The Most Important KPI for your Law Firm’s Profit Growth

Key Performance Indicators (KPIs) are much more than just information. They measure the key revenue and cash flow activities of a law firm to ensure its performance.

Not enough firms understand the importance of measuring and taking action to improve the fundamental KPIs around production management, in order to improve margin.

The core production KPIs are:

    • File Velocity Days
    • Average Rate
    • Productivity
    • Write-on (off)

Two high-level KPIs that firms need to focus on to drive overall performance are Average Rate and Lock-up Percentage.

Focusing on these Two Numbers gives you a framework to drive improvement in profit and cash flow. Average Rate directly correlates to driving profitability, while Lock-up Percentage focuses on improving cash flow.

This article deals specifically with Average Rate.

 

What is Average Rate?

When we refer to ‘Average Rate’, we are NOT discussing an average of fee earner charge-out rates. Average Rate is the calculation of revenue billed over professional employee labour paid.

This figure represents the average amount of revenue earned, for every hour your fee earners (including principals) are paid to work.

Average Rate = Revenue / Paid hours of direct labour

This KPI can measure the performance of individuals, teams, departments, and the business as a whole. Average Rate measures performance by incorporating productivity, write-offs, and recoverability over direct labour costs. As this number increases, so does businesses profitability (margin).

Average Rate is the most important KPI in terms of profit when it comes time to review your practice.

Need help understanding how to measure and track your Average Rate? Watch the following video (4:55) to see exactly how Average Rate is calculated.

The Factory

Your efficiency has a major bearing on your Average Rate. For a legal firm, efficiency can be described as the ratio between revenue and the direct labour cost to produce that revenue.

The ultimate financial measure for an efficient practice is gross profit, and the higher your Average Rate, the greater your gross profit. To improve gross profit from an efficiency perspective, you must ensure you carry the right amount of labour.

To determine the right amount of labour for your needs, you must have a “capacity management plan”. The starting point is to determine the Efficiency Factor for each team and department and the business as a whole.

Key Activities

Below are some of the key activities you can take that will drive improvement in Average Rate:

      1. Manage file velocity daily and weekly. The shorter the period a file is in the office, the better the recoverability of hours charged
      2. Bill everything in WIP, no write-offs
      3. Always remind the client of the value in the solution you provide to them
      4. Define your core products / service offerings and set minimum prices for them firm-wide
      5. Increase your charge rates across the board
      6. Set a minimum Average Rate per hour for the entire firm and bill to achieve this rate

When was the last time you reviewed your practice in respect of these activities? Not sure where to start? Let us guide you.

MANAGE YOUR VALUE

    • If your price increases exceed perceived client value, clients will eventually leave.
    • Be wary of the impact that your production systems have on client experience in the changes that you make. Client experience is just as valuable as the advice.

Key Takeaways

Challenge what is possible within your business. From a production perspective, Average Rate will provide you with the KPI to use to monitor your progress.

Key takeaways:

    • Average Rate tells us ‘What have we billed for every hour of labour we have paid for?’
    • Gross Profit = Revenue minus direct cost to generate revenue (including fee earner labour)
    • The key to profit is leverage: The number of fee earners per equity principal and the ratio of revenue earned per fee earner to their labour cost
    • Efficiency can be described as the ratio between revenue and the direct labour cost to produce that revenue
    • Warning: Numbers don’t lie but they can tell you the wrong story if you don’t read them correctly

If you are struggling to identify which KPIs are important for your business, more importantly if collecting said data in its complete form is also an issue, start tracking your Average Rate. This KPI will set your professional business on the right track.

Not sure where to start? Let us help guide you.

On-Demand Webinar:

The Most Important KPI for your Law Firm’s Profit Growth – Average Rate

Interested to learn more? Watch our recorded webinar to further drill down on how Average Rate can set the foundations for your firm’s profit growth. .

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Our webinars are an opportunity to tap into our knowledge and challenge your thinking.

 

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    Ensure Your Firm’s Survival

    For a professional services firm to survive in uncertain times – including but not limited to pandemics – they must understand and critically evaluate these important questions:  

        1. What expenses are fixed and what are tied to revenue generating activities
        2. What return are you getting on the expenses directly tied to revenue generating activities?  
        3. How efficient are you at producing the work you are currently undertaking?  
        4. What is your firm’s average break-even point (BEP) per month?  
        5. If under the BEP, then what is the firm’s cash burn rate until they cross over the break-even point?  
        6. Does your firm have partner and operational alignment?

     

    1. What expenses are fixed and what are tied to revenue generating activities?

    The cost structures of your firm are fundamental to its longevity. Understanding the link and interrelationships between generating more revenue and the additional costs required (or the opposite), cost allocations, and fixed or marginal costs has significant impact on profitability.

    Understanding costs

    Understanding costs ensures your business is spending in the right areas, as costs are not only tied to profits of a stable business, but they’re also linked to generating revenue to grow or maintain current levels.

    One of the biggest mistakes even accountants make is incorrectly allocating fixed direct and indirect costs to review a ‘true’ reflection of the business and provide meaning.

    Total costs = Fixed costs + Variable costs

    Fixed costs

    When people think of costs they generally lean towards fixed costs, which are predominately tied to labour and the majority of your overhead expenses. Fixed costs are fixed for a known period of time and can only be broken with notice.

