Basics Revisited: Evaluating The Profitability Of New Work

Your 50-attorney firm has been operating slightly under capacity; there is not enough work to keep all attorneys billing their standard hours. A prospect would like to engage the firm to handle all its litigation, which would mean a substantial number of guaranteed billable hours. Good news, right? This company, however, wants to negotiate a discounted rate and also wants specific partners to handle the work. Your initial instinct tells you to take on the work to keep the firm at maximum capacity. But will it be profitable in the long run? Should you take on the work? How can you decide?

The way a law firm makes decisions about taking on new revenue starts with an understanding of profitability ' and the underlying factors that affect profitability. Before accepting any new work, any firm should consider five key factors: production, utilization, realization, leverage, and speed. The first four elements are crucial any time a firm considers new revenue.

Production

In this context, production is an attorney's standard rate multiplied by the number of hours that attorney is expected to work. The key for new work is in the volume. Estimate the number of hours you expect it will take to complete the work. (American Bar Association task codes can be a useful shortcut.) Then, consider the capacity of the practice group or office that would be handling the majority of the work. How much staff time will the matter require? Will the matter require late hours and weekends? If so, would the workload be short-term or extend for longer? Is the billable rate premium or discounted?

Consider this: If it's short-term work, then you can be somewhat flexible given that the surge in work is temporary. Depending on your firm's capacity, however, larger scope or longer-term projects may actually work against the business. Why? Because a bigger or longer project can have repercussions. If the firm's partners are all tied up in working, they are not as available to bring in new business or to mentor associates. Ultimately, the firm may sacrifice work that is better-priced, has more cross-selling potential, or provides higher visibility.

In addition, if your firm's total capacity is 20,000 hours, the current billing is 18,000 hours, and you're bidding for work that would take 4,000 hours, then you've got more decisions. While premium-priced work may be worth it, the added load could also put a strain on your resources. Plan for how you'll handle the work before you decide to take it on. For example, if you're working above capacity and a $50,000 case comes in ' yet you have to hire a new attorney at $150,000 to support the additional load ' then you're actually reducing profits. Instead of hiring additional permanent staff, you may want to consider hiring contract attorneys or shedding lower-priced business in order to free up existing staff.

Utilization

Utilization is the actual number of hours an attorney works divided by standard hours (the number of hours the attorney is expected to work). Think about it as a percentage. For example, the average associate is expected to work roughly 1,900 hours a year (according to Redwood Analytics' 2003 benchmarking study), so if all 1,900 hours are worked, utilization is 100%. If 950 hours are worked, then utilization is 50%.

In other words, this associate has a lot of free time on his or her hands.

Utilization and pricing go hand in hand. If your firm doesn't use its associates fully, then it won't be a problem to bring in new revenue. Therefore, the firm should consider being more aggressive in bidding for more projects. With excess capacity, you would not be sacrificing “better” work. However, be careful about discounting to gain more business ' the immediate gain of increased volume could easily be offset by the longer-term hit to your image in the market. Instead of accepting discounted work, you may want to consider letting staff turnover increase the firm's utilization rate and decrease costs.

Realization

Realization is the cash collected for work that you perform. It's almost always smart to accept premium-priced work that will be easy to collect. However, discounts are another story. They can be a major hit to realization: as discounts increase, realization tends to drop. Not only are they harder to collect, but discounts are hard to shed without alienating clients. In other words, once you're viewed as lower-priced, it may be impossible to raise rates when utilization is high.

Consider this: If you take work today at a discounted price, it assumes that you can't get other work tomorrow at a better price. For an in-demand partner with specialized expertise, this is almost certainly false. Partners should be wary of accepting cut-rate work, especially for their own time.

Leverage

Leverage is all about allocating work to the “right” mix of attorneys for optimal profitability. Instead of staffing according to availability or colleague familiarity, the firm should shift work down from the senior partners whenever possible. Leveraging frees up the capacity of those senior partners, enabling them to work on business development or handle more complex and higher-paying matters. For example, in any given firm, some work is considered premium (such as international trade) and other work is considered commodity (real estate leases). Specialized and highly valued attorneys should spend their time on premium work. Further, premium attorneys aren't born, they're made. A major benefit of leverage is to groom young attorneys, which creates a profitable long-term scenario in which the young attorneys' rates increase faster than their salaries.

