Based on comments from the prior post, “The End of Write-offs?” I thought it would be a good idea to peel back another layer on this onion. The prior post was purposely over-simplified, to focus on the issues of AFAs and LPM. This post will better explore the impact of realization on profitability.
First-off – why is realization important? One comment to the post talked about 50% realization on $2000 per hour is still $1000 per hour. Although $1000 per hour sounds like a high rate, if the timekeeper involved is compensated as if they bill at $2000 per hour, that’s a different matter. The real issue is the relationship between compensation (comp) and billing rates. Rates need to cover comp, overhead and profit. This follows the basic rule of three where rates are broken down into three components: 1) comp + benefits, 2) firm overhead, and 3) profit (a.k.a. partner income). The general rule states that each of the three comprise about one third of the rate.
Functionally this means that every point off of realization means 3 out of profit, since comp and overhead remain the same. This also means that as you approach 67% realization on a timekeeper, a firm’s ability to make a profit disappears. So – $1000 per hour is fine if the timekeeper is compensated at a rate relative to that number. If the timekeeper is compensated relative to the $2000 rate, then 50% realization means the firm is losing money on this person. Since I don’t know many firms who run with rates that high compared to comp, it’s unlikely that $1000 per hour is a profitable rate for a firm in that scenario.
Another point made is that write-offs can come from clients that just don’t pay. This is absolutely true. I focused on write-offs in the prior post, since they are client-identified candidates for no or low value effort. However, write-offs occur for other reasons. It is also true that write-downs occur for multiple reasons. These may be ‘back door’ rate discounts or more likely recognition by the partner of low/no value work by timekeepers on the team. This is yet another prime target for LPM to tackle as it is typically time billed by associates but deemed not worthy of the client bill. LPM would suggest it’s a better idea to direct resources to certain tasks instead of condemning no-value tasks as worthless after the fact.
This was the main point of the prior post. Instead of targeting AFAs, LPM should be focused on eliminating and reducing no and low value efforts by lawyers regardless of the type of fee arrangement.
(The other, actually more important driver of law firm profitability is leverage. But that’s a topic for another post.)
On a final note – Anonymous comments “One additional point, write offs often come from clients that have no money. The client intake process is what needs to be addressed not LPM.” More importantly, I would argue that profitability needs to be addressed. Once that is a firm’s goal (instead of billables/revenue), then LPM, client intake and pretty much every other function at a firm will change. LPM is focused on a symptom – meeting budgets. The better focus is on profitability. That focus will drive real change for firms.