    Variable costs

    These are costs that increase or decrease with usage or volume of activities. The majority of variable costs are related to costs such as sales and marketing activities, direct costs (including labour or contractors), utilities or commissions.

    Costs allocations

    You will need to consider costs allocations in your business, especially at internal reporting levels. This will help identify profitability by team/business units, service/product lines and even the success of projects. To have effective costs allocations, first you need to identify the nature of costs and how they are assigned to each area of your business.

    Potential consequences

    COST TYPE ACTION POTENTIAL CONSEQUENCES
    Fixed costs Decrease

     

    • Decreasing fixed costs can lead to greater profitability if sales remain unchanged or if gross profit drops by less than the decline in fixed costs
    • Risk if those costs are needed to generate revenue
    Increase
    • Increasing fixed costs can lead to greater profitability if sales increase through better service delivery by an amount which is sufficient to compensate for the increase in fixed costs
    • Risk if new revenue isn’t generated
    Variable costs Decrease
    • Decreasing variable costs can be effective if the product or service quality is retained
    • Risk if the service/quality levels drop and has consequential effect on sales
    Increase
    • Improvement in product or service quality involves increasing variable costs but allows a higher price to be charged. This can improve profits if the price increase is both accepted by the market and sufficient to offset the higher variable cost
    • Risk if the service or product cost increase is less than increase in revenue

     

    2. What return are you getting on the expenses directly tied to revenue generating activities?

    Once you have broken down your firm’s costs structure, your direct costs and revenue generated will need to be assessed and analysed. This will include the productivity/efficiency of your professional employees, but more importantly, your marketing and sales activity spends.

     

    3. How efficient are you at producing the work you are currently undertaking?

    For professional businesses, efficiency can be described as the ratio between revenue and the direct labour cost to produce service-related revenue. How efficient your work force can finalise client work (job), including write offs, is directly tied to capacity management and costs to produce your average revenue per job.

    By understanding the break down in efficiency, you can improve your direct costs, and even repurpose these costs savings to the right revenue generating activities.

    Determining your efficiency factor

    ‘Efficiency factor’ is calculated by dividing revenue by capacity available. The efficiency factor KPI is extremely important as it indicates:

    • which area of your business needs attention to increase profitability; and
    • whether you have capacity for growth; or
    • if you are carrying too much labour.

    Read more here: Understanding your Efficiency Factor

    Efficiency factor = Actual Revenue ÷ Capacity

     

    4. What is your firm’s average break-even point (BEP) per month?

    Once you understand the difference between your direct, indirect, variable, and fixed costs at a minimum, you can then determine what your average break-even point per month is to hit as a non-negotiable for the firm’s survival. Be careful – firms often make the mistake of assessing a lower cost month verse the current average cost spend.

    Break-even point = Fixed Costs ÷ Contribution Margin

     

    5. If under the BEP, then what is the firm’s cash burn rate until they cross over the break-even point?

    For most firms running at below cost turnover figures, it is even more critical to understand the firm’s cash burn rate (i.e. how fast you are losing money and at what pace). Once you understand this, then you will have an idea how much money it will take to get back on track. You can plan in advance for your firm’s survival.

    Calculating cash burn rate

        1. Select a relevant period for calculation (usually the current and last two months)
        2. Normalise these amounts for any expected seasonality (i.e. holiday wind up or down)
        3. Find the difference between the starting and ending cash balance for the selected period
        4. Divide the total by the number of months in the selected period
        5. This is your current cash burn rate. Compare to a calculation of the previous period(s) to determine a negative or positive trend. This will be better visualised via a graph for ease of understanding.

     

    6. Does your firm have partner and operational alignment?

    Partner alignment is when all partners are aligned to the business strategy, not necessarily to each other personally. Personal outcomes will drive behaviours in a business context.

    When a firm is trying to survive, this alignment is more important than ever.

    If you have decision makers making inconsistent decisions, your cost of doing business increases. The firm will also start to decrease its efficiencies (productivity), adding further costs above what costs are predicted to increase.

    You will also send mixed messages to your employees who will need to help the firm survive. This is dangerous and can lead to poor culture and employment turnover.

    The first step to building a successful partnership is to get REAL with each other on what your personal goals and objectives are. Once this is out in the open, you can focus on setting an agreed business strategy that is achievable.

    The business will have standard systems and processes that we must all adhere to for consistency, efficiency, and quality assurance. But each partner must still be able to produce their results using the resources of the firm, each team may have a slightly tailored approach depending on their skillsets and industry specialty.

    Your firm must have a purpose other than money as to why it exists, but remember if the firm isn’t profitable, then it won’t survive. If you think of the firm’s purpose as the body, then profit and cash are the oxygen and blood that keeps it going.

    A strong, focused, and aligned partnership, working towards a common goal, will endure and produce amazing results.

     

    On-Demand Webinar: Ensure Your Firm’s Survival

    Interested to learn more? Watch our recorded webinar to further drill down on the implications for your firm. This webinar looks at how today’s response can position your business to thrive tomorrow.

    Watch Webinar


    Our webinars are an opportunity to tap into our knowledge and challenge your thinking.

    Your Firm has Real Value

    Principals of firms are constantly undervaluing, or even disregarding the value of their firms. More specifically the dollar value of its goodwill.

    I continue to see practitioners purchasing equity in firms, even smaller, sole practitioner firms. If the incoming principal didn’t think there was a value, they wouldn’t pay anything.

