Traditionally, law firms raised rates to increase profitability. However, Arndt suggested there are other methods, such as managing the client intake process, which Arndt considered to be the most important; tailoring rates and billing policies to specific clients and matters; managing rate and billing adjustments; billing often and keeping the client informed; tying partner reward structure to rate performance; and reporting rates achieved.
The business of law has changed since Arndt first published his principles. We propose building on the RULES principles by incorporating analytics and new approaches to matter management to provide ideas for improving profitability and client value in today’s environment.
Rates
There are four rates that firms should monitor to understand the impact of cash leakage on profits: standard, negotiated (worked), billed (write-downs) and collected (write-offs). Understanding the factors behind each rate provides insights into minimizing “cash leakage,” or the reduction from billable hours worked to realized amounts, thereby improving partner profits.
Standard
A standard rate is an attorney’s quoted hourly billable rate. Standard rates are more aspirational than realistic: Today’s profitability surveys ask about negotiated rates.
Interestingly, following the Great Recession, firms discovered that many clients measured their negotiating success by the percent discount achieved to standard rates. Firms that did not increase standard rates learned that it put them at a price disadvantage for many years against firms that continued to increase standard rates annually. With inflation running around 8% in the first quarter of 2022, many firms plan to increase their standard rates by 8% to 10%.
Negotiated (Worked)
Negotiated rates are agreed-to discounts from standard rates, ideally reserved for large clients with good credit and payment histories. The average firm negotiates discounts from the standard by 7.7%. Be watchful for deeper discounts: For a firm with a 33% profit margin, each 1% adjustment reduces profit by 3%. When clients persist, evaluate whether an alternative fee arrangement (AFA) or blended rate is appropriate. If a client’s discount is significantly below the firm average, it may be time to terminate the client and seek more profitable work.
Billed (Write-Downs)
Downward adjustments can occur when the billing lawyer feels the time worked exceeds the value the client received or agreed to pay. The average firm discounts worked to reduce billed rates by 8.2%.
Collected (Write-Offs)
Write-offs occur after an account is billed and the client is either unwilling or unable to pay the amount. In 2021, partial or total account write-offs averaged 9.4%.
Accumulated Leaks
The amount of lost opportunity in this cycle is enormous. Assume a firm with a standard worked value of $326 million, and using the average realization deduction percentages noted above, we arrive at a net cash collection of $250 million. As shown in the table below, for every 1% improvement in realization, firm profit would increase by $3.26 million.
Actions Firms Can Take to Improve Realization
Working with data from an Am Law 200 firm during the Great Recession, when realization was dropping across the industry, we used informative analytics to help the firm improve the standard to cash collected realization by 4%.
When presented with analytics as in the table below, partners were amazed at the impact of discounts they previously readily agreed to give. The partners embraced a new review procedure: All rate adjustments had to be centrally approved (in this case, by a retired partner). When clients asked for a discount, the partner could honestly say they did not have the authority to approve the request. If the client persisted, they were informed that their request had to be approved by a committee that reserved adjustments for extenuating circumstances.
The benefits of this system included shielding the partner from being the person who had to say no and ensuring that discounts were reserved for legitimate reasons.
Further analysis revealed systemic issues that, once addressed, further improved realization. Inconsistent standard rates were alleviated by implementing centrally set standard rates based on competitive rate information by practice, timekeeper seniority and geography. The client intake process was centralized and improved. Now clients were vetted for creditworthiness, past billing, and collection and profit trends, and retainers (advanced fees) were required for new clients.
Changes were made to improve the matter intake process, including requiring that all new matters have engagement letters that included the firm’s billing and collection policies. Partners were required to outline the scope and set fee budgets for all matters, proactively communicating and collaborating with clients.
The firm’s intake and matter management procedures were updated. Clients were informed as to their fee and evergreen retainer obligations. Time entry systems were programmed for alerts for time or expense entries inconsistent with client directives. This resulted in fewer pre-bill adjustments and audit exceptions, thereby speeding the time to payment. Other improvements included centralized contingency matter acceptance with enhanced risk assessment and the stopping of year-end discounts, which were previously thought to incentivize clients to pay accounts.
Utilization
Utilization in the RULES context starts with the worked billable hours per timekeeper. The 2022 Report on the State of the Legal Market found that average billable hours increased from 120 per month in 2020 to 124 in November 2021, an annualized increase of 48 hours per timekeeper. It should be noted that 2021 results are still 120 hours per year lower than in 2007, the year before the Great Recession.
Effectively Capture and Timely Record All Time
Studies show that a significant amount of time goes unrecorded when worked in short durations, on mobile devices, at night or on weekends.
Software solutions now can contemporaneously capture all activities performed on most electronic devices, including email, texts, phone calls and most computer software applications. Timekeepers can electronically review, amend and submit these, with the benefit that timekeepers are now capturing time that previously went unrecorded.
Based on a survey of users one year after one firm implemented such a system, they concluded that the firm captured 3.7% more time, contributing an additional 11.1% profit. The survey also concluded that the timekeepers spent 1.5% less time manually reconstructing and entering their time. Given current demand increases, this productivity gain could translate into billable hours without increasing the total number of hours that timekeepers work.
There are only so many hours in a day, and most attorneys feel that they are giving all they have. But there are still metrics that a firm should monitor to help attorneys ensure that their efforts are being used as productively as possible.
Firms should track the percent of billable time to total time recorded. Many of us know attorneys who are first in and last out but fail to achieve targets. This metric identifies those attorneys who may benefit from time management coaching. The uneven distribution of work should also be tracked. One firm introduced a red light/green light system. Attorneys choose a stoplight color from red to green, indicating how busy they expect to be in the coming week, month and quarter. New work assignments were given to lawyers with matching expertise and availability, and to those who asked for opportunities in new areas of law.
