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December 19, 2012

Discounting, realization, profitability, and legal project management (Part 2 of 4)

Last week we began the tale of a teenaged entrepreneur who wanted to build an ice cream cone empire at the beach.  He started with a $60 investment from his father, and a plan to buy 100 cones at 60 cents apiece, sell them all on the first day, and head home with $100.  Sixty dollars of that would be used to buy another 100 cones the next day, and he would have $40 of “profit” to pay for his time.

Suppose, however, that our budding tycoon is a trusting soul who is selling at a neighborhood beach where he knows many of the buyers. Some of them walk to the beach from their cottages and don’t bring any cash.  On the first day, he gets cash from 50 people, but ends up selling another 50 cones to neighbors on credit, telling them, “You can pay me back the next time I see you.”  At the end of the day he has created a receivable of $50, and he only has $50 in cash. This is not enough to buy 100 cones the next day, so he has to borrow $10 from his father or cut back on his business. This is a receivables problem. Although everything seems fine in theory, when people owe you money things don’t always work out the way you planned.

The theoretical problem becomes real when it rains for a few days, he does not see his creditors right away, and some of them leave the area on Saturday when their one week rental is up.  If 10 people fail to pay him, this reduces the original day’s income by 10% and profits by 25% (from $40 to $30).    

For a teenager selling ice cream the hard facts become apparent immediately and it is easy to borrow $10 from his father to buy more cones and put his financial house in order.

In a large law firm with millions of dollars moving through five or ten or twenty offices every week, managing receivables is complex and problems can easily sneak up on you. Even if you are eventually paid what you are owed, you may still have erosion of profit due to the interest rate cost of borrowing money when needed. A bigger risk is that some clients with payments due may run into trouble themselves and not be able to pay, leading to another realization problem.

The moral of this part of the story is that your price is not your price until it is paid. 

Profit and loss are simple things. The complexity of multiple matters in a large law firm masks this simplicity, but the same basic principles apply.

To illustrate this, consider the example of a matter which is supposed to bring in $30,000 in billable hour revenue. Here is a simple profit plan that allocates one-third of revenue to salary, one-third to overhead and one-third to partner profit/compensation:

Total revenue $30,000
Salary $10,000
Overhead $10,000
Partner Profit $10,000

Suppose that the client demands a 10% discount and gets it. Then $3,000 of total revenue is lost. Since salary and overhead must be paid, the $3,000 loss must come out of partner profit/compensation. The result looks like this:

Total revenue $27,000
Salary $10,000
Overhead $10,000
Partner Profit $  7,000

In this example, the drop in partner profit is 30%, not 10%. There is a multiplier effect in which the 10% loss in revenue is multiplied by three.

This multiplier effect will occur with any 10% loss in revenue, whatever the source. If it is due to a refusal to pay the full bill or a write-off, the effect is the same: Planned partner profits drop by $3,000 or 30%. As in the ice cream example, 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.  Because you are tempted to say, “It is only a 10% reduction,” the full impact of the loss on profits may be hidden.

The multiplier will vary depending on the financial specifics of each case: it could easily be higher or lower than three. But whatever the financial structure of the firm, there is a material multiplier affecting profits, and it is hidden from those who do not get the math.

Next week, we will provide more details about how this affects law firms, and what you can do about it.

 

This post was written by Matt Hassett and Jim Hassett.  

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