    Banks are lending to firms to enable succession and acquisitions to occur, and securing it solely against the firm, without any personal security other than guarantees from the principal(s).  Believe me, if the banks didn’t think there was value, they wouldn’t lend money for it or against it

    So, what’s your practice worth?

    The value is that which a willing and educated buyer will buy and a willing, but not anxious seller will sell.  At the end of the day, a buyer will consider the risk and return to work out how much they will pay.  The lower the risk and the higher the return, the greater the value.

    To improve value, you need to:

    1. Increase your profit and maintain your risk level,
    2. Maintain your profit and reduce your risk level, or
    3. Increase your profit and reduce your risk level

    Profit is what the firm makes after it pays all principals a commercial salary.  Risk level is the likelihood that the profit will be earned into the future after the purchaser buys the practice, or an interest in the practice, and turns into cash.

    Considerations

    If the profit you make in your business is just enough to pay you a commercial salary, then your value will be minimal.  This is because your profit is non-existent.  Also, it probably won’t have a strong cash flow and will struggle to fund itself.  So, the risk is very high.

    If your firm totally relies on you and your fellow principals to bring in all the revenue, and to a large extent, to do all the work, but makes a profit after commercial salaries to principals, then there will be a value, but the value will be lower due to the risk.

    Contrast the above with a firm that generates work without the principals, either from brand strength or proactive marketing activities. The firm can function and maintain its profitability because of it’s leverage and reduced reliance on principals. Higher profits, lower risk equals greater value

    How to increase your value

    Increase your profitability by better client engagement. Estimate the work early and advise your clients of the fees as you progress, especially if it’s out of scope, you need to re-price.

    Follow what your costs agreement or engagement terms are. Educate your clients on what your firm does and challenge their attitudes to price and value. Remove discretion around time entry.  Build systems and educate fee earners around what doesn’t get entered into WIP.

    Engage your fee earners around their time entry and billing budgets. Monitor the value of time entered against budgets every week, encourage your fee earners to plan their weeks around work to be done to achieve their budgets, run a weekly matter workflow meeting to focus on priorities.

    Consider Improving your cash flow from regular and systematic billing to reduce risk.

    Decision Making Structures

    Many professional firms grow from one practitioner and evolve into a team of silo teams sharing a common overhead structure, but is this really what is best for the firm? Even sole practitioners can’t juggle all responsibilities, let alone every practitioner juggling the same responsibilities in an ad hoc inefficient way.

    Across Australia, I see very dysfunctional information flow and decision-making structure. I see a lot unproductive discussion, lack of decision making and minimal if any implementation. If you want to get a different outcome, you need to do something differently.

    Whether you run a professional practice by yourself, or with other business partners, it’s important to define decision making roles to gain efficiencies throughout the practice.

    Split out your organisational responsibility

    Organisational responsibility is the most underrated diver of success for businesses. This is partly due to control over decisions not being delegated and if they are delegated, they’re delegated without any rules and direction.

    Delegating ​responsibilities for day to day business decisions enables a business to make decisions in a timely manner while freeing up owners to generate more revenue for the business, implement strategic projects without distraction, but more importantly allocates responsibility for those making decisions.

    Right people making decisions = ​efficient and effective

    Delegation of responsibility should only be allocated to those who have the ability to make decisions and have the time to do so. If you as an owner don’t have time or the skill sets, hire those who do. Only with effective delegation of responsibility will you get action.

    Responsibility​ +​ accountability​ =​ action​

    Who takes responsibility for what?

    The owners of a business, or the board if referring to a listed company, need to be guardians of the business context. This is the vision of where you want the business to go. This same group should be the ones setting the goals and objectives that stem from the vision.

    Decision making context = consistency

    Strategies required to achieve the goals and objectives need to be set by the operations team. For most this maybe a combination of general/practice manager and key directors.

    Once the strategies are set, it’s up to the team leads to monitor the team/department KPIs, both financial and non-financial, and become the key link in communication channels from operations team to individuals. This is a vital role that gets missed. How are your employees meant to understand their expectations or the businesses goals and objectives is they’re not communicated?

    Finally, Individuals need to take responsibility for their own KPIs once known. They also need to understand what actions they take, and how these actions this links into businesses strategy. These actions should include the businesses core value.

    Core values = behaviour

    Why implement decision structures?

    To create change in your firm, you must change the structure around how decisions are made, and the structure around how decisions are implemented. A culture of responsibility and accountability at every level is required for success

    Decision making structures enable a business to run effectively if delegated to the right people who are empowered and have the ability to make those decisions. Decisions are likely to get made in a timeframe needed for effectiveness and in a consistent manner.

    Finally, remember to focus on the good things (which are usually the majority) and manage the exceptions (which are usually the minority).  You can choose where to focus your attention.

    The Different Firm Structures

    There are many options available now for structuring your professional practice. These include:

    • Sole practitioner
    • Partnership of individuals
    • Partnership of discretionary trusts
    • Service entities
    • Companies

    There are advantages and disadvantages for each structure, and the relevant choice, as always, is dependent on each principals’ and practice’s personal situation.

    Sole practitioner

    Being a sole practitioner has its appeal. You’re the only boss and the start-up costs are low. Establishing and operating your business is simple, you have maximum privacy and you keep all the profits. This is a great starting structure as it’s easy to change your structure later if circumstances change and wind up is easily should you change your mind.

