Number of hours billed has traditionally been the benchmark for gauging law firm profitability. But this traditional measurement has a number of shortcomings — for example, it doesn’t take into account realization of billing rates, attorney utilization and leverage, or how fast clients are billed and money is collected.
Many law firms today are taking their analysis a couple of steps further by using a combination of different metrics beyond just billable hours to get a fuller picture of the firm’s true profitability. One approach uses the acronym RULES, which represents five key metrics law firms can use to evaluate profitability at a deeper level:
•Realization of billing rates
•Utilization of attorneys
•Leverage of lawyers
•Speed of billings and collections
A Better Handle on Profitability
The RULES acronym was coined by Robert J. Arndt in his classic book, “Identifying Profits (or Losses) in the Law Firm.” By digging deeper into the profitability equation, Arndt believes, you can get a better handle on how much money your firm is really making. This can help you make better decisions with regard to staffing, salaries and wages, and the kinds of clients and cases you decide to accept.
Following is a detailed breakdown of the five metrics represented by the RULES acronym and how they can help you better gauge your firm’s profitability:
1.Realization - The goal here is to come up with a composite hourly realization rate for the entire firm that you can use as a benchmark against actual results throughout the course of the year.
Start by making annual revenue projections based on how many hours you expect your attorneys to bill for the year, multiplied by their hourly billing rates. Then compare your actual billing results each month against this realization benchmark (your annual revenue projection divided by 12) to gauge how close you are to your target realization rate. Knowing this will enable you to make more informed decisions about billing rates, discounts and fixed-fee arrangements.
2. Utilization - In other words, how much of your attorneys’ time is being spent on billable activities, and how much is being spent on non-billable activities? While it’s virtually impossible for attorneys to spend 100 percent of their time on billable activities — devoting time to pro bono activities, for example, is important for many firms — the goal should be for them to spend as much time on activities that can be billed to your clients as possible.
You should set realistic but aggressive goals for the percent of attorneys’ time that should be spent on billable tasks, taking into consideration an allocation of time for pro bono activities. Then hold each attorney accountable for how they measure up against this critical metric. Make it a key part of each attorney’s performance review, and one of the criteria that’s used in determining their eligibility for (and the amount of) any year-end bonus or performance incentive.
3. Leverage - This is the ratio of non-equity partners and associates to equity partners in the firm. A highly leveraged firm will have proportionally more associates and non-equity partners than partners, while a firm with a proportionally large number of partners will be less leveraged. A firm with less leverage will distribute a higher percentage of net income to partners, while one with more leverage will distribute less net income (percentage-wise) to partners. Highly leveraged firms can increase the percentage of income distributed to partners by increasing productivity among associates and non-equity partners.
4. Expense control - Though law firms provide a service, instead of manufacturing a product, the expense side of the equation is still important. Excessive overhead (like luxurious office space) and attorney overtime can take a big bite out of law firm profitability. Make it a practice to monitor firm expenses carefully and rein in attorneys who are being careless with the firm’s money.
5. Speed - This metric measures the span of time between when billable hours are incurred and payment is received by your firm. In manufacturing and most other businesses, it’s referred to as the cash flow cycle. Two other metrics are key to measuring and monitoring your speed of billings and collections: work in progress (WIP) and accounts receivable (A/R).
Given the extended timelines that can be involved in legal cases, it’s imperative to keep a close eye on your WIP and A/R. For example, if two months of billing are tied up in WIP and another three months in A/R, it’s taking your firm at least five months from the time billings are posted to collect money owed to you. This can have a crippling effect on your cash flow.
An inherent part of the cash flow cycle for law firms is the recording and reporting of billable hours by attorneys, which must be done on a timely basis. A number of different time recording systems are now available to make it easier for attorneys to record their time promptly and accurately.
Know the RULES
If you don’t feel like you have a good handle on your law firm’s profitability, take the time to get to know these RULES better. Doing so will give you a better picture of your true profitability — and help you increase your profits in both the short and long term.