Discounting, realization, profitability, and legal project management (Part 1 of 4)
There was a time not very long ago when lawyers did not need to worry about the precise impact of discounting and realization on profits. Everyone knew that discounted rates and low realization were bad because they reduced the total revenue that partners divided up at the end of the year. But nobody got too excited about the details of exactly how bad, nor how to avoid problems. To maintain and increase income, they simply raised their rates.
Those were the days. But then in 2008 the economy declined and clients became more demanding. Associates and staff were laid off, partners felt squeezed, and law firms began to get more serious about protecting profitability.
For a quick overview of the basic concepts of law firm profitability, see an excellent series of blog posts, The Economics of Law and the Future of Legal Knowledge Management, by Toby Brown, the director of strategic pricing and analytics at Akin Gump. His five-part series explains the four key drivers of law firm profits: rates, realization, productivity, and leverage. The series we begin today will dig a little deeper into the basic math behind the first two – rates and realization – to reach some surprising conclusions about profitability, and then it will describe how legal project management can help.
We will start with a very simple story about how discounts and realization affect the finances of a teenage entrepreneur who decides to sell ice cream cones at the beach.
Assume that our enterprising high school student buys frozen ice cream cones for 60 cents apiece and sells them for a bargain rate of one dollar. His profit will obviously be 40 cents per cone or 40% of revenue. If he finds business is slow one afternoon and discounts the selling price by 10% he will sell the cones for 90 cents and cut profit to 30 cents.
But when he gets home and calculates the impact, he realizes that his 10% price cut has led to a 25% cut in the profits which are his sole source of income (10 cents divided by 40 cents). The problem is that the discount applies to the entire selling price, not just to the profit. He begins to think maybe discounting was not such a good idea.
Discounting is planned in advance. In the hard world of business, other things can happen that are not planned. Suppose our five-pound nine-inch 135-pound teenager walks up to the beach blanket of a six-foot-two college kid who weighs 220 pounds. The buyer says, “I would like one cone,” and starts searching his cargo shorts for cash. Our teenager hands over the cone while the customer continues to fumble for change. But after the customer takes his first bite, he says “Sorry, looks like I only have 90 cents. Guess you will have to take that.”
He doesn’t look sorry, but our teenaged mogul decides that discretion is the better part of valor. He would have trouble selling a cone that was partly eaten and it seems imprudent to argue with someone almost twice your size. So the teenager takes the 90 cents. This has the same impact as discounting by 10%, but it is a realization problem. The teenager intended to get a payment of one dollar but only realized 90% of it. The 90% realization rate reduced profit by 25%, just as a 10% discount did.
The key issue here is that anything that keeps you from getting your full, planned billing rate has a much larger impact on profit than you might think. And there are other challenges.
Suppose business gets slow, and our teenaged kingpin decides to run a sale. He goes out with a sign that says, “Everyday low prices – cones discounted from one dollar to 90 cents.” People quickly get used to the new price, and all of a sudden he is facing a permanent price reduction. Now if he has a realization rate of 90% of billed amounts after lowering his price, he is collecting 90% of 90 cents, or 81 cents. That cuts profits nearly in half, from the originally planned 40 cents to 21 cents per cone.
The moral of this part of the story is that a law firm partner cannot shrug off a loss of 10% of revenue as if it were only a loss of 10% to him. Partners derive 100% of their compensation from the end of year “profits,” and that pool is reduced by much more than the 10% given up.
Next week, the challenges facing our ice cream entrepreneur get worse.