    What you need to be aware is that there are some dire disadvantages for being a sole practitioner. You have unlimited liability for debts as there’s no legal distinction between private and business assets. Your capacity to raise capital is limited, while you’re taxed as a single person. It can also be it can be hard to take holidays and retain high-calibre employees

    Partnership

    In a partnership, you have more people to lean on for decision making, access to more capital and greater lending capacity. There is opportunity for income splitting according to performance and you are likely to attract a higher calibre of employees over being a sole practitioner.

    Your exposure to risk is much greater than being a sole practitioner, the liability of the partners for the debts of the business is unlimited with each partner ‘jointly and severally’ liable for the partnership’s debts.

    There are higher risk of disagreements and friction among partners while each partner is an agent of the partnership and is liable for actions by other partners.

    This is also another low-cost structure however one structure with the greatest future selling complications if partners join or leave, requiring value for all the partnership assets

    Service entity

    A service entity is a separate legal structure to provide asset protection by separating the running of the practice. Generally, it will employ all the staff, negotiate lease arrangements and sub-lease arrangements, purchase and provide equipment and incur all the expenses in the day to day running of the practice.

    The disadvantage is that you will also need to run more than one structure corresponding with service entity. Service entities practical use, now that most incorporation restrictions have been removed, is to share resources and lease arrangements between different parties.

    Incorporation

    There are many advantages of incorporation, with the main ones being an ease of succession, asset protection, taxation and cash flow management.

    Companies are also limited in liability and have greater access to leading capabilities provided the business is profitable and cash flow positive.

    A company can retain business profits and be taxed at 30% (lower for SBEs), the company tax rate and can be paid out in future years to control the businesses cash flow and taxation consequences.

    There are more associated costs in running your practice in a corporate structure than compared to a sole practitioner or partnership structure.

    Remember

    If you’re considering setting up and Incorporated Practice, make sure you seek advice to address all the issues that will impact on your decision.  Also be mindful of the significant advantages that incorporation provides and take a balanced view.

    Incorporated Practice

    There are many advantages of incorporation, with the main ones being an ease of succession, asset protection, taxation and cash flow management.

    Companies are also limited in liability and have greater access to leading capabilities provided the business is profitable and cash flow positive.

    A company can retain business profits and be taxed at 30% (lower for SBEs), the company tax rate and can be paid out in future years to control the businesses cash flow and taxation consequences.

    Some incorporate facts when incorporating

    1. You only need to transfer Goodwill and Fixtures & Fittings to the Incorporated Practice (IP), not WIP and debtors. This keeps the stamp duty cost down;
    2. The IP provides a layer of asset protection;
    3. IP simplifies partner entry and exit as it is only shares that are bought and sold, not partnership assets;
    4. If you are eligible for the small business CGT concessions, which most partners in partnerships or sole practitioners are, depending on the value of your net assets, CGT can either be completely eliminated or significantly deferred to ultimately exit from the business. Even better, with correct shareholding structured, you can maintain your access to the small business CGT concessions into the future;
    5. With appropriate asset structuring and funding in place, debt can be restructured into the IP to provide personal debt relief and repaid from after tax profits of 70% with interest being tax deductible, lower if the business is an SBE;
    6. By utilising correct shareholding structures, you can spread your share of business profits over your family members, including non-working spouse, children over 18 and even cap your tax at 30% in a corporate beneficiary, lower if the business is an SBE;
    7. You will receive fully franked income as dividends. If the ultimate recipient has a tax rate higher than 30%, you only pay the top up. If the tax rate is less than 30%, you get the difference back from the ATO

    Other considerations when incorporating

    One other issue that some firms don’t consider when they incorporate is the shift for cash to accrual in terms of the timing of when income is assessable.

    For firms that were previously on a cash basis for bringing to account their income, when they incorporate, they usually move to an accrual’s basis.  This means that the company (or principal if the company cannot retain profits) will pay tax on the income that has been invoiced, not received.

    If when you sell your practice to a company, you do not sell the WIP and debtors, and you were on a cash basis, then during the next year the WIP and debtors will be collected on a cash basis in your name, but the company will be taxed on all invoices issued. This can cause some cash flow issues if it is not adequately planned for.

    Remember

    If you’re considering setting up and Incorporated Practice, make sure you seek advice to address all the issues that will impact on your decision.  Also be mindful of the significant advantages that incorporation provides and take a balanced view.

    Structuring for Succession

    Implementing succession into your professional firm can be an extremely daunting thing. For most, this can be a new experience. For others, this maybe a second attempt at a bad succession strategy. Regardless of the reason, many questions are common in any succession.

    The most frequently asked questions I get are:

    • I’m wanting to retire, but don’t know how
    • What is my current practice worth?
    • Who is going to buy it?
    • How will I be paid?
    • Over what period will my succession process last?
    • What are the tax implications?
    • The two biggest questions that come from a selling practitioner once the decide they want to sell are:
    • How do it do it?
    • What’s the firm worth?
    • The first thing I need to tell you is … the closer to exit date without any plan the lower the value.

    Considerations for enabling succession

    To drive growth in your value, you need to increase your profits and reduce the risk. If you are considering your succession strategy and it is still a couple of years away, you need to start implementing strategies now to drive the value upwards.

    To enable succession, you first need to put yourself in the potential purchaser’s position. This is harder than you think as you will always take a bias viewpoint of your own interest.

