In the latest article in our "Practice Innovations" newsletter, we look into how law firms can improve their realization rate and stem profit leakage
Law firms often use realization as the primary, if not sole, metric to measure the financial health of clients and matters. This can lead to a misguided approach of focusing on clients and matters under a certain realization threshold as “problem children” instead of identifying those clients and matters where improvement is most achievable.
By diving deeper into the factors that cause realization and profit leakage, law firms can be much better positioned to invest resources on clients and matters where meaningful improvement is most achievable.
There are several steps firms can take to get them there, including:
Step 1: Understand the levers that drive profitability
The first step in developing a more focused approach to improving client and matter financial health is to understand the full range of factors that impact client/matter profitability. The three key metrics are rates, realization, and leverage.[*]
Looking at all three key metrics in combination provides a more complete and holistic view of the financial health of the work, and allows a law firm to see how different staffing and service delivery models can drive profitability. Many law firms develop client/matter profitability models that take all of these data points into consideration and produce a straight-forward “score” or result that reflects the interplay of these factors.
There are different ways to weigh the key metrics when developing a profitability model. Each has merit, and the decision of how to build an effective model should be based on the specific goals and objectives of the law firm. The key point for this discussion is that looking at only one factor will lead to an incomplete picture of profitability and a suboptimal allocation of resources to drive improvements.
Step 2: Distinguish pre-negotiated discounts from write-downs (All realization leakage is not the same!)
When analyzing realization, many law firms simply look at the overall realization number and take the blunt approach of assuming that clients and matters under a certain threshold are the ones deserving of critical attention. The problem with this approach is that it ignores the fact that not all realization leakage is equally fixable.
Realization leakage can be caused by any combination of: i) pre-negotiated discounts; ii) write-downs (reductions before a bill is rendered); and iii) write-offs (reductions after a bill is rendered). Understanding which of these factors are causing leakage is crucial to deciding where to deploy improvement efforts. In many cases, unwinding a pre-negotiated discount is about as easy as catching lightning in a bottle. Conversely, addressing write-downs caused by budget overruns might be easily addressed through better project management support.
Step 3: Focus on the low-hanging fruit
Armed with better information about the factors that contribute to client/matter profitability, law firms then can effectively focus resources on those clients and matters most ripe for improvement. This means not reflexively focusing only on clients with low profitability scores.
For example, assume a law firm has the following three clients, all of which have similar rates and leverage, but different realization levels:
- Client A (93% realization) — There are no pre-negotiated discounts, but just about every invoice gets auto-reduced by the client’s electronic billing system due to poorly written time entries, lack of diligence in getting new timekeepers approved, and late time submissions.
- Client B (84% realization) — This institutional client negotiated a 15% discount post-Great Recession and has expressed multiple times that it will pay reasonable annual rate increases; however, the client has also expressed that the 15% discount if fair, given the volume of work provided on an annual basis. The work is managed well with virtually no write-downs or write-offs.
- Client C (91% realization) — A newer client with no pre-negotiated discounts, but this client requires budgets for each matter and will not pay fees over budget unless the budget is revised and approved in advance of the additional fees being incurred. The law firm has had several budget overruns and has not been diligent about revising budgets throughout the course of projects, all of which led to write-downs.
In this example, Client A has the highest realization, but also represents the best opportunity to effectuate meaningful improvements through basic project management and billing hygiene changes. Conversely, Client B has the lowest realization, but reversing the long-standing, pre-negotiated discount would take a monumental effort. Similar to Client A, Client C is also ripe for improvement through better budgeting and project management support.
Now, imagine this law firm decides to focus most of its resources on clients below 85% realization, pays some attention to those between 85-90%, and draws a line that any client over 90% is doing just fine and will not be reviewed. Not only might the law firm expend a lot of effort for little result on Client B, but they will completely miss the bursting-ripe, low-hanging fruit dangling from Client A.
This example is not meant to suggest that law firms should ignore clients and matters with low profitability caused by pre-negotiated discounts. But, by developing a more nuanced approach to measuring the financial health of clients and matters that identifies the specific factors driving profitability, law firms will be much better positioned to make informed decisions on where to deploy resources to achieve measurable improvements.