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As you begin to prepare your business plan and supporting budgets for the year 2003, consider: "How can we use the budgeting process to shape constructive behavior in our law firm?" and "How can we use the process to provide value added of non-billable and administrative activities?"
The next five years will be a time of significant change for lawyers. The planning and budgeting process must now focus on improving distributable income. The budgeting process does affect the behavior of lawyers. A shift in approach shifts this behavior. The behavior shift will change the fiefdom-like behavior of lawyers in firms that encourage lawyers to act as profit centers. There will also be a shift in the behavior of partners in "eat-what-you-kill" compensation systems.
Past Approaches Are Inappropriate for the Future.
The shift of control from the law firm to the client makes old budgeting approaches ineffective. For example:· Projecting the future based upon the past assumes timekeeper hours and effective collected rates will be maintained during the planning period.· The use of zero-based budgeting assumes a prediction of the future. To quote the Nobel Prize winning economist Kenneth Boulding: "Any strategy which assumes a knowledge of the future involves delusions of certainty which can lead to catastrophic decisions."· Use of cost-based accounting assumes that the total cost is the sum of all separate cost centers in the firm, e.g., a lawyer, the library, etc. This is the cost of doing something rather than nothing. Cost accounting does not consider the total cost of the process for delivering legal services and the cost of not doing something.
New conditions make these approaches irrelevant. Increasing competition forces discounts on billing rates in order for firms to retain their market share. Clients demand more efficiency, forcing lawyers into non-billable project management activities and reduced billing hours. Law firms need to predict the future in order to understand the potential implications of what is happening to their clients and their competition and prepare effective responses to these inevitable changes.
A law firm must examine the entire process and cost of delivering legal services. What does it cost the firm for client negotiation time, collection time, and administrative overhead for $1,000 to sit in accounts receivable for 120 days or more? Using old assumptions and approaches will take the firm deeper into the black hole of cost cutting and/or a more intensive push on the old revenue components that will not increase distributable income. Review those assumptions and ask: "If you arrive at the final destination, where will you be?"
How to Make the New Approach Work.
Reinvent your process by taking two steps. Step one, establish a context for the budget. Step two, set up different reference points - your potential revenue and your distributable income. The objective: foster innovative ideas and improve the distributable income.
Establishing the Context
A small firm cannot truly start an effective budgeting process until its key players have established a direction. Once direction has been established with precise statement of vision, values, mission, and strategies, the selection of the best options and choices for investment of firm resources can be determined. Then the firm must have:· Communication. Discuss and reinforce the assumptions and how those assumptions support the firm's agreed upon strategies so that vision, values, and mission statements are realized.· Commitment. Provide dedication and enthusiasm for the vision, values, and mission of the firm. This will ensure that leadership follows through with decisions and actions to realize financial objectives. An example of a pitfall that can develop as the plans for the new system begin involves a firm which had started a program to ensure that total realization on billing rates would rise by five percent, only to give up because they got "too busy" with current client work. It was a waste of time and potential. Good intentions do not produce results - only sincere effort and determination can change the status quo.· Obedience to the guidelines of vision, values, and mission. Provide consistent support to those who are reconstructing the vision, values, and mission. Do not condone the behavior of people who do not "walk the talk."
Activity accounting, unlike old approaches, focuses on the full potential of an organization. If the firm perfectly met the needs of its market, what would be the revenue, expense, and required capital? For example, a law firm that has developed the right mix of talent and billing rates for its mission and the right mix of skills to support the clients and the bundles of services in the mission can realize its full potential. It will capture 100 percent of its billing rates, effectively utilize all time keepers, and maintain the lowest possible overhead per revenue hour - it has successfully adapted to the changes around it and can continue to maintain its edge through this new approach.
The fact that a law firm is experiencing a 61 percent overhead factor is not as much an expense problem as it is a revenue problem! Activity accounting focuses on increasing the size of the pie. Let's start with the basic rule of budgeting: "when outflow exceeds intake, the upshot is our downfall." As an example of inflow and outflow, picture a flow of dollars into the top of a tank as inflow and a spigot that automatically measures the flow of dollars out of the tank.
Inflow: billing rate (BR), utilization of billable hours available, realization on the rates (R), and the number of timekeepers per partner (L). Reduction of Work-in-Progress (WIP) and Accounts Receivable (A/R) also provides inflow by purging cash out of these two balance accounts. These purges are titled "negative investments" (-I1). Another source of funds (-I2) comes from the reduction of other assets or increasing liabilities, e.g., bank loans.