    Many practices have engaged my services to manage the process just for this reason. Some taking up to two years to transition and agree because of said parties involved.

    When enabling succession, you need to make the firm attractive. Key areas that need consideration are:

    • Current legal structure
    • Current debt and cash flow structure
    • Funding that is available
    • Distribution strategy
    • Risk mitigation
    • Partnership criteria

    What are the common succession pain points?

    You may have an idea of how you can exist your practice, or even how to make it more attractive prospective purchasers, but what about the biggest challenges you will face during the succession process. The most common challenges that I see facing practitioners are:

    • Lack of consensus
    • No defined strategy
    • Assuming instead of agreeing
    • Agreement on valuation
    • Current structures are inhibiting
    • Deciding on a successor
    • Bias decision making
    • Timing of succession
    • Letting go

    Plan ahead

    Prepare detailed strategy and advice document for the firm to implement the plan, including step-by-step project implementation action plan regarding:

    • Consider Incorporation to make it easier for the new partner
    • CGT implications and procedures required to apply the small business CGT concessions to the sale by the partnership and restructure to an ILP, including personal taxation impact for each partner
    • Debt restructuring implications and deductibility
    • Review your current finance structure, both personally and business, and develop a debt strategy to retire debt and support your business cash flows

    Consider preparing a valuation for your practice for capital gains tax purposes and to support the correct allocation of purchase price of Goodwill as the transactions are between related parties

    Understanding your Efficiency Factor

    For professional businesses, efficiency can be described as the ratio between revenue and the direct labour cost to produce that revenue.

    The ultimate financial measure for an efficient practice is gross profit.  To improve gross profit from an efficiency perspective, you must ensure you carry the right amount of labour.  To determine the right amount of labour for your needs, you must have a “capacity management plan”. The starting point with a capacity management plan is to determine each team, department and wider businesses efficiency factor.

    Efficiency factor

    Efficiency factor is calculated by dividing revenue by capacity available.Efficiency Factor

    The efficiency factor KPI is extremely important as it indicates which affecting area needs attention to increase profitability, if you have capacity for growth, or are carrying too much. Refer to the below table as a guide from our experience.

    Efficiency Factor

    Capacity Management

    Capacity starts with understanding how many hours your professional employees are available to work, factoring all forms of expected leave and public holidays. The remaining hours will be what capacity is available (what’s possible).

    Applying these hours by the relevant professionals charge out rate will calculate this into a monetary value. Once you have calculated the efficiency factor KPI, then you need to analyse what the percentage ranges mean.

    Productivity

    Most professional businesses confuse their capacity management with the revenue component of a budget which usually incorporates a productivity target.

    Once administrative time is factored in, most professional businesses refer to this as a productivity target. Capacity management targets what should be possible for the business not what you would like to achieve.

    Affecting Factors

    Efficiency is influenced by the volume of work produced, number of revenues generating employees (fee earners), pricing of services, internal systems in place and the experiences of the professionals.

    Time to Review your Revenue Practices

    Firms become complacent, they continue the norms and assuming revenue will remain the way it always has. This is a dangerous thought process to fall into, and many firms step in and out of this mentality. With a slowing market in professional services sectors predicted over the next five years, “Legal” being one of the worst followed by “Accounting”, now more than ever is a good time to review and agree upon your practices revenue strategies. Remember HOPE is NOT a strategy.

    Types of Revenue

    The first place you start with any revenue strategy is coming back to the type of revenue your practice is generating. Revenue can be broken up into three high level categories.

    • Recurring revenue
    • Reactive revenue
    • Proactive revenue

    Proactive Revenue

    Proactive revenue is known revenue from year to year. For accountants, this can be your annual accounting services. For Lawyers, this can be retainers that you may have in place with your key clients. For Pharmacist, this can be your recurring prescriptions.

    Whichever professional services industry you belong to, this type of revenue is controllable and quantifiable, it is the amount that may change from practice to practice.

    Reactive Revenue

    Reactive revenue is revenue that walks into your door. Regardless of your Revenue targets, the customer comes to you. They may have purchased from you in the past, or it may just be convenient or circumstantial. This is revenue that is not controllable or quantifiable.  You must factor this into your revenue mix, but you cannot rely on it to occur.

    Proactive Revenue

    Proactive revenue is revenue that is controllable and quantifiable but requires resources to generate. Resources of both time and money. You need to create product and then you need to market a funnel for a said product while nurturing the qualifying process. Depending on your product and industry this may require more time and effort but less product to market, or vice versa. Using myself as an example. I specialise in advising professional businesses. I have defined what industry I work with and the range of services for the industry. I have a multi-channel marketing approach to reaching my audience. And half of my marketing activities can be quantified.

    Focus on what you can control

    Your practice needs to shift its revenue strategies to activities that can be controlled and have the potential to be quantified in some way. For all professional services industries, the activity categories can be separated out as follows:

    • Product
    • Marketing
    • Sales
    • Production and delivery
    • Client relationship management

    Time to Review your Revenue Practices

    The first three activities are related to winning the work, with the final activity ensuring the client comes back for work to be performed. This is the important activity in my opinion as it is much easier to sell services to existing relationship … so make sure you build one.

    Understanding Costs

    The cost structures of your firm are fundamental to its longevity. Understanding the link between more revenue and additional costs required (or the opposite), cost allocations, fixed or marginal costs has significant impact on profitability.

