August 30, 2007
What Every Lawyer (and law student) Should Know About the Economics of a Law Practice
Below is a great article on the basics of law firm economics. As the author points out, most lawyers-let alone law students-have no idea (or rudimentary at best) about the economics of law firms. Students and young associates may think that law firms are doing them a favor by offering them entry level positions at firm. However a better understanding of law firm economics may lead one to conclude that firms actually make money from associates-even entry level associates.
Whatever the case may be, it can't hurt to have a basic understanding of how law firms make money and more importantly, how they make money off associates.
What Every Lawyer Should Know About the Economics of a Law Practice
Melchior S. Morrione
Marketing the Law Firm Newsletter
Why do so many lawyers know so little about the economics of practicing their profession? Not surprisingly, it's because their law school education did not address any of the business aspects of practicing law. So most young lawyers join law firms with little understanding of how they operate and without a clue as to what it takes to make a law practice successful and profitable. Many lawyers, especially those who join large firms, manage never to master these concepts -- and, in many cases, work hard at avoiding them.
This abyss between law school education and professional practice is finally being acknowledged in academia. Harvard Law School has established a research center, under the direction of professor David Wilkins, to identify the broad issues that have transformed the legal industry. In addition to research projects, it has identified the need to make law school curricula more relevant to current issues in the profession. I would hope that this will include the basic economics of practice, how law firms operate, how services should be delivered and how to adapt to the changing needs of clients.
TRIAL BY FIRE
Those who choose to practice law as solo practitioners or in a small-firm environment learn the relevance of economics early in their careers. They learn quickly that while they may be very busy working on client matters at a point in time, once those matters are completed, they need to find new work. They soon come to realize that in order to maintain a steady stream of work, they will need to pursue new assignments and new clients while working on their current matters. They discover that keeping all the balls in the air is not easy. Then there are the costs: secretary, rent, supplies, insurance, office equipment, etc.
What's left is net profit -- their compensation. At some point, they come to appreciate that their compensation is limited by the number of hours they can bill and collect from clients. And if they can hire an associate, at an overall cost less than the value of the associate's time that can be billed to clients, the difference will increase net profit -- their compensation.
THE INSTITUTIONAL COCOON
Then there are those who join large firms. Their experience is completely different. There always seems to be an endless supply of work. Their main concern is to charge the number of billable hours expected of them.
Even after they become partners, most lawyers in large firms manage to evade involvement in the economics of the business. They do not really understand, nor do they want to. Some won't acknowledge they are in a business. Others feel that the business of law is not their problem but that of the managing partner. Rather than spend time trying to understand the financial statements they receive, they focus only on their draw and annual compensation. These partners are often annoyed, and sometimes personally affronted, by management requests for certain levels of billable hours, monthly billing, reductions in write-offs, speedier collections and better management of associate time.
The basic economic infrastructure of a law firm is no different from that of any other service business. There is revenue, expense, profit (partner compensation) and capital (the funds needed to run the business).
The revenue cycle is the key to profitability. Once upon a time, law firms billed their clients once a year, and the statements said simply "for services rendered" -- but that was eons ago.
It is vital to understand the role that timing plays in the revenue cycle. Although a simple concept, most lawyers fail to focus on the fact that they do not bring in a single dollar of revenue until they bill the client and collect the fee. Assuming that you are proactive and manage to bill all the time charged to clients on a monthly basis, consider that by the time the bill is presented to the client, at least 10 or 15 days will have elapsed into the next month. Even if the client pays the bill within 30 days of receiving it, a minimum of 45 days (and more like 60 days if you average in the month over which the costs were incurred) will have elapsed since the costs were incurred that produced this revenue. These costs, which include associate and staff salaries, overhead and office costs related to the work billed, have already been paid and therefore need to be funded for two months, until the revenue is received. And this is under the best of circumstances.
What if you don't bill all your time charges monthly or the client doesn't pay in 30 days? You will need to carry your unbilled inventory and receivables even longer. So how do you fund unbilled inventory and receivables? The answer is: with working capital.
Because costs are incurred before revenue is received, you need working capital to run the business. Working capital is that which should funds the difference in timing between the collection of revenue and the payment of costs and expenses to earn it. In a properly capitalized firm, the required working capital is funded from capital contributed by the partners. Bank borrowing should be used only to fund temporary or seasonal shortfalls in working capital and for the acquisition of long-term assets.
