Law Practice Today

Fess up: Like most other firms, you’re likely still buying into the assumption – true or not – that the success of your firm can be gauged by how many hours your attorneys work or which attorneys bill the most fees. While these statistics are important, have they really helped increase your firm’s bottom line?

For years, we had made attempts to go beyond this simplistic approach to gauge our success. It took a book about Oakland Athletics’ coach Billy Beane’s view of statistics, Moneyball, written in 2002 by Michael Lewis, to convince me to look for those statistics that might mean a little more.

We began by looking more closely at the type of law and the type of clients we were bringing on. Our analysis showed a strong relationship between write-downs/write-offs and the firm’s ultimate realizations in certain areas that had nothing to do with working and billing attorneys. Some areas of law tended to be unprofitable and some types of clients tended to have the highest percentage of write-offs, both hurting our profitability. We definitely think twice now before working with certain clients and factor in the type of representations that are more likely to have their work written-off – and it’s paying off for us in increased Realization.

 

• So, if you aren’t seeing the profitability you’d like, it might be time to shake things up a bit. Start by using a combination of metrics to provide a better definition of your firm’s true profitability now and a predictor of your future success. In addition to measuring attorney productivity, have you analyzed the types of law or the type of client your firm is taking on? How about how your expenses could be better managed or how fast your invoices are being paid each month? Simply put, are you taking advantage of the data within your financial management system to evaluate what needs to be improved to increase your profitability? If you aren’t, consider the following multiple points addressed by the “RULES of law firm profitability” to best analyze this data. It’s easier than it sounds.

What Are the RULES?

The RULES, developed by the late Robert J. Arndt in the 1990s, enable firms to evaluate profitability by looking at:

 

• Realization of billing rates;
• Utilization of attorneys;
• Leverage of lawyers;
• Expense control; and
• Speed of billings and collections.

It allows you to analyze multiple data points so you aren’t just looking at one piece of the puzzle, which can be misleading. Let’s take a look at the RULES and how they can help your firm.

1. Realization: “How much is ultimately collected” versus the “effort expended.”

If you are like most firms, you’ve traditionally looked at Realization by billing attorney, working attorney or client by the fees billed and/or collected. While this is useful information, by itself it does not provide any clue as to how it relates to profitability.

So, how do you measure Realization?

First, set an annual revenue budget based on reasonable expectations for each timekeeper's hours and respective billing rates to lead to a firm-wide composite hourly realization rate. This composite rate may or may not be the same as the firm’s standard rate, but it establishes a benchmark to compare to actual results as the year progresses. Explaining variations from the benchmark, both positive and negative, will allow management to focus on those billing issues that bring the greatest benefit to the firm. Good investigations will go beyond the basic working/billing attorney and client level data. The contributing factors may not be so surprising, but the extent of the detriment or contribution may be a real eye opener.

Second, determine how close your realized rates are to the standards set in your budgeting process. You must first look at the value of your hours worked then look at what you’ve collected. Then examine your Realization by billing attorney, working attorney, and client or individual matter. This information is vital when considering billing rate changes, giving discounts, or negotiating fixed fee arrangements.

Let’s look at simple billing attorney Realization as an example. Say a firm has a simple matter that an attorney decides to handle on his or her own. His standard rate is $150 an hour but he agrees to do the job at $125 an hour. He works 10 hours. At this point, the standard rate of $150 would have netted $1500, yet his matter rate only generated $1250. Feeling especially nice, he discounts the bill by another $250, so he sends the bill at $1000. This means his billing rate is now $100 an hour. When the client pays the bill, it disputes 30 minutes of work, which means they only send $950. As a result, the attorney that supposedly has a $150 an hour standard rate only realizes $95 an hour. Sound familiar?

2. Utilization: How timekeepers use time on billable vs. non-billable activities.

It’s no secret that if timekeepers spend time effectively, they will be generating revenue for the firm. To measure Utilization, set goals and evaluate how well your firm is currently meeting them. Published billable hour goals are general expectations and are usually set by groups, such as partners, associates, paralegals and staff attorneys. By using group-based goals, there is never a perception that a firm expects more from one attorney than another.

