Discounting, realization, profitability, and legal project management (Part 4 of 4)
However they are calculated, realization rates have a significant impact on a firm’s bottom line, and in many firms an individual lawyer’s realization rate will also affect her compensation.
The way this key rate is calculated varies from firm to firm. According to a survey from several years ago by Lexis Nexis, “Billing realization has a relationship to increased partner income while collection realization doesn't.” In other words, lawyers are paid for billing more hours, whether clients pay for them or not.
From a straight business point of view, this is a bad idea. You get what you pay for. So when firms pay lawyers for billing more hours, whether clients actually pay those bills or not, they create a culture that values billing more than getting paid. The results of this can be seen in the data on realization rates at large firms, which are not pretty.
The best available public data on realization is published by Thomson Reuters. Its Peer Monitor Index is based on reported results from 116 large law firms including 45 from the AmLaw 100, 41 from the AmLaw second hundred, and 30 others. Their key measure is called “collected realization rate against standard” and refers to the “percentage of work performed at a firm’s standard rates that is actually billed to and collected from clients.” According to a recent Hildebrandt report, “Realization has now been falling fairly steadily for more than three years… Realization reached another new all-time low, with net collected realizations falling just below 84%.”
This figure represents a serious financial issue and a danger sign. Legal project management (LPM) can help solve this problem.
Many lawyers think of LPM as a way to improve performance on fixed price matters, and it is. But the vast majority of legal work is performed on an hourly basis, so at the end of the day its impact on improved hourly realization may be more significant.
Consider, for example, this common scenario: A client asks her lawyer how much it will cost to handle a particular matter. The lawyer replies that she really can’t say because so many different variables are involved. The client says, “Yeah, yeah, I know. But my board keeps asking me for the number. What should I tell them?” After additional hemming and hawing, the lawyer finally says, “Well, in the past, for situations like this we’ve seen costs ranging from $80K to $110K.”
The client hears, “I will do this work for $80K,” and passes that number along to the board.
The lawyer begins the work, and for the next few months everything seems fine. Until the matter ends, and the client receives a bill for $135K. “I can’t pay this bill,” she says. “You told me it would cost $80K, and that’s what I told my board. If it was going to cost more, why didn’t you say something sooner?”
An awkward negotiation drags on for months, and the client ultimately pays $90K. The firm has to write off the other $45K. The billing realization rate on this matter is 66.7% ($90,000 divided by $135,000). No one is particularly happy with the result, and the relationship and the chances of future business have been damaged.
This situation might have been avoided by applying LPM. Our approach is based on eight key issues we first published at AmericanLawyer.com several years ago, which have since become widely accepted:
- Set objectives and define scope
- Identify and schedule activities
- Assign tasks and manage the team
- Plan and manage the budget
- Assess risks
- Manage quality
- Manage client communication and expectations
- Negotiate changes of scope
If the relationship partner had taken some time at the start to clearly define scope, both the client and the law firm would have had a better idea of what was and was not included in the cost estimate. If she had planned the budget and managed it closely as things went along, at the very least she and the client would have had some warning about the rising cost. If there was room to negotiate changes in scope, perhaps the client would have paid more. If there was a hard cap, perhaps there would have been a chance to limit the work to stay closer to budget.
Constant management of client communication and expectations would have been a big help, not just for the realization rate, but also to maintain the relationship. If the lawyer in this scenario had discussed the issues with the client early in the process, she might have gotten a larger payment, or perhaps she could have satisfied the client’s true needs with fewer billable hours.
No one would argue that LPM will end all disputes over legal costs. But it has already started to end some of them.
To summarize, it is vitally important that part of your effort be devoted to assuring that you will be paid. There is a great deal of talk about how to set prices, but your price is not your price until it is paid.
This post was written by Jim Hassett and Matt Hassett.