Budget Monitoring

Firms today know the importance of budgeting. Preparing an annual budget requires a firm to focus on what services it expects to perform over the next year and the costs of doing so. It also allows the firm to make key investment decisions with respect to its priorities and provides partners with the information they need to make personal financial decisions in the upcoming year.

But preparing the budget is only one half of the exercise. For the budget to be a valuable financial planning tool, a firm must keep a close eye on its ongoing performance to budget throughout the year. Several measuring tools can help a firm do that. Here is a closer look at a few of them.

Utilization Rate

Law firm revenues each year are generated principally through the performance of services by its timekeepers, i.e., billable hours. By budgeting billable hours on a monthly basis over the year, a firm can compare actual hours billed during the month with budgeted hours for the month. The result is called the “utilization rate.”

Assume, for example, that a practice group budgeted 600 billable hours for each month, but recorded only 530 billable hours. The group's utilization rate for that one month would be 83.3%. Also important to consider, however, is the group's utilization rate year-to-date. Perhaps the month before the group similarly budgeted 600 billable hours, but due to a large client matter recorded 650 hours. For the two months, the group therefore has a utilization rate of 98.3%. This tells the firm that the group is performing close to budget for the year, so no significant changes need to be made in staffing, workloads, etc.

Firms must be careful, however, because not all billable hours are equal. Like many firms, your firm may allow associates to report pro bono hours as billable hours that count toward the associate's expected hours target for the year. In these cases, it is important to know exactly how many of the associate's recorded billable hours will result in revenue for the firm. To use the foregoing example, what if 150 of the 1,180 total billable hours reported by the group for the two months were pro bono hours? What at a glance may appear to be a 98.3% utilization rate in fact will be just 85.8% utilization (1,030 total billable hours divided by 1,200 budgeted hours).

A similar analysis should be done for any other hours that lawyers report as billable hours, but that do not eventually result in revenue. These may include hours for a special firm project, or perhaps collection litigation handled by firm lawyers with respect to the firm's own accounts receivable. In these cases, principles of fairness may dictate that a lawyer be awarded billable hours' credit for the work, but that does not mean the hours can be treated as revenue-producing hours for budget purposes, and hence must be backed out when calculating utilization rate.

Realization Rate

Close monitoring of a firm's realization rate throughout the year is also a key to understanding how the firm is performing to budget. The amount a firm actually collects for each hour of services its lawyers perform is rarely 100%. There can be “slippage” at two stages in particular. First, when the firm or the lawyer in charge of a matter bills time, there may be a reason to discount the amount charged, such as duplication of effort for which the firm feels it would be unfair to charge the client. Let's say that a practice group in the firm performed 100 hours on behalf of a client during November 2010 at a single billing rate of $250 per hour. The value of the billable hours initially is $25,000 (100 hours times $250 per hour), but if the firm for whatever reason decides to reduce the bill and only charge for 90 of those hours, the realization rate will automatically fall to 90%.

The second point at which “slippage” can occur is when the client receives the bill. The client may raise a valid objection to some aspect of the hours billed that causes the firm to eventually accept $21,000 as full payment for the services. This means that the realization rate on the account receivable drops to 93.3%. The overall realization rate on the 100 hours drops to 84%.

By monitoring these kinds of discounts on an ongoing basis, a firm can develop a reliable feel for roughly where its overall realization rate stands over one or a number of years. With that as a benchmark, it can measure current performance against that longer-term standard. If the firm's realization rate is declining during the year, a budget that was based upon historic realization rates may be in jeopardy.

Accrued Revenue

Lawyers tend to think in terms of billable hours, but law firm financial officers think in terms of revenue. Accordingly, as billable hours are reported and analyzed each month, the firm should “translate” those hours into accrued revenue (i.e., the revenue those hours represent at current billing rates), even though the hours have not yet been billed or collected. Lower than budgeted accrued revenue today means lower actual revenues tomorrow.

Billing and Collections Cycle

Still another tool to help monitor budget performance is the firm's billing and collections cycle. A firm's budget for the year will normally be based in part on how long it takes the firm to collect revenue with respect to each hour that is recorded. Most firms bill (or should bill) monthly, so there is already a 30- to 40-day delay in receiving the revenue associated with an hour billed on the first day of the month. The bill then has to be prepared and sent to the client, and the client has to pay it. Even the best paying clients will normally take 15 to 30 days to pay, which together adds at least another 30 days.

