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4 posts from December 2012

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.

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.  

December 12, 2012

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.

 

This post was written by Matt Hassett and Jim Hassett

December 05, 2012

Business development tip of the month: Don’t argue

An argumentative personality can be an extremely valuable  asset in many legal situations, but when it comes to developing relationships and new business, arguing is a very bad idea.  As Ben Franklin once said: “If you argue and rankle and contradict, you will achieve a victory sometimes, but it will be an empty victory because you will never get your opponent’s good will.”

 

The first Wednesday of every month is devoted to a very short and simple tip like this to help lawyers increase efficiency, provide greater value to their clients and/or develop new business. This month’s tip was adapted from my book the Legal Business Development Quick Reference Guide