IMPROVE PRODUCTIVITY TO INCREASE PROFITS
Just as solo practitioners come to realize that once they have reached the limits of billing their own time their profit can be increased only by adding an associate whose time can be billed to clients, so, too, in a large firm, the effective use of associates is the key to increasing profits. Many partners are perplexed by the concept of being able to improve their own productivity and consequent profit contribution to the firm, by learning to use associates more effectively.
Most partners will concede, albeit grudgingly, that not all functions involved in solving client problems require the same level of knowledge and experience. Therefore, projects can be broken down into discrete functions, and assignments can be parceled out to associates according to their individual abilities and experience. Delegating work should mean that everyone gets a challenge, and by pushing the work down to the lowest-cost associate capable of handing it, costs are reduced, and better value is delivered to the client. In a service business, efficiency and profitability are maximized only when people are working at their highest ability levels. So even though a partner is capable of performing the work that can be done by an associate, it is a waste of partner talent to do so.
RELUCTANCE TO DELEGATE
Getting partners to delegate work to associates is difficult, at best. Many who have tried have been unsuccessful because they just dump the work on the associate, without properly planning, communicating and supervising the assignment.
I believe I've heard all the excuses for not delegating. Some of my favorites include:
* I barely have enough work to keep me busy.
* Clients want only me to work on their matters.
* I can do it faster.
* Explaining things to associates is a waste of my time and the client's money.
* Why bring associates to client meetings; they don't say anything anyway.
* Associates never get the job done right the first time and are always late.
* Only a few of our associates are any good, and they are never available when I want them.
Some managing partners suffer from the same mind-set. I have known managing partners who, when they sought to improve the firm's bottom line, just told their partners to bill five more hours per week. What they should have said was to bill five fewer hours per week and use that time to go out and get 20 hours of new work from existing and new clients that could be done by associates.
HOW LEVERAGE AFFECTS PROFITABILITY
The improvement in profitability that can be achieved through the effective use of associates is best demonstrated by an example. To simplify the analysis in our example, assume that for every dollar the firm collects from clients, 55 percent goes for expenses, and 45 percent is net profit to be shared by the partners. Assume, too, that the firm is large enough that adding one or two associates to the staff will not materially alter the 45 percent profit factor.
As shown in the accompanying chart, a partner billing 1,700 hours will generate revenue of $1,020,000 and profit of $459,000. If this partner's billable hours increase to 1,900, the revenue goes up to $1,140,000, and profit rises to $513,000. Not bad.
But suppose, instead of increasing billable hours, this partner's billable hours are reduced to 1,500, and the 200 hours is used to find new work, a good portion of which can be done by associates. If the partner can bill 1,600 hours of Associate 1's time, then, although the profit from the partner's hours is reduced to $405,000, the combined profit from the partner and Associate 1 is $621,000. Therefore, even at 1,500 billable hours, a partner leveraged with one associate billing only 1,600 hours is considerably more profitable than that partner billing 1,900 hours alone. And if the partner could bill 1,800 hours of an associate's time (Associate 2) the combined profit is increased to $648,000. Now if the partner could find enough work to keep both associates busy, the combined profit would be $864,000. And this, while billing 1,500 hours and spending 200 hours marketing and developing new work. This is how real money is made in a professional services business.
The numbers are compelling. But to achieve them requires that managing partners recognize the need for partners to devote time to marketing and provide the motivation and tools to help them learn how to develop effective delegation skills.
The key to successfully growing a law firm is to have all the lawyers in the firm performing at their highest-ability levels. And while partners often resist, bringing associates into the firm is a fundamental tenet of growing a healthy law firm. It is the way young lawyers learn how to serve clients, working on the job as part of a team solving client problems. And it is the only way to train and develop new partners.
Everyone benefits from leverage -- clients, associates, partners. Clients get better value because all team members working at their proper experience levels get the job done at lower billing rates. Associates learn how to deliver service under the guidance of an experienced partner. And partners are able to spend more time interacting with their clients and performing the functions only they can handle.
This is not rocket science. It is Economics 101 for a law firm. I will admit that learning to delegate effectively does not come easily. It requires the development of project management skills, which, once learned, will put the partner in the position of spending more time planning, supervising, and reviewing the work and less time doing it -- without compromising quality. But the bottom line is that everyone on the client team participates at their highest-ability level in delivering better value to the client and increased profitability to the firm. And isn't that the objective?
Posted by hafeezt at August 30, 2007 11:20 AM