THE PIVOTAL ROLE OF REALIZATION RATE ON LAW FIRM PROFITABILITY, PART 1

re٠al٠i٠za٠tion [rē(ə)ləˈzāSH(ə)n/] noun

1. an act of becoming fully aware of something as fact
2. the fulfillment or achievement of an anticipated or desired result

Long ago, it was on a metaphorical accounting road to Damascus that I first realized the pivotal role played by realization in law firm profitability.  

In a law firm accounting context, the realization rate is defined as “the difference between the value of the billable time worked (number of hours x hourly rate) and value of the fee payments eventually received from the client.” Most law firms who track realization, measure it in terms of “fee billing realization” and “fee collection realization.”  

fee billing realization

• The “effective worked rate” for the matter is $250 an hour (computed: $50,000 ÷ 200 hours worked).
• The “fee billing realization rate” is 95.0% ($47,500 ÷ $50,000).
• The “fee billing realization loss” is $2,500 ($50,000 value of time worked - $47,500 fee billing).

FEE collection REALIZATION

• The “effective fee collection rate” is $220 an hour ($44,000 fee revenue ÷ the original 200 hours worked).
• The “fee collection realization rate” is 92.6% ($44,000 ÷ $47,500).
• The “fee collection realization loss” is $3,500.

Using the foregoing example, the 200 billable hours worked on Matter “A” were discounted $2,500 in the billing process and further reduced by another $3,000 in the collection process; $5,000 total “realization loss.”  Assume for the moment that the Matter “A” example is typical for that law firm and across the board the firm’s fee billing realization rate is 95% and fee collection realization rate is 92.6% for the year on all matters. If the firm’s fee revenue for 2017 was $5,000,000 after 95% and 92.6% realization adjustments, means the firm would need to work a total of $5,682,000 in billable time value to cover realization losses totaling $682,000.

Illustration #1: Realization Rate Formula

For a small/midsize firm generating $5,000,000 in annual fee revenue, a single $682,000 expense would normally received significant budget scrutiny.  A $682,000 expense item (13.6% of $5,000,000 revenue) most likely would be higher than any one of the following: associate salaries, staff salaries, rent, or business development. However, unlike spending categories such as salaries, rent, or business development, few small/midsize firms attempt to manage or contain their realization losses. For instance, a 0.5% change – increasing fee billing realization to 95.5% (from 95.0%) and collection realization to 93.1% (from 92.6%) -- on $5,682,000 of billable time worked would increase fee revenue by nearly $52,000 without incurring any additional costs -- increasing partner profits -- because managing realization losses really doesn’t cost anything other than diligence.

Interested in learning more?

In part two of this four-part series, I’ll tell you the tale of how I was introduced to realization during my first year at a law firm, and we’ll continue to explore concepts in realization rates and law firm profitability metrics. Subscribe to the 4L blog today to ensure you don’t miss the next installment.