Note: This is the second of a two-part blog on the law firm budgeting process. Read part one here.
A comprehensive law firm budget entails three distinct components:
- Revenue budget projected on an annual and monthly basis;
- Expense budget computed on a detailed level; and
- Cash flow budget.
Projecting expenses is relatively easy as compared to putting together the revenue budget. This is because the largest expense items are more predictable than billable hours, fee billings and fee revenue.
The starting point for the expense budget is the prior year’s actual expenses from the general ledger, then adjusting those numbers upward or downward for known or expected changes — e.g., new hires or expected departures, rent increases, changes in insurance rates. What’s most difficult to estimate are marketing and discretionary spending on professional and business development activities.
The expense budget requires a lot of input. You have to consult your insurance brokers for rate increase estimates and query decision-makers about planned new initiatives in IT, marketing, and recruiting. It often helps to build relationships between similar sets of numbers and use those numbers as a starting point in developing this year’s projection. For example:
- Last year payroll taxes were x% of gross compensation. Use the same percentage relationship to estimate payroll taxes for the new year.
- If bonuses for different employee classes tend to track a specific percentage of the group’s aggregate gross salaries, assume the same percentage relationship for the new year.
- Last year the business development spending was $x per lawyer. Use the same per-lawyer spend rate for the year ahead.
Finally, although not technically an expense, partner draws and distributions should be budgeted for the coming year, so your budget can illustrate two additional subtotals:
- Net income before partner compensation (i.e., revenue minus expenses); and
- Net income after partner draws and distributions (i.e., revenue minus expenses minus partner draws and distributions prior to year-end, final distributions).
Word to the Wise #2: Mathematical precision is impossible. Exercise your best judgment.
CASH FLOW BUDGET
It is axiomatic that a law firm’s annual revenue does not arrive in 12 equal monthly installments. Similarly, cash-basis expenses vary month-by-month.
To project monthly revenue, I typically create a spreadsheet detailing billable hours, billable time value, fee billing, and fee revenue for the two prior years and compute the percentage of the year’s annual revenue received in January, February, and so forth. In the next column, I reference the prior year’s monthly percentages to project the current year’s billable hours, billable time value and fee revenue.
Plotting the month-to-month expense flow begins with copying last year’s actual spending pattern, then adjusting that to take into account expected timing changes.
The final element of the Cash Flow Budget is a section incorporating the timing of partner draws and distribution payments and the possible and negative cash flow implications of (a) recording pension accruals and payments, (b) capital expenditures and depreciation, and (c) and debt-related borrowing and repayments.
Word to the Wise #3: Study the previous two years’ month-by-month numbers in the four revenue categories. If the numbers are skewed with highest monthly billable hours, fee billing or fee revenue at the end of the year, consider slanting the budget numbers to earlier months. This may encourage higher hours, billing and revenue in earlier months to “meet budget” and avoid lulling the firm into a false sense of security that “a strong 4th quarter will save the year like it has every past year.” Remember, “Past is not prologue”, and that a strong fourth quarter may never materialize. If your budget can inspire higher billable hours, billable time value, fee billing, and/or fee revenue earlier in the year, the partners will thank you later.
During the year, law firms also need to create forecasts to reflect how the firm’s performance is likely to change due to new facts or circumstances (or other factors not correctly incorporated into the budget).
Word to the Wise #4: Remember that things change. In the immortal words of former Secretary of Defense Donald Rumsfeld, “[A]s we know, there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there as some things we do not know. But there are also unknown unknowns — the ones we don’t know we don’t know….” For that reason, periodic forecasts are required to update the budget for “new knowns.”
Many writers before me have opined that a budget is a roadmap charting the firm’s annual financial journey. In addition, a Chinese proverb holds that “a journey of a thousand miles begins with a single step.” Accordingly, the first step of the annual financial trek begins with the budget. Without a law firm budget, you won’t be able to advise the firm whether this year’s journey is on pace to end as they hope it will — and, if so, why or why not. If you have any questions or would like to talk about your firm's budget then please contact 4L Law Services.