Eye on the Profession: Some tips for all seasons to improve law firm profitability

A lot has been written in this column and elsewhere about the relentless wave of change in our profession in recent years. Much of the change has been initiated by our clients, who have reacted bitterly to the cost of legal services. Corporate America has been reducing outside legal spending and demanding that outside lawyers find ways to do more with less. Meanwhile, consumer spending on legal services has been curtailed by individuals trying to represent themselves and by the proliferation of internet-based legal “self-help” providers such as Legal Zoom. The result of this change is that lawyers have seen their profits and their incomes stagnate or fall. Sadly, however, many lawyers have not adopted measures to make themselves more profitable. There is no time like today.

For many firms, the model of practice has pretty much been the same for decades. Each year in January the firm starts business. At the end of the month, the bills are paid, and the excess bills get shared by the partners according to a formula. A little extra may get tucked aside for later. This routine is maintained month after month, and at the end of the year, any extra funds are paid out and the firm prepares to start over again in January.

When times are good, this method of operation works. When times are lean, it doesn’t. Now, with the changes in our profession, partners in firms are awakening to the fact that this way of practicing is not working very well. They are looking for ways to improve profitability.

For many firms, improving profitability is as simple as engaging in some common-sense strategies that other businesses observe. Here are a few tips to get you started on improving your profitability.

Budgeting: This one sounds too simple to be true, but many law firms do not operate with a budget. To have genuine and sustainable profitability, firms must undertake budgeting. It starts with an assessment that is based on historic revenues of the firm and individual lawyers and paralegals so that a reasonable revenue forecast can be made for the year ahead. The very task of making a revenue forecast requires the firm to look at historic revenue sources and think strategically about how those revenues can be achieved in the year ahead. Once total revenue is reasonably forecast, the firm must estimate every expense that can be anticipated for the year ahead. Once revenue and expenses have been assigned for the year ahead, the firm can determine whether the revenue will be adequate or whether expenses will have to be cut in order to make a profit. The budgeting process also allows the firm to set reasonable lawyer compensation for the year.

Ideally, once a budget is established, the firm should study revenues and expenses against the budget on a month-to-month basis to make sure the income and spending forecasts are on track. Once a year has passed, then, ideally, revenues and expenses should also be benchmarked against the same time a year before.

The process of budgeting can be time-consuming, but as a management tool, it is indispensable. Depending on the size of the firm, it is likely worth having the firm’s CPA assist in the process.

Strategic planning: Improving profitability requires a firm to examine its strengths, weaknesses, opportunities and threats. In the final analysis, profitability is a factor of improving revenue and reducing expenses. A strategic planning process does not have to be a long and drawn-out ordeal, but it does require a firm to be intentional. Only through a thoughtful and wide-ranging review of the firm can the lawyers see where they are losing money and where greater revenue might be obtained. The planning can be done with the help of consultants, but it can also be done by reference to some pretty good guide books on the market.

Cost of labor/pricing: Many lawyers are not strategic about pricing their services. A very basic starting point is to understand your labor cost per hour. To calculate the cost of labor per hour, you take the anticipated cost of pay and benefits for a lawyer for the year ahead, add the lawyer’s reasonable share of overhead for the year and divide by the number of hours the lawyer is expected to bill/work. For example, if the lawyer anticipates wages and benefits totaling $100,000 and overhead of $100,000, for a total of $200,000, then 2,000 hours translates to an hourly labor cost of $100 per hour. If the lawyer works or bills 1,600 hours, then the cost of labor is $125 per hour. With either figure, the lawyer must engage in legal work that produces more than the cost per hour or there will be no profit. While this sounds simple, it is often overlooked, and far too often lawyers do not price their services or work the hours that will produce a profit.

Realization: Realization is the amount of time actually billed compared to the amount of cash actually collected. Many lawyers will keep track of their time and then write down their time or the time of their associates before they bill it. That results in an initial reduction in realization. Then, if they collect less than the full amount billed or the client writes down some of it before payment, realization is even lower. Most law firm consultants suggest that a realization rate between 90-95 percent is good. In a full-time hourly practice with standard rates, realization of 97 percent is ideal. The point of this discussion is that many lawyers do not know or track their realization, but they should. Low realization rates can be a huge hit to profitability. At a minimum, firms should identify the clients for whom realization is lowest and move away from them.

Billing and collections: A subset of realization is a firm’s billing and collection practices. It is well-known that lawyers will lose lots of time if they do not record their time as soon as possible after the time is worked. Similarly, firms that do not bill promptly will not collect their payments as quickly or as completely. A disciplined approach to recording time and billing that is matched by early and prompt follow-up with accounts receivable is essential to profitability.

Overhead management: Today more than ever, technology allows law firms to work with fewer staff per lawyer, less space per lawyer and savings on phones, postage, paper and other tangible expenses. Good firms are reducing overhead and improving efficiency to save money. Clients expect it.

One big overhead component is marketing expenses. Firms must be strategic and intentional about how they spend their marketing dollars and how lawyers spend their marketing time. These can be huge profit drags it they are not controlled. Further, with social media, so much more can be done to touch clients and prospective clients with minimal expense.

In summary, profitability goes hand-in-hand with good basic business practices. There are many other methods of improving profitability, but hopefully these few tips will get you started. As the saying goes, “You may not want to work harder, but you sure want to work smarter.” #WillYouBeThere?•

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• John C. Trimble (@indytrims) is a senior partner at the Indianapolis firm of Lewis Wagner LLP. He is a self-described bar association “junkie” who admits that he spends an inordinate amount of time on law practice management, judicial independence and legal profession issues. Opinions expressed are those of the author.