If you want to judge effective Utilization at a firm-wide level, you should use a standard of realistic expectations of billable hours and billing rates based on the following conditions:

 

• Current economic conditions including billing rate changes
• Status of large non-recurring matters
• Impact of contingency fee matters in firms where most work is non-contingency
• Impact of other alternative billing arrangements
• Other factors (i.e. health issues) affecting staff performance
• Staff turnover (new attorneys may have the hours but collections will lag initially for 1 to 3 months)
• Attorney commitments to non-billable activities such as local and state bar leadership roles or firm management

These factors would be used to develop a firm-wide revenue budget and to project the best estimate of what the firm’s revenue would be for the coming year. This revenue goal uses a combination of the firm’s composite rate with expected number of timekeeper hours. For example, your firm might allow Partner A 1800 hours per year and Partner B 1700 hours. Partner B might have a higher bill rate and generate more money, but Partner A uses more associates and paralegals with lower billable rates but generates a greater per case revenue. You’ll always find some good news and some bad, and a much better basis for judging how you are doing with your revenue plan. When an individual sees how well – or not so well -- they are doing against their goal, they’ll want to try even harder.

Note that to accurately measure—and eventually increase—Utilization, the firm must monitor and enforce prompt time entry. Without compliance from all timekeepers, law firm management reporting is basically useless. By entering ALL time, billable or otherwise, the firm can also accurately judge all of the factors that determine what should be billed on certain matters and help evaluate the efficient use of the timekeeper’s time.

Tracking Realization and Utilization by attorney helped us tremendously after Hurricane Katrina tore through New Orleans in 2005. The storm forced Stone Pigman and hundreds of other law firms to shut down. Needless to say, attorneys on payroll were unable to work, so cases were stalled. Because we have always evaluated how much we ultimately collect based on the number of hours our attorneys work and their expected billing rates, we were able to determine the cost that the business interruption had on the firm financially and file a business interruption claim accordingly. Unfortunately, other firms did not collect the data to evaluate this type of “Realization,” so they were unable to measure expected decreases in revenues and had a difficult time proving claims under business interruption insurance.

3. Leverage: Ratio of associates or non-equity partners to equity partners in the firm.

Understanding your ratio of net income to revenue (Realization) has a lot to do with your ratio of partner to non-partner timekeepers (Leverage). As the ratio (Leverage) goes down, a greater percentage of net income must go to partners to maintain or increase their income. If a firm has 10 associates and 10 partners, it has a leverage of 1:1. If the firm has a ratio of less than one, it has more partners than associates. If a firm is “highly leveraged,” it means that fewer partners are sharing the firm’s net income.

If you manage your payroll correctly and continue to bring in work, you can be highly leveraged and have associates at the lowest levels working at the highest productivity, which can generate more income for the equity partners.

Take the following example:

Firm A:	Firm B: (highly leveraged)
10 partners	2 Partners
Gross Revenues: $10 M	Gross Revenues: $10 M
Net Income = 50% revenues: $5 M	Net Income = 25% revenues: $2.5 M
Each Partner income: $500,000	Each Partner income: $1.25 M

 

If Firm B adds additional partners without increasing the firm’s gross revenue, the individual partners’ income will decrease. The firm has to expand the revenue they are bringing in either directly by increasing work hours or by generating new business. The new – and even the old – partners aren’t going to be happy if they aren’t making the amount of money they were promised.

4. Expense Control: A planning process or budget that supports a firm’s goals.

If you aren’t measuring expenses, which are tied to revenue, you can’t build up the number of secretaries, buy computers, or add extra phone lines, etc. Your payroll budget should be related to your revenue budget with as much detail as possible. Budget all timekeepers as close to expected periods of employment as possible and maintain an efficient timekeeper-to-secretary ratio and then consider how other services are impacted by staff changes.

