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A law firm negotiates complex financial transactions for sophisticated clients. One day the client relationship partner receives a call from her client. Her client says something like this: “I know you will be surprised by this call because we have not talked much about our changing needs. However, we have found a quality law firm that can deliver most of the transaction services you provide through an intranet subscription, and we are going to switch law firms. They can provide the legal services we need in these securities transactions at 20 percent of your fees and at twice the speed. Thanks for all the help in the past.” As the lawyer hung up the phone, she started asking herself the following questions: “How can they do that without lawyers? What am I going to do with the 12 lawyers that work for this client? How did this other firm do this? How did they finance it? What is next?” This lawyer just discovered that she and her firm were managing their financial affairs under the old guild environment for delivering legal services. She remembered her college history lessons. The industrial revolution had destroyed the old guilds more than 100 years ago while the old guild masters had sat smugly on the side lines believing their past successes would protect them. Her firm must develop a system that focuses on the return on investment. Enter the need for a new approach. In the past, the firm had planned and managed its financial affairs based on an old paradigm in which law firms controlled the supply of legal services. The shift of control from the law firm to the client makes the old financial management methods ineffective and causes problems. The firm projects the future based upon the past assumptions about timekeeper hours and the effective collected rates that would be sustained during the planning period. Second, the law firm uses a cost-based financial reporting system that assumed the total cost of doing business is the sum of all separate cost centers in the firm, e.g. a lawyer, the library and other costs. 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 projections based upon past success and cost accounting dangerous to the health of the firm. Activity accounting is the new tool that helps firms plan for and manage the increasing cost of resources, e.g. associates, the clients’ demand for efficiency, the demand for discounts, the assimilation of new practices and lawyers into the firm, and partner performance and contributions. Activity accounting measures everything as a return on the investment of firm resources against the firm’s potential revenues. How to make activity accounting work in financial planning and management. Step one: Establish a context for financial planning. Step two: Set up new reference points for your potential revenue and distributable income. The objective must be to foster teamwork, collaboration and innovative ideas that will improve the size of the pie. By using activity accounting in one $40 million firm, partners were able to identify where to recapture 10 percent of their lost revenues and thus increased the partner income pool by $4 million. STEP ONE: Establishing a Context. A law firm cannot start an effective financial planning and management process until its partners establish strategic criteria for how they will allocate critical resources. Those criteria are based upon well-understood statements of vision, core values, mission and strategies. Using that understanding, firms can create a client investment model and a service investment model. STEP TWO: Migrate to Activity Accounting. Activity accounting focuses on the full potential of a firm — what the firm could achieve if it was organized and running to meet the needs of the market. The firm would capture 100 percent or more of its billing rates, fully utilize all timekeepers and maintain the lowest possible overhead per revenue hour. This is not zero-based budgeting but “potential” budgeting. If a law firm is experiencing a 61 percent overhead factor, it is not as much of an expense problem as it is a revenue problem. A visual example of activity accounting is four tanks with connecting pipes. Each tank has clear water at the top, representing income, and a thick liquid at the bottom, representing overhead. The first tank represents potential revenues. The second tank represents work-in-progress. The third tank represents accounts receivable. The final tank represents collections. Under the old assumptions, the tanks and the pipes have leaks. Potential Revenues (tank one) starts full and represents the potential revenues from available billable hours from each timekeeper (P) times the expected return on time (BR) times the number of timekeepers. However, this tank already has a leak in it. Some lawyers don’t feel compelled to bill at their expected return on time. The pipe from tank one to tank two also has leaks including the following: 1. current agreements with clients to discount rates in return for volume; and 2. poor time recording. A loss of 10 percent here reduced distributable income by 10 percent. While in the WIP (tank two), a leak develops as the value of time ages 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. The pipe connecting the WIP (tank two) to Accounts Receivable (tank three), leaks from poor project management or lack of communication with clients. Time and/or rates must be written down. A loss of 10 percent here reduces the return on resources to 81 percent (90 percent times 90 percent). While in Accounts Receivable (tank three), dollars evaporate as the receivables age. On the trip down the pipe connecting the AR (tank three), to the Collections Tank (tank four), other leaks appear from lack of communication with the client about scope and progress. Clients balk on paying the full bill. A loss of 10 percent here reduces the return on resources to 72 percent. What is left in the Collections Tank (tank four) contains only a fraction of what was in the first (potential tank). Realization on potential revenues carries no overhead load. If the $40 million firm had overhead of 65 percent, the $14 million would be income. But if the firm had realized a 100 percent return on its potential, it would be a $55.6 million firm, and income would have been $15.6 million more or $29.6 million. These tanks may be graphically represented in bar charts for the firm, an office, a portfolio of clients or projects and a working lawyer. Using activity accounting to measure the return on investments by the firm allows leaders to do several things: 1. measure the true contribution of lawyers in their return on firm resources; 2. identify and determine the return on investments in new practices and clients; and 3. determine where the firm should invest in new services, partners and lateral hires. When a firm sees everything as an investment decision and not a cost or profit center decision, expert systems such as the one the client wanted would be a great investment. William C. Cobb is the president of WCCI Inc. Cobb Consulting based in Houston. Cobb has been a national consultant in strategic issues affecting professional service organizations since Jan. 1, 1978. Cobb provides counsel to improve the competitive position of his clients. He can be reached via e-mail at [email protected] His Web site is www.Cobb-Consulting.com.

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