Profitability isn't about having the most revenue, but about having the most profit for any work. Consider a matter requiring 100 hours and no leverage. The firm might have $50,000 of revenue but just break even. With leverage, the profit could increase to $15,000, even while revenue drops to $35,000. This is because junior attorneys cost less than their billable rate, while senior partners rarely (if ever) do.

Speed

Speed is the gap between finishing the work and getting paid. The most meaningful thing here is the probability of collection. For the average firm, if a receivable ages three months, the firm will collect 10 to 20% less on such invoices. If it ages six months, the losses jump to 40%.

Conclusion: Deciding on New Work

Should you accept new work?

To determine that, focus on each of these issues. At the very least, have your firm's finance department track and report data relative to each profitability factor. This information should be readily available to support efficient and prudent decision-making. Incorporate this information as part of your RFP process, intake process, pricing, and hiring decisions.

This information, obviously, ought to supplement whatever you already know about your business. You want to shift the emphasis from what has happened to what will or may happen. In order to do so, look at the relationships among the different factors. Create an automated financial forecast that's integrated with your firm's billing and collections system so that you can draw inferences from your history and look to the future. While some firms have mastered their historical data, only a few have started using the information to project financial results and forecast future performance.

For most of your attorneys, the profitability factors discussed in this article will become more meaningful if you put a dollar value on them. For example, suppose your firm has a 20% profit margin on work billed at $500 per hour. A 10% discount on that work would reduce revenue by “only” $50 per hour, but that $50 comes straight out of what would have been $100 per hour profit: a 50% cut.

Similarly, if utilization last year was 95% and this year it's only 90%, that slip of “only” 5% would represent a $1 million difference to a firm with $20 million of total compensation.

So when it comes to profitability, not all revenue is not necessarily good revenue. Harnessing the relationships among the key profitability factors will help you identify profitable revenue and cultivate the best opportunities for making money.

Your 50-attorney firm has been operating slightly under capacity; there is not enough work to keep all attorneys billing their standard hours. A prospect would like to engage the firm to handle all its litigation, which would mean a substantial number of guaranteed billable hours. Good news, right? This company, however, wants to negotiate a discounted rate and also wants specific partners to handle the work. Your initial instinct tells you to take on the work to keep the firm at maximum capacity. But will it be profitable in the long run? Should you take on the work? How can you decide?

The way a law firm makes decisions about taking on new revenue starts with an understanding of profitability ' and the underlying factors that affect profitability. Before accepting any new work, any firm should consider five key factors: production, utilization, realization, leverage, and speed. The first four elements are crucial any time a firm considers new revenue.

Production

In this context, production is an attorney's standard rate multiplied by the number of hours that attorney is expected to work. The key for new work is in the volume. Estimate the number of hours you expect it will take to complete the work. (American Bar Association task codes can be a useful shortcut.) Then, consider the capacity of the practice group or office that would be handling the majority of the work. How much staff time will the matter require? Will the matter require late hours and weekends? If so, would the workload be short-term or extend for longer? Is the billable rate premium or discounted?

Consider this: If it's short-term work, then you can be somewhat flexible given that the surge in work is temporary. Depending on your firm's capacity, however, larger scope or longer-term projects may actually work against the business. Why? Because a bigger or longer project can have repercussions. If the firm's partners are all tied up in working, they are not as available to bring in new business or to mentor associates. Ultimately, the firm may sacrifice work that is better-priced, has more cross-selling potential, or provides higher visibility.

In addition, if your firm's total capacity is 20,000 hours, the current billing is 18,000 hours, and you're bidding for work that would take 4,000 hours, then you've got more decisions. While premium-priced work may be worth it, the added load could also put a strain on your resources. Plan for how you'll handle the work before you decide to take it on. For example, if you're working above capacity and a $50,000 case comes in ' yet you have to hire a new attorney at $150,000 to support the additional load ' then you're actually reducing profits. Instead of hiring additional permanent staff, you may want to consider hiring contract attorneys or shedding lower-priced business in order to free up existing staff.