    Understanding costs will make sure your business is spending in the right areas as costs are not only tide to profits of a stable business, they’re also tide to generating revenue to grow or maintain current levels. Below are some initial area relating costs to challenge your thoughts for your business.

    Types of costs

    When people think of costs, they generally lead towards Fixed Costs which are predominately linked to labour and the majority of overheads. Fixed costs are fixed for a known period of time and can only be broken with notice.

    One of the biggest mistakes even accountants make is incorrectly allocating fixed direct and indirect costs to review a true reflection of the business to provide meaning.

    Then you have Variable Costs. These are costs that increase or decrease with usage or outcomes. The majority of variable costs are related to costs such as direct costs (including labour or contractors), utilities or commissions.

    Costs allocations

    You will also need to consider costs allocations in your business, especially at internal reporting levels. This will help identify profitability or team business units, service/product lines and even the success of projects. To have effective costs allocations, first you need to identify the nature of costs and how they are assigned to each area of your business.

    Potential consequences

    Cost Type Action Potential Consequences
    Fixed Costs Decrease

     

    • Decreasing fixed costs can lead to greater profitability if sales remain unchanged or if gross profit drops by less than the decline in fixed costs.
    • Risk if those costs are needed to generate of revenue.
    Increase
    • Increasing fixed costs can lead to greater profitability if sales increase through better service delivery by an amount which is sufficient to compensate for the increase in fixed costs
    • Risk if new revenue isn’t generated.
    Variable Costs Decrease
    • Decreasing variable costs can be effective if the product or service quality is retained.
    • Risk if the service/quality levels drops and has consequential effect on sales
    Increase
    • Improvement in product or service quality involves increasing variable costs but allows a higher price to be changed. This can improve profits if the price increase is both accepted by the market and sufficient to offset the higher variable cost.
    • Risk if the service or product cost increase is less than increase in revenue.

    Economic principles

    When applying economic principals to costs, there are a few key areas you need to understand. These are:

    • Profits are maximised when marginal costs equal marginal revenue
    • Shut down your business, business unit/service line or project when marginal and variable costs are equal
    • There is profit produced if price and quantity meet above average total costs

    Note – Economic principals assume there is perfect competition and no other factors come into play i.e. knowledge, location, relationship value. You need to apply additional factors that concern your business.

    Where do you start?

    If you’re unsure of where to start in your business, then simply start with identifying your firm’s cost structures. Assign responsibilities around costs moving forward and understand your cost links before performing a current cost structure review.

    Automate the Billing Process

    Billing is one of the worst looked after internal areas for professional businesses. Through neglection, most cash flow systems are designed for the benefit of the client, not for the benefit of the business.

    Furthermore, billing practices are left to technical employees who only want to perform technical work and not administrative work, further delaying the billing process.

    You set the rules of engagement, so why not design them around reducing the time between engagement and time to collect cash for work performed?

    Most Billing Processes

    Your billing cycle will, more or less, follow the process below:

    • Client work come in;
    • Client engagement letter (hopefully) sent;
    • Work started;
    • Interim fees end of first month;
    • Client queries sent out;
    • Waiting, waiting, waiting;
    • Client queries returned;
    • More client work;
    • More client queries;
    • Waiting, waiting, waiting;
    • Work finished, reviewed and sent to client (or maybe a client meeting to deliver);
    • Bill completed at the end of the month;
    • Waiting, waiting, waiting;
    • Cash arrives

    For those businesses who provide transactional types of work, the two monthly turnaround time can be reduced to one month. Even in this scenario, the date from commencing the work to collecting payment can be over 100 days. Below is a simple example explain this.

    Automate the Billing Process img

    Benefits of Automation

    There are many benefits from automating the billing process. The first benefit is an immediate cost savings in both time and resources spent. This leads into a simplified collection process, with invoices raised in a timely manner from monies in trust or via direct debit arrangements. Below is the same 100-day example with automation.

    Automate the Billing Process

    Indirectly, you will form better customer relationships for being upfront about the process and expectations. Automation can also be developed out of your core business technologies providing better information on your customers.

    Where to Start?

    If you want to get a different cash result, you need to change the way you engage clients. Therefore, start by reviewing your engagements and cost agreements.

    Fix your current agreements and engage clients around making billing an automatic admin function of the business in these engagements i.e. Initial fee billed when cost agreement is signed.

    Implement reviews. These should be weekly and focusing on WIP that can be withdrawn or billed. Reviews don’t stop with billables, follow up debtors weekly instead of monthly

    Remember to only focus on what you can control: the terms of doing business around billing and collections.

    Client Engagement

    It costs so much less to keep a client than it does to find a client. If you’re wanting to improve the cash flow of your business, one of the first places to start is with your existing client engagement. Client engagement is linked to both revenue and costs, and therefore significantly impacts cash flow.

    A strong client engagement process makes sure your clients play by your rules. It addresses your fees, therefore your profit, as well as the want to buy again, therefore your revenue. and your cash flow. Include a plain language covering letter with your costs agreement outlining the work, the fee amount, your billing cycle, your trust account policy (if one) and your payment terms. Then follow the rules that your client has signed up for.

    Client Relationship Management

    The sole function of client relationship management (CRM) is top manage the relationships so that clients come back to buy your services again and again. Clients and prospective clients have multiple touch points with the practice during the revenue cycle. Identifying these touch points will identify cost inefficiencies and leverage opportunities. Have the conversation about fees right at the beginning and it will sort out your profitability and cash flow, so long as you then bill it.

