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Why budgeting and cash flow forecasting are essential for effective law office management

Regardless of your opinion of budgets, they are vital for building and managing a law practice, says Brenda Barnes, a certified public accountant (CPA) and managing principal of B2 Management and Consulting LLC. She adds that while lawyers often don’t appreciate or pay attention to budgets, they are critical to financial planning within your firm.

The benefits of a budget

“Your budget maps out your firm’s plan for financial growth and profitability and provides a powerful tool for identifying opportunities and avoiding problems,” says the Austin, TX-based accountant.

“Your budget maps out your financial success. If you don’t map it out, how are you going to know where you are going?”

Budgeting also ensures that your firm’s plans are financially viable. Imagine you’re sitting with your managing partner, conducting your planning and implementation strategy for the coming year, and the MP says he wants to add on an employment law practice. Part of your budgeting process will allow you to see whether or not the firm can afford to add overhead.

“It takes a good six months for even a partner with a good book of business to get up and running. Budgeting is a great way to put your firm’s plans into hardcore numbers,” she says.

A budget also provides law office managers the opportunity to identify areas of potential cost-savings and increased revenue.

Let’s say your MP has asked you to reduce overhead by X percent, when you have a budget in place you can compare it to your actual expenditures for the past year and see areas where you have gone over and under budget, and why that has happened.

Other benefits of budgets:

  • They can be used as a method to gently force policy decisions, such as decisions on business travel to conferences.
  • They can also encourage certain types of behavior. For instance, Barnes says if associate mentoring is an important directive at your law firm, then you might want to establish a budget per attorney regarding how they are rewarded for investing time in mentoring.

The budget basics

Budgets are generally set for one operating cycle, most likely a calendar year. They typically focus on the income statement—revenue minus expenses.

Budget are also frequently aligned with your business’s strategic plan and talk about what the next year or beyond is likely to hold for your firm.

There are different kinds of budgets. Zero-based budgeting is typically used by very new law firms or ones that have undergone significant changes, such as mergers or acquisitions. Basically, you are starting from scratch.

However, Barnes says most firms employ incremental budgeting, where the data from the previous year or couple of years is entered on Excel spreadsheets. All these worksheets can be linked together and you can make comments and notes on what has occurred during that year, and use what you’ve learned for planning next year’s budget.

Barnes adds that “trends are our friends” that are valuable for supporting and validating your cash flow models.

Trend data can also influence changes in your firm’s behavior, for example, billing cycles, collection cycles and time of draws and profit distributions.

Looking at revenue drivers

In establishing a firm’s fee budgets, law office managers need to understand key revenue drivers—including billing rates, productivity/hours, realization and industry measurements—and how they contribute to the bottom line.

Barnes says most lawyers have low billing rates, default rates and high rates.

“You are going to want to take a look at what their effective billing rate has been and your time and billing system should be able to deliver that information for you,” she says. “Budget time is a good opportunity to evaluate the rate that you’re charging your clients.”

As salaries and expenses increase, it’s important to have a corresponding increase in rates, says Barnes, adding that clients need to be informed about rate increases and why they are necessary.

You also need to know your firm’s cost per billable hour. To determine that figure, take total monthly expenses minus attorney salaries to determine your overhead costs. Then you need to divide that figure by the number of billable hours to calculate overhead per billable hour. Next, add back in attorney costs, including salaries and benefits, to determine cost per billable hour.

Next, determine your profit margin per billable hour.

“If the average partner’s billing rate is $391 per hour and your gross billing for that partner is 1,500 hours, you know you are billing out about $587,000. If your billing realization is 93 percent and your collection rate is 80 percent, your overhead per attorney is $96,000.

“So then you have a net available to pay that attorney and deliver the required profit margin of $340,000. On a profit margin of 35 percent that means that partner would only get paid $221,000,” she says.

Most partners are not going to be satisfied with $221,000, according to Barnes. That means that billing rates either need to increase, attorneys’ billable hours must increase, or the firm needs to do better with its collection realization.

“Accurate budgeting creates predictable owner compensation. If you split the pie up based on origination percentages and collection percentages, the budgeting and the cash flow forecasting are able to really help you determine what’s going to be left after you get your basic fixed costs paid for,” she says.

Don’t fiddle with the budget

“There is a difference in budgeting which does not change, versus a forecast, which reflects the actual events and requires regular monitoring,” says Barnes.

She says attorneys typically want to change the budget anytime something alters within their law firm, but changes should only be made when there is a significant shift in operations, either on the revenues or expense side.

Barnes recommends that law office managers try to discourage partners from asking for budget revisions unless there is a significant operational change, such as a new practice group or a merger.

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