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Faulty Assumptions

One longstanding myth is that value of services rendered is equal to the effort (billable hours worked). That is False! Another: Growth in income will come through growth in volume of hours produced by the firm. That is False! Yet another: Any work is better than no work. That is False! And: The future is best based upon the past. That is False! Many times these statements remind me of a managing partner’s remark on some of his partner’s perception of law firm economics: “The shallower the stream the louder the burble.”

Clients do not equate effort with the value added by the lawyers. If there is no perceived value added, clients will ask for discounts on rates or on the fee bill. Volume of hours produced and fees billed will not necessarily produce higher income. If the volume of hours billed goes up there is a very high probability that there will be a lower return on rates because of discounting, write-downs, write-offs and/or fogging, churning, and rate transfer. Fogging is adding time to a file without adding value e.g. “Review of file.” Churning is running too many people through the file, each having to spend time coming up to speed on the file. Rate transfer is when a higher rate person does work that a lower rate person should do because the higher rate person “needs the hours” to make budget. If a firm sets hourly budgets too high in order to increase volume, time-keepers must choose between the trailer park and treachery. They will choose treachery every time.

Also heard at many law firms is “any work is better than no work.” That would be like Southwest Airlines saying: “let’s fill up every seat, even if we have let them fly for much less that it cost us to fly that seat.” Sure, the argument is that such work might cover overhead, but in most cases, the rate of return on the file won’t even cover the compensation of the partners and associates running the file. I suggest that you find and read the book The Myth of Market Share by Richard Miniter.

Finally, the future is not based upon the past. Legal work is becoming more episodic and transactional as clients move to lowering their legal costs by picking and choosing what matters they will give to any law firm. Most legal work is perceived by sophisticated clients as a commodity and priced that way. Their sophisticated risk managers are now in charge—not the outside lawyers.

Calculating Realization

Although volume is important, in these times the key success factor in performance and viability must be the return on benchmark rates (realization). First we must define “benchmark rate.” The benchmark rate (BR) is not a reflection of value added. The benchmark rate is a reflection of the expected return on the investment the firm has made in building the experience, expertise, and knowledge base of a timekeeper within the firm. Back to the airline analogy, if an airline has a cost system that cannot be cut without destroying the competitive advantages, a load factor of 65% per plane might be their break even point. If they are flying at 65.5% they are making a million a day. If they are flying at 64.5% they are losing a million a day. The same rules of economics affect law firms. The benchmark rate must reflect the expected return on the firm’s investment. There is always a break point at which earnings will be zero.

A simple starting point is to focus on only nine key variables that drive net income. Picture a tic-tac-toe chart with three lines, three columns, and nine cells. The top line, Potential Revenue, is the result of the Leverage employed per partner times the average lawyer Pace (hours worked) times the average Benchmark Rate (the expected return on time). The second line shows the return on the top line; R1, R2, and R3. Realization one (R1) is the return on the benchmark rates as the work moves into Work-In-Process. For example if the client is promised a 10% discount, R1 becomes 90%.

Realization two (R2) is the return on the value of work in Work-In-Progress (WIP). For example if the billing lawyer relieves $10,000 from WIP and only bills $9,000, R2 is 90%.

Realization three (R3) is the return on the value of work in Accounts Receivable (A/R). For example, if the client gets the billing lawyer to write off 10% of the fee billed, R3 will be 90%. The result: The net revenue is now only 72% (R1 times R2 times R3) of what it could have been had the firm had a stronger intake process, managed projects more effectively, or had a better understanding of the client’s issues and billing guidelines.

The third line represents the use of the net revenues after discounted by realization. Expenses (E) per partner plus the Investments in capital items (I1) and the Investments due to the increase in Work-In-Process and Accounts Receivable balances over the measurement period (I2).

Why such a focus on realization? As in the concept of the balanced scorecard, there are direct links between responsible leadership and management and net income per partner. Lawyers must keep their eye on increasing the size of the pie for the entire firm. Focusing on overhead and cost accounting steers lawyers toward criticizing staff and away from their personal accountability.

The focus on Realization requires the following lawyer-driven tasks. First, they must realize that every new matter results in an investment by the firm on which the firm should receive a fair return. Second, lawyers are responsible for managing their matters responsibly so as not to incur write-downs. Poor project management, poor training, poor delegation skills, and the resulting turnover of lawyers and staff will guarantee lower realization on the values created in Work-In-Process. Third, their lack of an understanding of client expectations, an agreement on their internal financial responsibilities, the abdication of responsibilities in billing and collection, and the inadequate effort to develop a long-term client relationship will drop the realization on the value of services in Accounts Receivable.

