October 23, 2012

Raising Revenue versus Cutting Costs: It's Only Horse Sense

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By David Bilinsky and Laura Calloway

We all know the expression, "He's penny-wise and pound-foolish," and we understand its meaning, even though for most of us, its origins are shrouded in the mists of time. The maxim refers to people who make foolish financial decisions. Could it refer to your law firm, too?


A little puttering on the Internet reveals that the source of the "pound- foolish" maxim is an old English fable about a man who was too cheap to have his horse reshod when a shoe became loose. As a result, a rock became lodged between the loose shoe and the horse's hoof. First the horse became lame, then it stumbled and broke its leg, and in the end it had to be shot.

Thus, while the owner saved the price of the blacksmith's services, he lost the much greater value of the use of his horse. Penny-wise, but pound-foolish he truly was.

So what can loose horse shoes teach us about law firm finance? More than you might initially think—especially if the lawyers in your firm don't understand the difference between cutting costs and raising revenue.


When Alarm Bells Ring: "My Kingdom for a Horse!"

In previous columns we've counseled that every firm needs a written budget and should consult that budget periodically to make sure that expenses are within expected limits. Unfortunately, more often than not, firms don't have written budgets based on well-reasoned projections of what expenditures will be needed to operate the firm.

Consequently, when revenue is flat or declines for one or more accounting periods, here's what happens: Panic sets in, and because the projections were inaccurate, it sends the firm's lawyers scrambling outside of the budget and into a cost-cutting frenzy, slashing spending on everything from legal pads to technology upgrades.

On the surface, this may seem like a reasonable reaction. It is, after all, what we are accustomed to doing when, for whatever reason, our own personal incomes suddenly decrease. Everyone knows that you can't spend more than you bring in—at least not for long—without severe consequences.

And so when revenues or profit margins in a law firm decrease, the partners' natural impulse is to attempt to reduce the various costs that go into providing a particular service, either directly or indirectly. But, like the hapless owner of the horse in the fable, firms that concentrate on reducing expenses rather than focusing on effective ways to increase revenue will find that, instead of riding high, they're walking unhappily—and sometimes sooner rather than later.

It goes without saying that law firm expenses should be reasonable—which is why a well-thought-out budget is an absolute necessity. However, because a law firm's major expense item is salaries—its people—there is only so much "fat" that can be trimmed before you start to cut away at the "muscle" that is the firm's ability to get work done and generate income. Let's discuss what you can do instead.


Why to Leave Expenses Alone: An Illustration

Firms that really want to improve their profitability should be looking for ways to increase their revenues while keeping their expense structures unchanged—or at least growing as slowly as possible. Why? In his book The Lawyer's Guide to Increasing Revenue: Unlocking the Profit Potential in Your Firm ( ABA, 2004), Arthur G. Greene provides this excellent demonstration:


For example, assume that the firm generates $1.5 million annually and that there is a 50 percent profit margin, meaning $750 thousand goes to overhead and the other $750 thousand goes to the partners as compensation or profits.

Annual Revenue $1,500,000

Expenses 750,000

Partner Profits 750,000

Now, if the firm is able to increase its revenues by 10 percent while maintaining the same cost structure, 100 percent of the additional revenue dollars will go to the partners. Therefore, partner profits would be $900,000.

Annual Revenue $1,650,000

Expenses 750,00

Partner Profits 900,000

As Greene's example illustrates, when expenses remain unchanged, a 10 percent increase in revenue will fall straight to the bottom line—resulting in a 20 percent increase in lawyer profits. Up the revenue increase to 15 percent, and the profits to partners will increase by 30 percent.

Surely, this is a much more effective way to improve the bottom line by leaps and bounds than by cutting down on pen and pencil purchases! Yet many lawyers don't think about, or may even resist, calls to increase revenue because they equate it with working longer hours. That doesn't have to be the case, though.

There are lots of other places you can look for additional revenue without upping your hourly billing requirement. We've discussed these concepts in previous columns, and now you will see how they all come together and get tied up in a neat little bow.


Where to Boost the Firm's Bucks

Realization. The first place you can look to gain additional revenue is in your realization rates—both billing realization rates and collection realization rates. You can almost always find additional time (and profits) by improving your billing realization, which you do by reducing the number of hours worked on a given matter but not billed to that matter. Improving your collection realization requires reducing the number of hours billed to a matter but not collected—either through write-downs of time recorded or write-offs of unpaid accounts.

Leverage. A second place to look for additional revenue is through increasing personnel leverage. If, for example, you can hire a paralegal or associate to do billable hourly work that you have been doing yourself, you can not only bill that person's time but also free up your time for other, higher-hourly rate work.

Alternative billing. A third, and perhaps less obvious, option for adding revenue is through the implementation of alternative billing in tandem with increased use of technology. Let's consider this in more detail.

First, take a careful look at the types of work you do to determine whether any of them would lend themselves to document automation with guaranteed flat fees for the client. In your thinking, consider possible bonuses for yourself or your firm for decreasing the turnaround time for delivering the work product. Here, then, is how guaranteed flat fees can work for the betterment of your firm and your clients.

Let's assume that you can track both the time logged and the fees billed on a certain type of legal service. It would be best to start with a commodity service (say, for example, the incorporation of a certain type of LLC). If you know the typical fees realized and hours logged on this type of matter, then you can determine your effective hourly rate (EHR) on these files. Now determine the average number of billable hours (ABH) put into these types of files.

Your EHR x ABH = Your average fee realized on each of the files.

Now quote the work to the client at, say, 25 percent above your average fee. You will then be guaranteed to make a greater profit on these files over the long term.

Plus, there are other benefits. When you can tell clients up front what they will be charged for the matter, before heading into the work, it increases their feeling of comfort with you. Not only that, but because you have quoted a fixed fee, you and your staff now have every incentive to look for new ways to use technology to perform the work with the same accuracy but in a more efficient way—further increasing the profit margin on the work.

This is a win-win for you, the client and the bottom line. Moreover, once you have grown comfortable with working in a fixed-fee environment, you can start to extend this approach to other legal services that lend themselves to this analysis—and can start to use the numbers to your advantage.

Billing turnover. A final place to seek increased revenue is in your billing turnover rates. How long does it take for you to produce a bill once the work is done? The average billing turnover time—meaning the time work-in-progress is banked before a statement is sent to the client—is 60 to 70 days. If you can decrease that time, you will increase your billing turnover rate. You will also reduce the number of days before payment is received (which is, on average, 105 days), thereby increasing your payment turnover and increasing the speed with which revenue flows through the firm.

Of course, as we've said before, decreasing the time that WIP and accounts receivable are outstanding is a one-time source of revenue—for the simple reason that you can only shorten your turnover rates so much. However, there is a longer-term benefit from undertaking this—and that is decreasing the billing "leaks" in your firm, since it is well-known that the longer WIP is accumulated and A/Rs are outstanding, the smaller the percentage of both that are eventually recovered. By tightening your WIP turnover and your A/R's days outstanding, you will receive (in cash) a greater percentage of the time actually worked on all your files.


Don't Put It Off Until Tomorrow

As you can now see, careful husbandry of your revenues is a better road than cutting expenses, and it can result in substantial increases in profits. But be warned: The time to start implementing the foregoing tactics is now—while the horse still has all four shoes. In other words, before times get lean and tough, you want to experiment with the different approaches to find the ones that best work to increase your revenue. And that's a gift horse you can't afford to look in the mouth.