    The new work generally comes from your network, and this is usually tied to existing clients either coming back or referring someone to you, or from your referral network. What this means is that clients and prospective clients have already made up their mind that they are going to buy from you. They have made that decision based on what you have already done for them or based on what they have been told about you.

    Terms and Conditions

    Most firms have some sort of engagement processes, but what they do next is critical. Your clients have signed up for your services. They have signed a costs agreement, or have received a shorter form of engagement letter, depending on the matter size. Regardless, they have agreed to your terms & conditions. Yes, that’s right, your terms & conditions.

    The terms and conditions that some of you heavily rely on during debt collection proceedings for your clients apply just as much to how you engage with your clients during the service.

    Practice what you preach. Follow your own rules. Bill when you say you are going to, money into trust or upfront and top ups along the way, apply the rate you say (no WIP write-offs). If it’s good enough for you to tell your clients to do it, make sure you do it yourselves.

    How to Improve Cash Flow

    Lock-up is the KPI measurement between when an engagement or costs agreement is signed and when you ultimately receive all the cash for the work you have done. When you engage your clients properly, lock-up is reduced as your client understands the basis upon which you will help them, and that includes how you expect to be paid.

    Good client engagement will ensure the client is clear on how much they will be billed, when they will be billed, and when they are expected to pay. If you’re building a house and you don’t pay the builder, they stop work. If you buy some new shoes, you have to pay for them before you leave the shop.

    Your practice is a business. It must follow its rules around cash, which means your clients must follow the rules.

    Collection Processes

    Collecting cash shouldn’t be an issue if you integrate automation with the billing process as you will only need to deal with the minority of cases. For most professional businesses, the automation process is a work in progress, or they haven’t thought about how to collect from those troublesome clients. For these businesses, how you collect payment is critical to survival.

    Collection Techniques

    Communicating the businesses credit terms and expectations clearly and as early as possibly will ensure there is no confusion and sets engagement expectations upfront. Likewise, quantifying fee expectations in advance and communicating variations as they’re known will avoid confrontation upon billing.

    Change your clients and employee’s perception of overdue. Instead of your traditional 30, 90 and 120+ day methodology, change this to a “Due Now” and “Overdue”. This simple perception change alone will bring significate uplift in collections and will also identify those trouble collections early on before they turn bad. Where possible, automate/systematically follow up on debts and communicate this at the start or include in the engagement.

    In summary, the faster you bill and communicate, the easier it is to collect an aging WIP and Debtor amount owed. Don’t forget to be professional when collecting debts, non-confrontational reminders will get the best results for the majority while maintaining reputation i.e. the friendly reminder.

    Collection Policy

    Good collection policies will include a number of considerations. You need to develop a clear collection policy to get the desired results and state this in your engagement letter or cost agreement. For those who don’t know where to start, at the very least they should include:

    • A grace period;
    • Penalties (if any) post this grace period;
    • When collection reminder notices are sent and how;
    • When to send and when to call;
    • Expected actions that will be taken and when;
    • When are accounts placed with outside collection firms; and
    • When you will write off the account as a bad debt.

    Other considerations

    You, as a businesses owner, need to be all in. What I mean by this is consistency as well as a commitment to the process. Consider when sending invoices and when best to fit within the clients best timing and only discount where risks are higher.

    Consider who is the person responsible for the work and if their the best fit for invoice responsibility. Set KPIs around lockup and collections to drive the desired result.

    For those professionals who don’t want to follow suit, the KPIs should be linked to the sometimes-forgotten relationship. Accounts pay wages and bonuses, if you don’t bill and collect then the individual and team will be penalised in some way.

    If you have found this article useful and would like to know more, reach out to FWO today.

    Two Numbers

    It is easily get lost in the numbers, especially when you don’t know where to look. Most of the time it’s a combination of knowing what data to gather and collecting said data in its complete form.

    Having analysed numbers for thousands of professional businesses, there are two high level KPIs that you need to focus on to drive performance within your business. These are Average Rate & Lock-up Percentage.

    Continually focusing on these two numbers gives you the framework to drive improvement in profit and cash flow. Average Rate directly correlates to driving the profitability while Lock-up Percentage focuses on improving cash flow.

    Average Rate

    Average Rate is the calculation of revenue received over professional employee labour paid. This KPI tracks performance of individuals, teams, departments and the business as a whole.

    At a very high level, this KPI tracks performance by incorporating productivity, write-offs and recoverability over direct labour costs. As this number increases, so does businesses profitability (margin).

    Average Rate = Revenue / Paid hours of direct labour

    Lock-up Percentage

    Lock-up is a term that refers to revenue that hasn’t been billed or collected. Lock-up is a combination of unbilled revenue (WIP) and revenue that has been billed but not yet collected (debtors).

    Lock-up Percentage is the rate once Lock-up is divided by annual revenue. This KPI is very important for cash flow. By tracking how many days revenue sits idle and its comparison to revenue as a whole, we can understand how we can release cash.

    If you’re struggling to identify which KPIs are important for your business, more importantly if collecting said data in its complete form is also an issue, start tracking Average Rate & Lock-up Percentage. These two key KPIs will set your professional business on the right track.

     

    What you can Measure you can Manage

    Numbers don’t lie. But they can tell you the wrong story if you don’t read them correctly.