Utilization

Utilization is the actual number of hours an attorney works divided by standard hours (the number of hours the attorney is expected to work). Think about it as a percentage. For example, the average associate is expected to work roughly 1,900 hours a year (according to Redwood Analytics' 2003 benchmarking study), so if all 1,900 hours are worked, utilization is 100%. If 950 hours are worked, then utilization is 50%.

In other words, this associate has a lot of free time on his or her hands.

Utilization and pricing go hand in hand. If your firm doesn't use its associates fully, then it won't be a problem to bring in new revenue. Therefore, the firm should consider being more aggressive in bidding for more projects. With excess capacity, you would not be sacrificing “better” work. However, be careful about discounting to gain more business ' the immediate gain of increased volume could easily be offset by the longer-term hit to your image in the market. Instead of accepting discounted work, you may want to consider letting staff turnover increase the firm's utilization rate and decrease costs.

Realization

Realization is the cash collected for work that you perform. It's almost always smart to accept premium-priced work that will be easy to collect. However, discounts are another story. They can be a major hit to realization: as discounts increase, realization tends to drop. Not only are they harder to collect, but discounts are hard to shed without alienating clients. In other words, once you're viewed as lower-priced, it may be impossible to raise rates when utilization is high.

Consider this: If you take work today at a discounted price, it assumes that you can't get other work tomorrow at a better price. For an in-demand partner with specialized expertise, this is almost certainly false. Partners should be wary of accepting cut-rate work, especially for their own time.

Leverage

Leverage is all about allocating work to the “right” mix of attorneys for optimal profitability. Instead of staffing according to availability or colleague familiarity, the firm should shift work down from the senior partners whenever possible. Leveraging frees up the capacity of those senior partners, enabling them to work on business development or handle more complex and higher-paying matters. For example, in any given firm, some work is considered premium (such as international trade) and other work is considered commodity (real estate leases). Specialized and highly valued attorneys should spend their time on premium work. Further, premium attorneys aren't born, they're made. A major benefit of leverage is to groom young attorneys, which creates a profitable long-term scenario in which the young attorneys' rates increase faster than their salaries.

Profitability isn't about having the most revenue, but about having the most profit for any work. Consider a matter requiring 100 hours and no leverage. The firm might have $50,000 of revenue but just break even. With leverage, the profit could increase to $15,000, even while revenue drops to $35,000. This is because junior attorneys cost less than their billable rate, while senior partners rarely (if ever) do.

Speed

Speed is the gap between finishing the work and getting paid. The most meaningful thing here is the probability of collection. For the average firm, if a receivable ages three months, the firm will collect 10 to 20% less on such invoices. If it ages six months, the losses jump to 40%.

Conclusion: Deciding on New Work

Should you accept new work?

To determine that, focus on each of these issues. At the very least, have your firm's finance department track and report data relative to each profitability factor. This information should be readily available to support efficient and prudent decision-making. Incorporate this information as part of your RFP process, intake process, pricing, and hiring decisions.

This information, obviously, ought to supplement whatever you already know about your business. You want to shift the emphasis from what has happened to what will or may happen. In order to do so, look at the relationships among the different factors. Create an automated financial forecast that's integrated with your firm's billing and collections system so that you can draw inferences from your history and look to the future. While some firms have mastered their historical data, only a few have started using the information to project financial results and forecast future performance.

For most of your attorneys, the profitability factors discussed in this article will become more meaningful if you put a dollar value on them. For example, suppose your firm has a 20% profit margin on work billed at $500 per hour. A 10% discount on that work would reduce revenue by “only” $50 per hour, but that $50 comes straight out of what would have been $100 per hour profit: a 50% cut.

Similarly, if utilization last year was 95% and this year it's only 90%, that slip of “only” 5% would represent a $1 million difference to a firm with $20 million of total compensation.

So when it comes to profitability, not all revenue is not necessarily good revenue. Harnessing the relationships among the key profitability factors will help you identify profitable revenue and cultivate the best opportunities for making money.