Bar News - October 19, 2007
Law Practice Management: Getting Ready for Wild-Side Budgeting
“The times they are a changing,” especially for lawyers. Nowhere is this more obvious than in a law firm’s budgeting process.
Nowadays, a firm’s planning and budgeting processes must focus on improving distributable income via client-driven activities. Shifting control from the law firm to the client makes old budgeting approaches inappropriate and ineffective. For example:
- Future projections based on the past suppose that timekeeper hours and effective, collective rates will be maintained during the planning process.
- Zero-based budgeting presumes a future prediction.
- Cost-based accounting systems measure the total cost as a sum of individual cost centers and predicts total revenue based on the desired profit margin. Such systems do not promote critical evaluations of potential revenues or how a firm’s revenues and profits are being leaked through poor intake disciplines, inefficient management and lack of attention to the cost of carrying work-in-progress and accounts receivable.
New conditions make these approaches irrelevant. Increasing competition forces discounts on billing rates so firms can retain their share of business. Clients are demanding more efficiency, thereby forcing lawyers into non-billable project management activities and reduced billable hours. Firms need to assess changes in the markets in which their clients compete and how those changes affect the manner in which legal and related services are purchased.
“Client-driven” describes how firms must change their guild approach to producing legal services by creating new ways of measuring lawyer contributions. Law firms need to examine the entire process and cost of delivering legal services, including their cost for client fee negotiation and collection times and administrative overhead for $1,000 to sit in accounts receivable for 120+ days. Old approaches take firms deeper into the black hole of cost cutting and perhaps a more intensive push on old revenue components that won’t increase distributable income.
Making New Approaches Work
There are two steps that, if taken, will reinvent your process, foster innovative ideas and improve distributable income.
Step 1: Establish Context – before beginning an effective budgeting process, key players must establish a direction with precise statements, core values, a mission and strategies. Only then can the best options and investment choices be made. The firm must:
- Communicate: Discuss and reinforce the assumptions and how they support the firm’s agreed-upon strategies.
- Commit: Provide dedication and enthusiasm to ensure that leadership follows through with the decisions and actions to attain financial objectives.
- Obey the vision, values and mission guidelines.
Step 2: Activity Accounting – Establish different reference points using your potential revenue and distributable income. Unlike its predecessors, this approach focuses on an organization’s full potential. Activity accounting concentrates on increasing the size of the pie. According to the basic rule of budgeting, “When outflow exceeds inflow, the upshot is your downfall.”
Inflow includes billing rate (BR), using available billable hours, realization of benchmark rates (R) and the number (L). Reducing work-in-progress (WIP) and accounts receivable (A/R) provides inflow by purging cash from these two balance accounts. These purges are called “negative investments.” Reducing other assets or increasing liabilities (e.g. bank loans) serve as other funding sources.
Outflow consists of expenses, investment in work-in-progress or accounts receivable and increasing assets, such as equipment or decreasing liabilities.
The following will help [you] visualize activity accounting:
Four tanks of equal capacity are connected by pipes that flow from the “potential” tank one to tank two, then from tank two to tank three and so on. The leak in the examples represents a small sampling of what exists in law firms.
- Tank one (potential) starts out full and represents potential revenues from available billable hours from each time-keeper – times the benchmark billing rates – times the number of timekeepers. Realization on billing rates is 100 percent.
- A pipe from tank one to tank two (WIP), leaks from current agreements with clients to discount rates in return for volume, poor time recording and poor negotiations in the scope of work.
- While in the WIP tank, a leak develops as the time begins to age and the firm must use working capital to support this inventory and/or the work’s value becomes less evident to the client and must be put in writing.
- In the pipe connecting the WIP to take three (A/R), leaks evolve from poor project management, fogging time into files that don’ add value and lack communication with clients. Time and/or rates must be written down.
- While in A/R (tank three), dollars leak out of the bottom or evaporate as the receivables age. Regardless of whether a firm received 100 percent of the amount billed after resting for six months in accounts receivable, the cost of the money alone would have decreased the receivables’ presented with the final fees.
- The remaining revenue is only a fraction of what was originally in tank one. The actual distribution is produced by draining off the expenses.
Budgets should begin with potential inflows and minimal outflows. Expenses play a small role in the loss of distributable income. The entire legal services delivery process must be examined. For every dollar that is leaked out of the process, another dollar cannot be distributed to the firm’s owners.
This new process can be incorporated into your firm in three steps.
Step 1: Set up the budgeting process to capture lost revenues.
Step 2: Set up the assumptions of inflow and outflow.
Sample Inflow Questions
- What should the potential or benchmark rate be for the firm’s timekeepers, despite discounts given for particular types of work?
- What is the best combination of experience and billing rates for each service rendered?
- What return should each practice area produce?
- What are the clients’ realization rates and matters that make up 80 percent of the firm’s revenues? How can that be improved?
Sample Outflow Questions
- How much age is the firm willing to target on work-in-progress? Accounts receivable?
- How much is the firm willing to borrow to provide the necessary funds for each month of the fiscal year?
- What are the missions of each administrative support member? The mission should identify the core members; clients’ service locations; services critical to those clients; and available options to abandon services, such as directly delegating to staff who support the timekeepers or outsourcing that support.
- What should be the unique mix of administrative personnel supporting those groups?
- What is the appropriate mix of support personnel not specifically assigned to timekeepers?
Once benchmarks are set, specific action plans that can move a firm’s current levels toward and above those benchmarks must be identified. Owners need to develop a statement on how to add value by identifying more realistic targets for improvement in each assumption and resulting line item.
Step 3: Measure realization on benchmark rates and establish reporting against the budget for the current period and year-to-date (in graph form). Graphs can illustrate creation and balances. Bar charts can depict the current month and year-to-date activities and the value of hours worked, billed and collected versus estimates. Another set of graphs can mark the tanks at the expected, actual levels and the volume of the leaks.
When implementing the activity accounting approach to budgeting, the cost of the entire process of delivering legal services must be examined. Look at the cost of inactivity and understand that lost revenues are costs and investments. Activity-based budgeting motivates lawyers to focus on the area that can become their biggest contribution – increasing the size of the revenue pie.
A key to the budgeting process is using your business plan to improve distributable income by enhancing the return on the firms find better ways to increase their return on time, talent, accumulated knowledge, investments in training and technology and other resources.
The reward? Firms generating $30 million in cash revenues, a 10 percent increase in realization on benchmark rates, will create more than $3 million in unencumbered, distributable income before taxes. The firm, however, must work backward from the client to eliminate leaks. Additionally, firms need to find ways to use alternative billing to provide predictability for their clients and give themselves a chance to increase their realization rates to 100 percent.
Editor’s Note: This article was reprinted with permission by Brayman, Houle, Keating & Albright, PLLC. It first appeared in the Summer 2007 issue of the Profit Counselor.