    A law firm has 5 key financial numbers that it needs to measure at least weekly:

    1. Productivity %: the percentage of total hours charged by fee earners to WIP of the hours they are at work
    2. Write-on/off %: the percentage of WIP billed either over or under the amount charged to WIP
    3. Average rate: the average amount of revenue earned per hour paid
    4. WIP days: the number of days of revenue that has been charged to WIP but unbilled
    5. Debtors days: the number of days of revenue that have been billed but hasn’t been paid by clients

    There are many more financial numbers that should be measured to provide a complete financial story for the performance of a legal firm.  Here I’m only focussing on the five key measures that drive improvement in revenue and cash flow on a daily basis.  To improve the financial performance of a law firm, you must first get these right, then the other key numbers will take care of themselves.

    These numbers are called key performance indicators (KPI’s).  KPI’s are more than just information.  These KPI’s measure the key revenue and cash flow activities of a law firm.   Albert Einstein defined insanity as doing the same thing over and over and expecting a different result.  So it makes sense that unless you do something different with the activities that drive these KPI’s, you won’t get a different result.

    Some key activities that will drive improvement in these KPI’s are:

    Productivity %

    • Set clear daily and weekly hours and $ based targets for each team member
    • Have each team member report on their $’s added to WIP (self monitoring)
    • Focus on marketing and sales activities to drive work for team members
    • Closely monitor work flow to ensure each team member is working to their capacity
    • Focus on file velocity (i.e. completion of matters)

    Write-on/off %

    • Engage all clients by providing an estimate of the work you will do for them and have clients sign off on this before you start work
    • Plain English covering letter stating terms of engagement attached to costs agreement
    • Re-engage clients during the matter when WIP is likely to materially exceed the estimate
    • Bill the amount in WIP
    • Ensure the right person is doing the right work at the right rate

    Average rate

    • Value the solution you provide to your client and bill them accordingly
    • Increase your charge rates
    • Set a minimum average rate per hour for the entire firm and bill to achieve this rate
    • Provide high end high value solutions to clients with your products/service offerings
    • Implement a marketing strategy that creates awareness around the value to the client of the products/service offering to them
    • Always remind the client of the value of the solution you provide to them
    • Constantly cross-sell & up-sell
    • Define your core product/service offerings and set minimum prices for them firm-wide

    WIP days

    • Engage all clients by ALWAYS providing an estimate of the work you will do for them and have clients sign off on this before you start work
    • Plain English covering letter stating terms of engagement attached to costs agreement which includes the timing of your billing
    • Bill clients early and often
    • Given that billing is aligned to the agreed timing and estimate per the engagement process, billing is to become an administration function, not required to be done by the fee earners until the final fee is prepared

    Debtors days

    • Take debtor follow up away from fee earners
    • Debtors collection to be the responsibility of a debtors champion (non-fee earner)
    • Define the debtor collection process
    • Deposit cash directly to trust account and review WIP every week (as a minimum) to withdraw cash to the general account

    Measure the outcomes of the right activities to get a different result.

    Different Legal Firm Structures

    There are many options available now for structuring legal practices.  These include:

    • Sole practitioners
    • Partnership of individuals
    • Partnership of discretionary trusts
    • Service entities
    • Companies

    There are advantages and disadvantages for each structure, and the relevant choice, as always, is dependent on each principals’ and practice’s personal situation.

    Since 2007, legal practices in Queensland have been able to incorporate.  Provided  there is compliance with the Legal Practitioners Act 2007, legal firms can now enjoy the same structuring advantages as most other businesses in Australia.

    There are many advantages of incorporation, with the main ones being:

    • Succession
    • Asset Protection
    • Taxation
    • Cash flow management

    Whilst any eligible legal practitioner can incorporate, the taxation benefits commonly considered to apply to all companies, may not apply to all practitioners.  It has long been understood that a company can retain business profits and be taxed at 30%, the company tax rate.  However, where the income is regarded as personal exertion income, this generally cannot be retained in the company and must be paid out to the principal.  A simple distinction between business profits and personal exertion income can be made by looking to who has earned the income.  Where there are at least the same number of principal and non-principal fee earners, on a full time equivalent basis, the profits are more likely to be regarded as business profits.  Whether a paralegal is considered to be a non-principal fee earner is a point for discussion.  My view is that they would not be considered a fee earner because they cannot provide legal advice as a legal practitioner.  So an incorporated legal practice where the principal is the sole fee earner with one or more paralegals and administration people will generally not be able to retain profits.  These profits would need to be paid out to the principal as wages and taxed at their marginal rates.

    These rules are different to the personal services rules, and should not be confused with them.

    One other issue that some firms don’t consider when they incorporate is the shift for cash to accrual in terms of the timing of when income is assessable.  For firms that were previously on a cash basis for bringing to account their income, when they incorporate they usually move to an accruals basis.  This means that the company (or principal if the company cannot retain profits) will pay tax on the income that has been invoiced, not received.  If when you sell your practice to a company, you do not sell the WIP and debtors, and you were on a cash basis, then during the next year the WIP and debtors will be collected on a cash basis in your name, but the company will be taxed on all invoices issued.  This can cause some cash flow issues if it is not adequately planned for.

    If you’re considering setting up and Incorporated Legal Practice, make sure you seek advice to address all the issues that will impact on your decision.  Also be mindful of the significant advantages that incorporation provides and take a balanced view.