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Can Your Firm Afford You?

Can Your Firm Afford You?
The Profit and Loss Equation for Associates


by Ronda Muir, Esq. and Tanja Diklic, Esq.


Understanding the economic dynamics involved in the business of law and particularly how lawyers contribute to the firm’s revenue is just as important to the success of young associates as is being an expert in legal problem-solving.


In most U.S. firms, the cost of salary and benefits plus the overhead expenses for each associate means that the total realized revenues that each lawyer must produce every year, just to cover his or her expenses, without producing any profit for the firm, is upward of $300,000.  As a result, it takes, on average, from three to five years for a young associate to contribute to the net profit of the firm and often longer for the firm to break even on its investment in a new lawyer.


To understand his/her impact on firm revenue, a young associate should periodically make a personal Profit and Loss Statement (P & L).  The P & L is essentially a statement that reflects what an associate brings in (revenues) and what he/she costs (expenses) to determine whether he/she is profitable (“P”) or a loss (“L”) to the firm.


Profit & Loss Equation


During the first few years of practice a young associate’s most important contribution to the firm is to meet any billable hour expectations.  The billable hour targets are based on the total projected expenses of the firm, including salaries, rent and overhead.  A margin for uncollectible revenues, which often can be as much as 15% or more, is added to the expenses.  These total expenses are divided by the firm’s total weighted billable rates to determine how many hours each lawyer must bill in order to pay all firm expenses.


The number of billable hours that an associate billed in any given month, reduced by the number of hours written off, times the billing rate produces that associate’s personal revenue number for that month.


Therefore, an associate’s personal P & L for the month looks like this:


Revenues realized from billable hours – (direct + indirect expenses) = ?


The direct expenses include the total cost of the compensation package (gross salary, profit sharing/pension plan contributions, health insurance), the cost of the associate’s secretary and his/her share of the rent.


The indirect expenses include the amount of office overhead by percentage that is attributable to an associate.  Overhead includes insurance, utilities, entertainment, education, marketing and promotional material costs.


Checking this formula on a regular basis can quickly let an associate know whether and how much he/she is personally contributing to the financial success of the firm.


In order to meet billable targets, young associates should determine how many hours are required to be billed per day/week/month and regularly compare their actual time with the budgeted time. The rule of thumb is that it takes between 10 and 12 hours to bill 8.  Booking hours slightly above the budget not only covers occasional breaks and the friendly chitchat with colleagues, but also unavoidable contingencies that might make the numbers drop later, such as sickness or death in the family.  Also, it allows associates to take advantage of opportunities where time isn’t billable, but the learning opportunity is valuable.  Such opportunities include attending client meetings or court hearings, performing pro bono work, participating in bar association activities, helping with firm recruitment, overseeing more junior associates, attending training sessions and assisting partners in marketing efforts by writing speeches or articles for publication.


Utilization



Firms use a term called “utilization rate” in discussing how many hours associates have billed towards their billable hours targets.  Utilization is simply the amount of time an associate actually bills as a percentage of his/her targeted number of hours.  So, if the billable hours target is 2000 this year, and an associate bills 2200, then the utilization rate is 110%; if an associate bills 1800, then the utilization rate is 90%.


How easy or hard it is to attain 100% utilization rate depends on one’s area of practice. Litigation, for example, is usually more amenable to generating additional billable hours than is trademark practice. For that reason, an associate who is not fully utilized may be given work from another practice group to bolster his or her utilization rate.

Realization



There are two types of realization:  Billing Realization and Collections Realization.


Billing Realization


Billing Realization is the percentage of billable hours that are actually billed to the client.  For example, if an associate worked 100 hours on a project, and only 85 of those hours were billed to the client, the realization rate would be 85%.  The remaining 15% of time is “written off.”


It is not unusual for a portion of a young associate’s time to be written off.  In fact, firms plan for differing realization rates during the budgeting process.  In most firms, realization rates are not communicated to the associates unless there is a problem.


Collections Realization


The second type of realization is Collections Realization.  This is the percentage of fees billed to clients that is finally collected.  While sometimes client payments are delayed, some legal bills or portions thereof are never collected for a variety of reasons—including disputes as to the merits of the fees and changes in the client’s management or financial fortunes.  These are the uncollectibles that firms try to anticipate in their budgets at the beginning of the year but that in any given year can make major reductions in the partners’ shares of net income.


The length of time between when an attorney performs work and when the law firm receives payment for those services is called the cash collection cycle.  If the work was recorded on September 2, invoiced on October 5, and the check received on November 21, the total cash collection cycle for that matter would be 80 days.  Obviously, the shorter the cycle, the better for the firm.  The average age of the Fortune 500 companies’ accounts receivable is 39.6 days.  For law firms, the average age is 77.6 days.


Sensitivity to all of these cash management issues will help young associates appreciate the pressures the supervising and other partners may be facing, particularly at the end of the year, and the importance of a young associate’s role in keeping the firm’s cash flow steady.

What can you do?



Apart from billing more hours that are realized, there are two other ways that a young associate can increase his/her profitability for the firm.


Delegate – With the knowledge and consent of the supervising attorney, a young associate could delegate as much of his/her work that can be competently done by someone with a lower billing rate (a more junior associate or a paralegal) as possible.  This would allow senior lawyers to spend more time at their increased billing rate on other matters while younger associates are performing as much of senior lawyer work as they can competently perform.  Making sure that the person doing the work is both competent but also least expensive to the client creates a more efficient firm and also helps young associates grow to the next level of expertise.


Increase billing rate – A young associate would need to discuss with the supervising attorney or practice group head what would be required from his/her performance for the firm to justify an increase in his/her billing rate.  Any increase immediately improves an associate’s revenues.


 Conclusion



Understanding these aspects of the business of law allows young associates to provide better service to their clients and the firm and ultimately leads toward greater personal career success.


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