Evaluate your firm’s ability to control expenses in the following ways:

• Management-Level Reports— Income statements with comparison to budget for month and year-to-date should be in enough detail so management feels comfortable, yet not overwhelmed by detail. Add value with good groupings and subtotals.
• Supervisor-Level Reporting —Provide supervisors with focused reports, delivered on a regular schedule. Most financial management systems offer an automatic report generator to ensure delivery.
• Account ranges/groupings —A budgeted amount may cross a range of accounts but you should continue to monitor individual activity. For instance, you may budget a lump sum for client entertainment for all attorneys in G/L group 6456, yet record the expenses by individual attorney in accounts 6456-xxxx.

Be sure to get the following:

• Total compensation costs
• Total number of personnel over the same time period
• Average compensation by employee category
• Cost per lawyer in operating expenses and how it compares to industry average.

While controlling expenses is important, you need to remember that it doesn’t have nearly as much impact on profitability as Realization, Utilization, and Leverage. Often, expenses aren’t as controllable as you may think. Rent for office space is usually set for several years. Non-attorney staff cuts may not be reasonable unless the number of attorneys is also reduced. Even controlling overtime, which is widely abused, can add tens of thousands of dollars to your firm’s profitability, but not nearly as much as adding new clients or billing more hours, which is what you can control. Leave Expense Control to administrators and accountants.

 

5. Speed: Gap between time charges incurred and date payment is received.

Speed control usually looks at a monthly billing average. When firms begin putting emphasis on monthly billings they will likely penalize attorneys that don’t bill on a monthly basis no matter how much they bill. This new way of looking at your data should encourage your attorneys to get their time in promptly so they can bill clients more often. If you aren’t billing all of your time, you’re basically giving a free loan to your client.

The sooner the firm can bill something, the sooner the client has the opportunity to pay the bill. The firm might have collected a lot of money (Realization), but it can have more than 12 months worth of inventory between Work In Process (WIP) and A/R at any given time.

Another maxim of that: The sooner a firm bills the client, the more the client will remember about the details of work the firm has done for them. For example, if it takes three months to bill the client, the client is less likely to remember the 10 times they called their attorney during an 8-hour day.

Two especially helpful statistics to look at are the number of months of billing currently in WIP, and the number of months the firm has in A/R. When added together it tells you how long it takes from when the billings are posted on the books to when money comes in the door. For example, three months in WIP and two months in A/R means there were five months from time on the books to when the money actually comes in.

Speed can be measured in several ways:

• WIP Management— Use reports that include aged WIP and billed fees & costs by billing and working attorney to monitor billing progress and quality of billing. If the firm has a mixture of contingent and non-contingent work, report each type separately. When clients require something other than a normal billing cycle, the firm should still use the same client reports. Basically, you still need to manage the WIP effectively so you know how much you have in inventory. If an attorney is putting a significant amount of time in a pure contingency case and the firm isn’t going to get any additional payback when the case is won, you need to make sure you aren’t working at a discount.
• Costs —Unbilled hard costs are a drain on cash requiring capital contributions and/or borrowing from a bank. Never ignore them.
• A/R Management —Use Aged A/R reports with detail to identify client/matters for which an attorney may need collection assistance. Even though advance deposit and trust balances are on drafts, this report gives the attorney a quick snapshot of the matters that need their attention. Every billing attorney should get a report of payments received on their matters at least weekly. This keeps them well aware of the changes in their receivables.

Following the RULES Beyond Standard Statistics

While you don’t need to evaluate all aspects of the RULES at all times to increase profitability, you’ll notice that none of them is totally independent of each other. You can’t have any Realization unless you get some Utilization. Leverage doesn’t make a lot of sense if you don’t get Realization from non-partners to contribute money to the partners. Following the RULES will enable you to look beyond the standard statistics to get the data that will help your firm build profitability and continue to compete with the big boys with the big budgets. It might take some time to figure out the trends unique to your individual firm, but it will be worth it.