the type of information you require and authorize outside help, as necessary, from professionals who know how to configure the financial software. Also, your reports should not be producing massive pages of detail without the critical summary information that is useful for management purposes. A software professional should be able to set up a series of tailored monthly reports that can be produced automatically with the press of a button.

FIND HIDDEN REVENUE OPPORTUNITIES.

The next step is to identify the reasons for the revenue shortfalls. Certain parts of the analysis will be simple. If lawyers and paralegals are not busy, there is either not enough work or a culture that does not support a strong work ethic. If everyone is busy but recorded hours are low, this suggests poor recording habits. These are easy. Low monthly billings or monthly collections can be more problematic and require digging deeper.

There are three aspects of revenue generation that are often a problem in small and midsized firms but are more difficult to identify. These aspects are highlighted here because they are the most common reasons that small and midsized firms are struggling with revenue.

Billing Realization Rate: This is the percentage of recorded billable time that gets billed to clients. The amount that is not billed to clients may have been written off for a variety of reasons. In some cases, it represents time invested that is not well spent; in other situations, it is time that cannot be justified based on the intrinsic value of the work or the arrangement with the client. Some lawyers have to write off time due to inefficient work or poor practice methods.

A billing realization rate example for one client matter is shown:
Dollar Value of the Time Invested
Amount Billed to the Client
Billing Realization Rate
$1,755
$1,200
68%

A billing realization rate of 68 percent means that the work is not profitable for the firm.

Now, analyze the average billing realization rate for all of the firm’s work for a particular year:

Dollar Value of Time
Recorded in 2011
Amount Billed to Clients
Billing Realization Rate
$1,560,300
$1,250,750
80%

This example demonstrates that more than $300,000 of revenue is lost due to billing write-downs. If this hypothetical firm could add half of the shortfall back as additional profits, it would be no small matter!

A further level of analysis can be conducted by sorting the billing information and calculating the billing realization rate for a practice area or for an individual lawyer. The billing realization report is in many ways the most important tool, yet it is the most underutilized by small firms.

There is no standard rate that all firms should strive to achieve. A billing realization rate of 95 percent is considered good by most standards. A billing realization rate of 85 percent or less would be considered problematic. But, regardless of the firm’s current billing realization rate, the goal should be to improve the current rate.

Leverage: In looking at partner billings or partner receipts, successful firms encourage measuring leverage. This means that the partners get credit for the associate and paralegal dollars billed and collected. By including associate and paralegal revenues in the partner’s column, the firm is measuring the amount of the firm’s work that is being managed by each partner. Partners who produce work for others are considered more valuable than partners who only generate work for themselves.

In addition, it is only by assigning associate and paralegal dollars to the supervising partner that the firm can assess the partner’s effectiveness in his or her delegation habits. If your reports are limited to the dollars only assigned the associate and paralegal, those associates and paralegals will take the “hit” for write-offs, which is unfair, because they do not participate in client intake decisions or write-off decisions. Many small firms are losing substantial revenues by partners who write off associate time and are not held accountable. Tracking the write-offs by responsible (billing) attorney is a key measurement tool.

Turnover Rates: Billing turnover is the amount of time it takes on average until the work is billed. The information needed to calculate this is the average billings per month and the amount of work-in-process on the books at year’s end. The billing turnover rate is determined by dividing year-end work-in-process by the average monthly billings.

For example:
Average Billings per Month
Year-End Work-in-Process
Billing Turnover Rate
$90,126
$251,863
$250,000 ÷ $90,000 = 2.8 months

The turnover rate varies based on the type of work as well as billing practices. Probate work or other areas where it is the practice to collect the fee at the conclusion of the matter causes the average turnover rate to be substantially longer. Similarly, contingency work leads to a much longer time frame. This calculation can be done firm-wide, but it is most useful if it is also calculated separately for each practice area.

The information needed to calculate collection turnover is the average daily billings and the year-end amount of the firm’s accounts receivable. The collection turnover rate is determined by dividing the year-end accounts receivable by the average daily billings.

For example:
Amount of Annual Billings
Average Daily Billings
Year-end Accounts Receivable

Collection Turnover Rate
$825,000
$825,000 ÷ 365 = $2,260
$275,000
$275,000 ÷ $2,260 = 122 days

Keep in mind that if you can reduce a turnover rate by two weeks, the firm receives a surge of two weeks’ extra revenue. On the other hand, if the rate slips by two weeks, the result will be a loss of two weeks’ revenue.

RECOGNIZE THE UNDERLYING CAUSES OF REVENUE SHORTFALLS.

