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Tuesday, July 17, 2012

Strategic Budgeting for Law Firms


A Strategic Budget is a roadmap that ties the financial goals of a law firm directly to its firm-wide strategy.

It aligns resources with stated goals, helps management set expectations and make critical decisions about issues such as profitability, partner distributions, adding partners, financing, resource allocation (hiring and terminations), acquisitions and other significant issues. Similar to a traditional budget, a Strategic Budget consists of three main components: projected revenue, projected expenses and projected profit and cash flow.

The difference between a traditional budget and a strategic one is the process surrounding how these projections are derived. A Strategic Budget is a product of the entire law firm because every practice group and every cost department is involved in the process.

Projected Revenue
Among the three components of a Strategic Budget, projected revenue poses the greatest challenge. Law firms operate in a constantly changing environment. Different factors, both external and internal, affect the revenue generation and collectability of different practice groups. Sometimes, the same factor may benefit one group but affect another adversely.

In order to make a meaningful revenue forecast, you cannot simply project a firm’s revenue by assuming a certain percentage of growth—you need to dig down to the practice group levels. This will help to pinpoint specific issues the firm may need to monitor.

No one understands the operating climate and the future of the practice groups better than their leaders. For instance, how many cases are likely to go to trial next year for the Litigation Group? How many deals are in the pipeline for the Corporate Transactional group? What’s the impact to the workload of the Estate Planning group if the estate tax exemption dropped back to $1 million?

The practice group leaders have a better answer to these questions than anyone in the firm. Therefore, you need to go over the projected billable hours for each group and for each of its members with the practice group leaders. The projection should be centered around the individual business plans of the group members which are driven by the amount of work coming from existing matters, new matters, and new clients for the budget period (providing them with their current client list detailing revenue broken down by matter, may help facilitate this process).

Based on the projected billable hours, you can now assess the capacity issue of each practice group with its leader. A typical billable hour goal for a professional is 1,800 hours per year. If the average projected billable hours are in the 1300 range for next year, the group may have over-capacity issues that need to be addressed. The firm will want to either re-evaluate the current marketing strategy of the group to improve growth or consider reducing the group’s headcount.

On the other hand, if a practice group leader is expecting a boom in the workload of the group, the firm should consider such issues as whether the growth is long-term or just a spike. If it is long-term, should the firm train the attorneys in-house or hire lateral attorneys from outside to support the growth? Should the firm acquire a smaller firm that has this specialty?

These are all issues that a Strategic Budget needs to consider to insure that the direction of each practice group aligns with the firm’s strategic goals and that each group is provided with the appropriate resources in order to achieve these goals.

In a perfect world, every dollar billed would be collected the day after the bill was sent. Unfortunately, we do not live in that world. You’ll obviously need to discount billings by a realization rate, which reflects the percentage of fees billed that are expected to be collected. This rate should be calculated based on prior years’ actual realization rates (adjusted for any unusual events). For many firms, realization rates have dropped significantly in the past few years, so you may need to pay special attention to this area.

In addition to the points already mentioned, there are other factors that should be considered when projecting revenue for budgeting purposes. Some examples are the collection cycle for billed fees, the transition costs of lateral hires, discounts given to major clients, and alternative fee arrangements on major matters.

This is obviously the most difficult area to project, but it is also the most important. In order to monitor progress and pinpoint issues, this level of detail will be necessary.

Projected Expenses
It is relatively easy to project most expenses because the largest expense items for a law firm, namely payroll, rent and insurance, are usually known before the beginning of the budget year. However, keep in mind that in a Strategic Budget, expenses should follow revenue. Even the “known” expenses need to be adjusted at times.

For instance, if the revenue goal is to expand a particular practice group by bringing in more lateral hires, the firm should increase the projected payroll, benefits and infrastructure that will be required to support this growth.

Another key to a more precise expense projection is, again, involving all the key players. Departments such as Marketing, IT, Records, Library, Benefits, and Recruiting should also develop a detailed budget, which must align with the firm’s overall strategy.

Although each firm is different, there are a few categories of expenses that may require special consideration when preparing your strategic budget:

Salaries – Attorney and support staff salaries should be aligned with revenue projections and based on the necessary capacity to handle the work expected. Keep in mind that changes to the workforce can be costly and complicated so staffing levels need to be carefully considered by management on a regular basis.

Bonuses – you may want to consider aligning specific individual bonuses to achieving stated performance goals.

Marketing – In today’s environment, a marketing plan is as important to law firms as research and development is to pharmaceutical companies. A good marketing budget should support the firm revenue strategies along with the individual partner business plans (this also needs to be monitored as part of the Strategic Budget process). It is not about spending the money but, about whether the money is well spent.

Capital Expenditures – The budget for capital expenditures should not be limited to one year because it is typically heavily comprised of technology, which is often outdated in a few years. A long-term plan for various hardware and software upgrades will be necessary. The timing of these upgrades and how the firm finances them have a direct impact on cash flow, partner distributions and taxes—both in the current year and in future years.

Projected Profit and Cash Flow
Finally, with the projected revenue and expenses tied down, the firm arrives at a projection of profit for the following year—not only at the firm level, but at the practice group and individual partner levels. If the bottom line falls short of the firm’s goal, it is time to revisit the revenue strategies for next year and re-examine the expenses to identify areas for reduction.

It is important to note, projected profit is different from projected cash flow. To project cash flow, the budget should be extended to include uses of cash that may not impact profit. A few examples of these are as follows:

  • Loan proceeds or payment on any firm debt – this will obviously affect the cash balances but will not change the firm’s net profit (except, of course, for the interest portion).
  • Client costs advanced on behalf of clients – these costs are expected to be repaid and are therefore loans to clients. They are neither an expense of the firm nor income to the firm and, therefore, should not impact the firm’s net profit unless determined to be uncollectible.
  • Pension Plan accruals and payments
  • Deposits
  • Partner distributions and contributions
  • Capital expenditures
  • Depreciation

Based on this Strategic Budget, firms will be able to set expectations for partners’ compensation and determine the optimal investment and financing options for meeting the firm’s strategic objectives.

This economy will have many challenges or “road hazards” that lie ahead. It will be critical to know, in advance, where these “road hazards” are. Developing a Strategic Budget will help insure that you reach your destination successfully.

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