Analysis of major law firms indicates that attorneys working on smaller clients have lower billable hours. They experience small bursts of work for many clients instead of the large blocks of attorneys working on more significant clients. Firms should, therefore, be mindful of the size of the clients served by each lawyer. This conclusion was drawn from a client segmentation profitability analysis. Do you need to freeze hiring (which is a soft way to say that low-profit clients and areas of law should be downsized)? Based on a profitability study during the recession, a firm implemented a policy to freeze new hires for practices where total underutilization hours were greater than the equivalent hours of a full-time attorney.
Leverage
Leverage is the billable hours ratio of equity partners to other timekeepers and is one of the best drivers that lower-rate firms can use to improve partner profits. Take Cole, Scott & Kissane, an Am Law 2nd 100 group firm with 541 lawyers in Florida. The average profit per timekeeper was approximately $20,000; yet the profit per equity partner of $3.7 million ranks it as one of the most profitable firms on Am Law’s 2020 survey. Cole achieved this result through high leverage.
While leverage may not be a key factor for all practice areas, clients are increasingly seeing the value of delegating work to the least expensive, competent professional—thereby increasing leverage and profits through enhanced utilization of paralegals and other paraprofessionals.
Firms could use leverage to turn the war for talent from being money-driven to offering enhanced training and mentoring, a holistic sense of purpose, and a better work/life balance.
In the 2021 Above the Law Millennial Survey by Major, Lindsey & Africa, associates were asked what they would desire over increased salary:
- More time off: 29%
- Flexible work schedule: 25%
- Reduction in billable hours: 26%
- Time for career training and development: 8%
A Thomson Reuters (TR) survey indicates that associate turnover reached 23.2% in 2021, compared to 15% in 2020. Moreover, TR estimated that the turnover cost for an associate is 1.5 to 2 times their annual salary. Based on an average third-year associate salary of $250,000, the cost to the firm for turnover would be $375,000 to $500,000 per associate.
Let’s assume a firm with 100 associates worked an average of 1,488 billable hours per year. If total associate hours remained the same and the firm hired five additional associates, then average associate hours would drop down to 1,417. By increasing leverage, the firm would have the opportunity to meet the associates’ priorities for fewer hours, flexibility, etc., and save costs over the long term. How? By cutting hours, a firm could potentially get to 2020 attrition rates, possibly lower. Assuming no salary reductions (and average salary noted above), the net savings from lower turnover ($1.5 to $2.4 million) would more than pay for the compensation of the additional associates ($1.25 million), as shown in the table below.
If a firm were to follow this recommendation of increasing leverage and addressing associates’ priorities for reduced hours, flexibility, professional development, etc., they would almost certainly improve associate satisfaction and retention. In David H. Maister’s book Practice What You Preach, survey results found a causal relationship between employee satisfaction and profit, where a 10% satisfaction improvement causes a 25% increase in firm profit.
Expenses
If firms can increase negotiated rates equal to inflation, then partner profits will increase at the inflation rate. Further net income profit margin improvement will come to firms that reduce their space footprint. Because rent is the largest expense following salaries, those gains could be significant.
Speed
Speed refers to the time lag from the date work is done to when payment is received. Work in process (WIP) is time worked but not billed, and accounts receivable (AR) is work that has been billed but not yet paid. WIP plus AR equals “lockup.” According to a recent PricewaterhouseCoopers survey, in the average firm lockup is 115 days. How can a firm reduce their lockup?
Different approaches have been used. An imaginative approach came from a firm in Atlanta. They implemented a policy whereby lawyers would be paid a princely sum of $7 a day if they submitted each day’s time by 10 a.m. the next morning. The firm’s accountant stated: “You would be amazed at what lawyers will do for $7 a day.”
Another approach is an e-billing system that checks time for date worked versus date recorded; if there is too long a lag, the time may not be accepted. Other systems watch hours recorded by day and monitor for timekeepers attempting to game the system with time reversals.
The results on profit and working capital are clear in the numbers: Just a five-day decrease in lockup increases profit per equity partner by over 2%. Some other ways to reduce lockup include what we’ll call “Cash is king”—evaluating partners on cash collections as opposed to hours worked or billings. Profits are then linked to cash collected, not accrual accounting. You might determine client profit based on collections; partners do not get credit for work done until it is collected. Bill frequently and at time(s) where results were achieved. Bill half your clients in the first two weeks of the month and the others in the last two weeks.
Be sure to measure the right indicators. Billing rate and billable hours are not the best metrics for monitoring conversion and velocity. Billable hours and billing rates are too early in the work-to-cash continuum to be meaningful. Instead, focus on collected rates and cash collections, and tie evaluations and incentives to these targets.
Monitor lockup and have a senior partner follow up with partners with delinquent clients; if possible, stop existing work and cease taking on new matters for those clients. Or you might link draws to cash management; this has been suggested many times but is rarely implemented. Use engagement letters on all matters, incorporating billing and collection terms, and consider evergreen retainers when appropriate. Get timely information by moving to real-time reporting versus printed reports that are outdated almost immediately. And finally, cut out the speed bumps. Client account audits slow down the collection cycle, so ensure that e-bill accounts are audit-proof. There are real-time time capture tools that are very effective in ensuring client guidelines are met.
Working smarter and not harder is a well-worn maxim. Today, by following the RULES and employing effective technology tools and informative analytics, we can achieve greater profit without flogging associates to death with their billable hour requirements.