If a firm historically has a billing and collections cycle of, let us say, 2.8 months, knowing how the firm is performing to that standard in the current year will give some idea of when it can expect its accrued revenue to be realized as cash receipts. If the cycle has suddenly increased to 3.5 months from 2.8 months, revenues anticipated to be received over the coming months will be “bumped back” by as much as 1.3 months, absent corrective action. That could mean a full month's less revenue for the year. You can imagine what this does to the annual budget.

Billings

Including total billings for the month and year-to-date in the monthly financial statements is still another way a firm can monitor how it is progressing toward its full budget goal for the year. Are billings ahead or behind the billings projected in the budget through the relevant date? If they are behind, why are they behind? Are partners sitting on accrued time and failing to bill, or are the lower billings a result of lower billable hours and utilization rate for the lawyers? Although billings from month to month can vary for a number of reasons, knowing why they are below budget for a particular month or several months is the first step in helping the firm make decisions on how best to get back on target.

Expenses

Let's not forget an obvious item, which is monitoring expenses relative to budget. While most expenses over the entire year will not play out precisely as projected, it is important to understand whether an uptick in expense in a particular category is attributable to special circumstances, a consistent trend, or just a timing difference. The former two may require action, while the latter indicates that the category eventually will come back in line with projections. A good example of an item that could get out of hand absent careful monitoring is staff overtime. The added expense may be well worthwhile if it will result directly in an increase in revenues, but action may be called for if no benefit can be identified from the added expense.

Conclusion

At the start of a new budget year, and monthly throughout the year, firms should use all of these financial tools available to identify early signs that performance for the year is not where the partners had anticipated. Firms can do this only if they use the proper tools to understand what the monthly financial statements are saying in the context of the full year's budget. Armed with this timely information, the firm then can consider what actions, if any, may be required to correct any problems and get back on its budget track before the end of the year. Early intervention is key to hitting budget goals.

Michael E. Mooney, a member of this newsletter's Board of Editors, is the managing partner of Nutter McClennen & Fish, LLP, in Boston. His firm maintains an active tax and business practice, representing and advising domestic and international corporations in a broad range of tax issues, reorganizations, business combinations, and divestitures. He can be reached at [email protected].

Firms today know the importance of budgeting. Preparing an annual budget requires a firm to focus on what services it expects to perform over the next year and the costs of doing so. It also allows the firm to make key investment decisions with respect to its priorities and provides partners with the information they need to make personal financial decisions in the upcoming year.

But preparing the budget is only one half of the exercise. For the budget to be a valuable financial planning tool, a firm must keep a close eye on its ongoing performance to budget throughout the year. Several measuring tools can help a firm do that. Here is a closer look at a few of them.

Utilization Rate

Law firm revenues each year are generated principally through the performance of services by its timekeepers, i.e., billable hours. By budgeting billable hours on a monthly basis over the year, a firm can compare actual hours billed during the month with budgeted hours for the month. The result is called the “utilization rate.”

Assume, for example, that a practice group budgeted 600 billable hours for each month, but recorded only 530 billable hours. The group's utilization rate for that one month would be 83.3%. Also important to consider, however, is the group's utilization rate year-to-date. Perhaps the month before the group similarly budgeted 600 billable hours, but due to a large client matter recorded 650 hours. For the two months, the group therefore has a utilization rate of 98.3%. This tells the firm that the group is performing close to budget for the year, so no significant changes need to be made in staffing, workloads, etc.

Firms must be careful, however, because not all billable hours are equal. Like many firms, your firm may allow associates to report pro bono hours as billable hours that count toward the associate's expected hours target for the year. In these cases, it is important to know exactly how many of the associate's recorded billable hours will result in revenue for the firm. To use the foregoing example, what if 150 of the 1,180 total billable hours reported by the group for the two months were pro bono hours? What at a glance may appear to be a 98.3% utilization rate in fact will be just 85.8% utilization (1,030 total billable hours divided by 1,200 budgeted hours).

A similar analysis should be done for any other hours that lawyers report as billable hours, but that do not eventually result in revenue. These may include hours for a special firm project, or perhaps collection litigation handled by firm lawyers with respect to the firm's own accounts receivable. In these cases, principles of fairness may dictate that a lawyer be awarded billable hours' credit for the work, but that does not mean the hours can be treated as revenue-producing hours for budget purposes, and hence must be backed out when calculating utilization rate.