Figure 1 creates a picture of the degradation in income due to losses in realization.

An example will help you see the impact of realization on a firm. There are two partners in a law firm. Partner A, Mr. Shark works 2,000 hours a year. His benchmark rate is $300 per hour and his compensation and overhead is $600,000. His collections were $1,500,000. Partner B, Ms. Team works1,800 hours a year. She makes the same amount as Partner A and has the same billing rate. She collected $1,000,000. Who should make the most money?

Hold on, we are not through. Partner A’s overall realization was 72% which meant that the firm invested $2,083,333 to get the $1,500,000. Partner B’s realization was 98% which meant that the firm invested $1,020,408 to get the $1,000,000. If associates typically bill $350,000 each and carry salary and overhead of $200,000, then Partner A used 4.24 associates and Partner B used 1.37 associates. After deducting the partner’s compensation and overhead and the associates’ compensation and overhead, Partner A’s return on the firm’s investment was $52,381 while Partner B’s return to the firm was $674,519. Now who should make the most money?

The emphasis must be on improving realization. For example, take a 15 partner, 35 lawyer firm with $10,000,000 in revenues. Assume the firm’s realization on benchmark rates is 80%. That means the firm had to generate $12,500,000 in fees to get the $10,000,000. A 10% increase in realization would produce $11,250,000 or an increase in revenues with no increase in overhead of $1,250,000. That would be over $83,000 per partner. A decrease in realization by 10% would drop per partner income by over 83,000. Volume means nothing without a focus on realization.

The Checklist for Setting Up the Realization Focus

Step 1: Point out to partners the importance of realization to the firm. Use Figure 1 and show the impact on your firm. People who grew up in the culture that effort equals value and volume equals profit will not come along quietly. You can use the following to make the argument.

First, if the firm generate $50 million in revenues and can increase their realization by 10%, then revenues would be about $5 million dollars, all of which would go to the bottom line. Second, if salaries were reduced by 10%, an almost impossible task, the amount returning to the bottom line would be about $1.8 million.

Step 2: Set new targets for benchmark rates and realization for each time-keeper. Each time-keeper should be given a benchmark rate that accurately reflects the expected return on their time regardless of type of practice. For example, litigators who do commercial litigation and litigators who perform insurance defense work must be given the same benchmark rates. If an insurance defense lawyer gets only 70% of benchmark rate because of discounts, he or she must leverage work more effectively to maintain and overall realization rate for R1 that the commercial litigators get.

Step 3: Start with a zero based budget on expenses, investments in capital items, and investment in WIP and A/R. What must be in place in overhead to make the realization targets? How much will the firm, based upon history, invest in WIP and A/R?.

Step 4: Don’t focus on cost accounting. Focusing on the improvement in realization and set minimums for realization by group. Set up the benchmarks for realization based upon the overhead that must be carried. For example, if given the overhead numbers, the break even point for minimum partner distributions is 65%, focus on that as critical performance measure.

Step 5: The spreadsheet for revenues. Each timekeeper should be listed in one column. Across the top the following columns should be labeled. For each of the last three years the collections, R1, R2, and R3. That will take Columns A through M.

For the coming year the following Columns should be created.

• Column N: Hours expected.
• Column O: Benchmark Rate (the expected return on the investment of the firm in the individual).
• Column P: Columns N times O.
• Column Q: the expected realization on benchmark rates (R1).
• Column R: Columns P times Q.
• Column S: the expected realization on WIP through better project management and training.
• Column T: Columns Q times S.
• Column U: The expected return on A/R in getting to collected dollars.

Columns Q, S, and U are targets agreed upon by the partners who are tasked to improve the overall return from their clients.

Step 6: Set up benchmarks and review points. For the targets set up by the leadership with each partner, create the programs that will enable them hit their targets. Set up review points after the end of each quarter for the leadership to review status and make adjustments.

Step 7: Use the realization numbers to identify problems and drill down to specific programs that need to be executed more effectively. For example, should individual practice groups or sections be more focused on leverage, alternative pricing, client loyalty, expanding the bundle of services to provide legal related services, turnover, training, or other key programs.

Remember the key measurement is realization, not the volume of hours or the volume of dollars.

Bill Cobb has been consulting to professional services firms since 1970. In 1973 he joined the small law firm of Bracewell & Patterson in Houston as their COO and helped them develop a strategic plan that supplied the infrastructure for their growth to over 250 lawyers today. He has written and published books for professionals on strategic planning, partner compensation, pricing legal services, creating client-driven firms, and other critical strategic issues. Mr. Cobb has an undergraduate degree in Aeronautical Engineering, and an M.B.A., and he is a CPA.