Outflow: expenses (E), investment in Work-in-Progress or in Accounts Receivable (I1), and increase in assets such as equipment or decreases in liabilities (I2).
To visualize activity accounting assume four tanks of equal capacity are connected by pipes that flow from one tank, then from tank two to tank three and so on. The leak examples represent only a small sample of what is usually present in law firms.· Tank one starts full and represents the potential revenues from available billable hours from each timekeeper (P) times the billing rates (BR) times the number of timekeepers. However this tank already has a leak in it - it's the leak from current agreements with clients to discount rates in return for volume.· A pipe from tank one to tank two, Work-in-Progress, leaks from poor time recording and poor negotiations in scope of work.· While in the WIP tank two, a leak develops as the time begins to age and the firm must use working capital to support this inventory and/or the value of the work becomes less evident to the client and must be written down.· In the pipe connecting the Work-in-Progress (tank two) to tank three, Accounts Receivable, leaks evolve from poor project management or lack of communication with clients. Time and/or rates must be written down.· While in Accounts Receivable (tank three), dollars leak out the bottom or evaporate away as the receivables age. Even if a law firm received 100 percent of what was billed after resting for six months in A/R, the cost of money alone would have worked on the present value of the receivable.· On the trip down the pipe connecting the A/R tank three, to the Collections tank (tank four), other leaks appear from lack of communication with the client about scope and progress. The client then balks on paying the full bill.· What is left in Collections (tank four), contains only a fraction of what was in tank one. Drain off the expenses and the distributable income remains.
The budget should start with the potential inflows and minimal outflows. Expenses are only a small part of the loss distributable income. The entire process of delivering legal services must be examined. For every dollar that leaks out of the process, one dollar is not available for distribution to the owners of the firm.
Step 1: Set up the budgeting process to also capture lost revenues.Step 2: Set up the Assumptions of Inflows and Outflows.
Possible Inflow Questions:· What should be the potential or benchmark rate for every timekeeper in the firm, despite any discounts given for particular kinds of work?· What is the best mix of experience and billing rates for each type of service rendered?· What return should each practice area produce? If the return rates in the insurance defense group are $150 for a mid-level partner and the client will only pay $110, is the firm willing to accept a 73 percent return on that work? What is the return expected on that 27 percent investment?· What are the realization rates on clients and matters that make up 80 percent of the firm's revenues? How can the realization improve?
Possible Outflow Questions:· How much age is the firm willing to target on work-in-progress? On accounts receivable?· How much is the firm willing to use banks as a source of funds in each month of the fiscal year?· What are the missions of each of the administrative support members? The mission should answer the following questions: Who are the core customers? In what locations must we serve these clients? What services are critical to those clients? Are there options to abandon some services, delegate them to staff directly supporting the timekeepers, or outsource them?· Given the mix of timekeepers providing specific services, what should be the unique mix of administrative personnel supporting those groups?· What is the appropriate mix of support personnel not assigned specifically to timekeepers?
Now that the benchmarks have been set, identify the specific plans of action that can move the firm's current levels toward and above these benchmarks. After answering these questions, develop a statement on how you as owner(s) will add value by helping the firm identify more realistic targets for improvement in each assumption and resulting line item.
Step 3: Set up all reporting against the budget for the current period and year to date in graph form.
The graphs can show both creation and balances. Bar charts can illustrate the current month and the year-to-date activities, and the value of hours worked, billed, and collected versus the estimates. A second set of graphs can show the tanks at the expected levels and the actual levels and the volume of the leaks.
When a firm uses the activity accounting approach to budgeting, it must look at the cost of the entire process of delivering legal services. In this process the firm must look at the cost of inactivity and remember that lost revenues are costs. The concept of activity-based budgeting is motivating lawyers to focus on the area which can become their biggest contribution - increasing the size of the revenue pie. The key to the budgeting process over the next five years will be to use the development of the business plan to find ways of improving distributable income by enhancing the return on the firm resources. Successful law firms will find better ways to increase their return on the firm's time, talent, accumulated knowledge, investments in training and technology, and other resources.
William C. Cobb is the managing partner of WCCI Inc. (Cobb Consulting) in Houston, Texas. He is a consultant in strategic issues affecting law firms and provides counsel to improve competitive position and net income. Cobb can be reached at (713) 227-2300; http://www.Cobb-Consulting.com
Reprinted by permission of the Texas Bar Association and William C. Cobb. This article was first published in the Texas Bar Journal, July 1999, Vol. 62, No. 7. "From a Walk in the Park to the Wild Side: Getting Ready for Wild Side Budgeting" was written by William C. Cobb.
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