THE PIVOTAL ROLE OF REALIZATION RATE ON LAW FIRM PROFITABILITY, PART 2

Portrait of an Accountant as Young CFO: A Law Firm Billing War Story

It happened near the end of my first year at the law firm. Six months earlier, one of the founding partners transferred billing responsibility for our largest client—let’s call them Mega Corp—to a younger partner. Towards year-end, I was reviewing some year-to-date numbers on our larger clients, and the data for Mega Corp seemed odd. Mega Corp’s billable hours were virtually the same in the first six months of the year vs. the second six months. However, fee billing and fee revenue were down. Seeking an explanation, I went to the usual suspects, but there was no serious change in unbilled time; the client had paid at the end of each month like clockwork and there were no significant aging or outstanding invoices. Something did not add up.

Digging Deeper into the Law Firm Financial Statements

To get to the bottom of things, I did some more forensic snooping. Here’s what I uncovered:

• Unbeknownst to the New Business Committee, a new billing partner had begun using an alternative “rate table” for new Mega Corp matters which applied an alternative billing rate 10% lower than the one applied during the first half of the year; so, a timekeeper who formerly billed $200 an hour on Mega Corp’s matters was now set at $180.
• The new billing partner also began discounting the fee value recorded on the pre-bills by 10% across the board on the theory that the work performed by the other lawyers would have taken less time if he’d done it himself.
• Mega Corp’s new general counsel invariably complained each month that the invoices were “too high” and demanded a 10% discount from the sticker price which was accepted without protest.

Through this succession of 10% + 10% + 10% discounts, the new billing partner had transformed Mega Corp from a $1,000,000 a year client into a $729,000 a year client, while at the same time performing the same number of hours worked—reducing law firm profitability. You can be sure I double- and triple-checked my numbers before sitting down with the new billing partner to discuss. My work papers probably looked something like this:

ILLUSTRATION #2: CHANGES IN REALIZATION RATE FORMULA

• First six months of the year, the founding partner supervised 2,000 billable hours of work/$500,000 fee value and managed to invoice and collect $500,000 on that work.
• Effective work rate was $250 an hour.
• Billing realization was 100%.
• Collection realization was 100%.
• Second six months of the year, the new billing partner supervised 2,000 billable hours of work/$450,000 fee value due to use of the alternative rate table; invoiced $405,000 after a 10% discount of time value; and collected $364,500 after a 10% collection write-off.
• Effective work rate was $250 an hour.
• Billing realization rate was 90%
• Collection realization was 90%.

Unwittingly, the new billing partner gave Mega Corp a 27.1% discount on work for which they formerly paid $1,000,000 a year.

The Aftermath: Improved Financial Management

Suffice it to say, the whole episode was a learning experience for me as a nascent CFO. My meeting with the new billing partner to outline my concerns went about as good as you might expect. The discussion involved a lot of blank stares, head-shaking, and what only can be called defensive deep denial. It was a long time ago, but his parting shot was something like: “Your analysis makes no sense. I went to law school to avoid having to deal with statistics. I have client calls to return.”  Unbowed, I went over his head to the founding partner. Here’s what happened next:

1. The founding partner was much more receptive to the financial analysis;
2. The new billing partner kept the client, but only after a series of meetings with the client and founding partner to set new billing guidelines which eliminated most (not all) of the realization losses going forward;
3. I was asked to provide a series of recommendations to improve procedures to tighten controls over fee discounting in all its forms; and
4. Billing and collection realization reporting took center stage in all law firm financial reporting for the rest of my career.

Interested in Learning More About Law Firm Billing?

In part three of this four-part series, we’ll talk more about law firm realization rate loss—the “invisible expense”—and how to determine the right realization rate target for your firm. Subscribe to the 4L blog today to ensure you don’t miss the next installment, or contact us to learn more about our accounting services.