Realization Rate

Close monitoring of a firm's realization rate throughout the year is also a key to understanding how the firm is performing to budget. The amount a firm actually collects for each hour of services its lawyers perform is rarely 100%. There can be “slippage” at two stages in particular. First, when the firm or the lawyer in charge of a matter bills time, there may be a reason to discount the amount charged, such as duplication of effort for which the firm feels it would be unfair to charge the client. Let's say that a practice group in the firm performed 100 hours on behalf of a client during November 2010 at a single billing rate of $250 per hour. The value of the billable hours initially is $25,000 (100 hours times $250 per hour), but if the firm for whatever reason decides to reduce the bill and only charge for 90 of those hours, the realization rate will automatically fall to 90%.

The second point at which “slippage” can occur is when the client receives the bill. The client may raise a valid objection to some aspect of the hours billed that causes the firm to eventually accept $21,000 as full payment for the services. This means that the realization rate on the account receivable drops to 93.3%. The overall realization rate on the 100 hours drops to 84%.

By monitoring these kinds of discounts on an ongoing basis, a firm can develop a reliable feel for roughly where its overall realization rate stands over one or a number of years. With that as a benchmark, it can measure current performance against that longer-term standard. If the firm's realization rate is declining during the year, a budget that was based upon historic realization rates may be in jeopardy.

Accrued Revenue

Lawyers tend to think in terms of billable hours, but law firm financial officers think in terms of revenue. Accordingly, as billable hours are reported and analyzed each month, the firm should “translate” those hours into accrued revenue (i.e., the revenue those hours represent at current billing rates), even though the hours have not yet been billed or collected. Lower than budgeted accrued revenue today means lower actual revenues tomorrow.

Billing and Collections Cycle

Still another tool to help monitor budget performance is the firm's billing and collections cycle. A firm's budget for the year will normally be based in part on how long it takes the firm to collect revenue with respect to each hour that is recorded. Most firms bill (or should bill) monthly, so there is already a 30- to 40-day delay in receiving the revenue associated with an hour billed on the first day of the month. The bill then has to be prepared and sent to the client, and the client has to pay it. Even the best paying clients will normally take 15 to 30 days to pay, which together adds at least another 30 days.

If a firm historically has a billing and collections cycle of, let us say, 2.8 months, knowing how the firm is performing to that standard in the current year will give some idea of when it can expect its accrued revenue to be realized as cash receipts. If the cycle has suddenly increased to 3.5 months from 2.8 months, revenues anticipated to be received over the coming months will be “bumped back” by as much as 1.3 months, absent corrective action. That could mean a full month's less revenue for the year. You can imagine what this does to the annual budget.

Billings

Including total billings for the month and year-to-date in the monthly financial statements is still another way a firm can monitor how it is progressing toward its full budget goal for the year. Are billings ahead or behind the billings projected in the budget through the relevant date? If they are behind, why are they behind? Are partners sitting on accrued time and failing to bill, or are the lower billings a result of lower billable hours and utilization rate for the lawyers? Although billings from month to month can vary for a number of reasons, knowing why they are below budget for a particular month or several months is the first step in helping the firm make decisions on how best to get back on target.

Expenses

Let's not forget an obvious item, which is monitoring expenses relative to budget. While most expenses over the entire year will not play out precisely as projected, it is important to understand whether an uptick in expense in a particular category is attributable to special circumstances, a consistent trend, or just a timing difference. The former two may require action, while the latter indicates that the category eventually will come back in line with projections. A good example of an item that could get out of hand absent careful monitoring is staff overtime. The added expense may be well worthwhile if it will result directly in an increase in revenues, but action may be called for if no benefit can be identified from the added expense.

Conclusion

At the start of a new budget year, and monthly throughout the year, firms should use all of these financial tools available to identify early signs that performance for the year is not where the partners had anticipated. Firms can do this only if they use the proper tools to understand what the monthly financial statements are saying in the context of the full year's budget. Armed with this timely information, the firm then can consider what actions, if any, may be required to correct any problems and get back on its budget track before the end of the year. Early intervention is key to hitting budget goals.

Michael E. Mooney, a member of this newsletter's Board of Editors, is the managing partner of Nutter McClennen & Fish, LLP, in Boston. His firm maintains an active tax and business practice, representing and advising domestic and international corporations in a broad range of tax issues, reorganizations, business combinations, and divestitures. He can be reached at [email protected].