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December 26, 2012

Discounting, realization, profitability, and legal project management (Part 3 of 4)

In the first two parts of this series, we provided several examples of the way that discounting and problems in realization can have a surprisingly high impact on partner profits and compensation.

As times have gotten tougher in the last few years, the first step most firms took was to lower their costs by reducing salary and overhead expenses.  This helps, but not as much as reduced discounting or increased realization would.

For simplicity, consider the effects of a 10% cost reduction on the $30,000 matter we introduced in Part 2. Here was the original plan: 

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

Now suppose we kept revenue the same, but cut both salary and overhead by 10%.  The result looks like this:

Total revenue $30,000
Salary $ 9,000
Overhead $ 9,000
Partner Profit $12,000

Saving 10% in cost saves $2,000 and thus can add 20% to partner profit. However, as we saw in Part 2, losing 10% of income to discounting or realization loses $3,000 and takes 30% out of partner profit:

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

Thus a 10% reduction in cost has less effect than a 10% loss in revenue. The reason is simple enough: a 10% loss in revenue is applied to all of revenue, but the 10% reduction in cost acts only on the two-thirds of revenue that is applied to costs.

In the first two parts of this series, we also mentioned a related problem that can have an important impact on law firm finances: receivables. That topic is beyond the scope of this post, but there are many excellent sources on billings, collections and receivables, including Arthur Greene’s article, “The new normal: Restoring profitability,” in the July issue of ABA’s Law Practice magazine, and a number of related articles in the October 2012 issue of Law Practice Today.

Realization, on the other hand, is very closely related to our interest in legal project management, so we will go into that in some detail.

Anyone who has been involved with law firm finances knows that the realization rate is critical to every firm’s success.  What they may not understand is that different firms use different formulas to calculate their realization rates, and there is sometimes confusion about what kind of realization people are talking about.

In general, there are three main types: billing realization, collections realization, and total realization.

Billing realization compares what is actually billed to a client to what could have been billed.  More formally, billing realization is equal to the amount billed to the client divided by the value of the time recorded on the matter. There are two main ways to calculate the value of the time, one based on the actual rates negotiated with a particular client (and affected only by write-offs or premiums), the other based on standard hourly rates (and affected by write-offs, premiums and discounts). 

For example, consider a small matter that required 10 hours of partner time at $400 ($4,000) and 40 hours of associate time at $200 ($8,000) for a total of $12,000.  But the relationship partner feels that the associate could have been much more efficient, and decides to bill only 20 of the 40 associate hours and write off the rest.  He sends out a bill for $8,000 ($4,000 for 10 partner hours at $400 plus another $4,000 for 20 associate hours at $200).  When billing realization is calculated based on the actual rates charged to this client, the rate is 66.7% (the $8,000 actually billed divided by the $12,000 value of the time cost at discounted rates).

However, some firms calculate billing realization based not on actual hourly rates for a particular client, but rather on the standard rates for each lawyer before discounts.  Assume that this particular client had negotiated a 20% discount, and that the partner’s standard rate is $500 and the associate’s standard rate is $250.  In that case, the value of the original time is $15,000 ($5,000 for 10 partner hours at $500 plus $10,000 for 40 associate hours at $250), and the billing realization rate is just 53.3% (the $8,000 actually billed divided by the $15,000 value of the time at standard rates).  This rate reflects both the discount and the write-off.

Collections realization is more straightforward and compares what clients were billed to what they actually paid, and it reflects the percent of billed time that is actually paid.  Unpaid bills may be classified as post-facto discounts, write-offs, or bad debts. But whatever you call them, they reflect lost income, which could have gone directly to the bottom line.

In this case, suppose the client feels that the $8,000 bill was too high, argues his case, and ends up paying only $7,000.  This yields a collection realization rate of 87.5% (the $7,000 paid divided by the $8,000 billed).

Total realization combines the effects of billing and collections realization in a single figure.  In this example, if it were based on actual discounted rates, total realization would be 58.3% ($7,000 paid divided by the $12,000 value of the time at discounted rates.)  If it were based on standard rates, it would go down to 46.7% ($7,000 paid divided by the $15,000 value of the time at standard rates).

This series will conclude on January 9 with a discussion of what is happening to law firm  realization rates in the current marketplace, and how legal project management can help.

This post was written by Jim Hassett and  Matt Hassett.

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