An examination of firms struggling with unacceptable realization rates demonstrates without doubt that failed client expectations are always a major cause of revenue problems. When a client becomes dissatisfied, timely payment of legal fees becomes less likely. And more significantly, when the lawyer detects a level of client dissatisfaction, he or she may record less time on the time sheet, write off time when billing, and be more defensive and less demanding when it comes to collecting an overdue bill. The lost revenue from lawyers who are feeling defensive about billing and collecting from clients can be substantial.

A loss of $100 on one client bill and a loss of $1,000 on another may seem like minor adjustments. But multiply those numbers by a substantial number of clients, and most lawyers would be shocked at the potential revenue that is lost.

The best approach to these issues is to create realistic expectations during client intake, and then satisfy those expectations by performing the services in an effective and efficient manner. The conclusion is inescapable. The benefits from satisfied clients are nearly endless. Clients will feel a greater obligation to pay legal fees in a timely manner and, if inspired, will send the check by return mail. Lawyers will feel comfortable billing 100 percent of the time on the file and, if necessary, pressing for timely payment.

Some would say there is nothing new here. But the problems discussed about client satisfaction, billing issues and collections issues continue to haunt many law firms. The point that needs to be made is that improving realization rates and revenue flow is more than managing numbers. It is all about the clients. Most firms that have achieved improved revenue have accomplished it based on an increased focus on client expectations and client satisfaction.

MANAGE WITH A TRANSPARENT FINANCIAL MODEL.

More and more firms are turning to more frank openness when it comes to the firm’s financial goals and encouraging discussion from all firm members. One of these ways is through increased transparency of the firm’s objectives and sharing the firm’s financial model. The financial model will have the amount of revenue needed to achieve its goals for the year and how the firm expects to achieve that revenue broken down by month, by practice area and by individual. An open discussion of the firm’s progress against its goals should become a normal part of monthly meetings.

Experience demonstrates that goals are essential to achieving desired results. Lawyers who track their productivity in hours or dollars on a daily basis will end up with better performance at the end of the year. It doesn’t matter whether the goal is modest or aggressive. The fact that there is a goal is important. Work spreads out to fill available time. The lawyer whose plan for the day is to only complete those projects that cannot be deferred to the next day will end the year with anemic productivity results. This has been proven over and over. The financial model will provide the tool necessary to create goals and manage progress.

Another advantage to the financial model and the monthly discussion of progress is that everyone will stay involved in the challenges of meeting the firm’s goal. This sharing of information will promote better collaboration and/or sharing of work to keep everyone more productive and the firm on track.

Many businesses, including law firms, are realizing that financial transparency encourages and enables its employees to make more meaningful contributions. The level of transparency can be tailored to meet the needs of the individual firm. The financial model will not have the detail reserved for the partners but will include enough information for everyone to be invested in achieving the revenue and profit goals set for the year.

ENCOURAGE INNOVATION.

For years now, the profession has been told by legal commentators to brace for substantial change in the practice of law. Back in the 1990s, we heard discussions about the emerging new paradigm. Despite these warnings, the profession has become split between innovative firms and traditional firms.

The recession has added momentum to the firms offering innovative services and has not favored firms that resist change. The number of traditional firms clinging to historical methods is in decline.

Innovative firms are leading the way to new practice methods and pricing strategies. Some firms have terminated hourly billing in favor of alternative billing methods and have used these predictable fees as a successful marketing strategy. We are seeing more efficiency, more-effective project management, state-of-the-art technology, product value replacing associate leverage, virtual arrangements, smart outsourcing, talent development, Internet marketing, social media and globalization for firms large and small.

From a management perspective, innovation is more than copying what other firms are doing. Rather, it involves understanding and responding to your clients’ needs and concerns about the legal services you provide. Being first to the market in your geographic region with a new approach or a different pricing method is a powerful concept. For innovation to occur, there needs to be active support by the firm’s leadership and management. It should be on the agenda for every practice group. Consider creating the position of director of innovation and assign that role to the firm’s most open-minded and creative lawyer. Encourage new ideas and pilot programs. Reward success based on innovation.

LAW FIRMS MUST PLAY CATCH-UP.

Practicing law in the new normal requires more skilled management and businesslike models that are common in other businesses. Lawyers are no longer able to remain successful operating under a different set of practices than other businesses.

The revenue capacity ratio analysis is the starting point to assessing how well the firm is doing against objective business standards. For those firms that do not measure up against that objective standard, there is still time for improvement—but aggressive change will be necessary. Identify revenue shortfalls, create a financial model, and shift to increased transparency and accountability. Set revenue goals and actively manage to those revenue targets. Finally, develop a culture that embraces, promotes and rewards innovation and change. Get ahead of the curve.

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