In a recent Legal Project Management workshop that I conducted, several law firm partners and I were discussing the importance to clients of predictability in their legal budgets. Most agreed that if a couple dozen outside law firms submitted invoices that were delayed and over budget by even a modest amount, the aggregate impact would be troubling to the client. However, few agreed that on an individual basis, any one invoice could cause much harm. I explained that something as simple as a $15,000 surprise on a legal invoice on a $100,000 matter could have far-reaching impacts. Those familiar with chaos theory recognize the butterfly effect as the potentially large impact of seemingly innocuous small actions, popularly characterized as the flapping of a butterfly’s wings leading some weeks later to a hurricane in another corner of the globe. There was also a popular film of the same name demonstrating this concept. The partners found it helpful for me to illustrate mathematically how this concept plays out in a corporation.
I won’t go into great detail into corporate budgeting here, but let’s stipulate that businesspeople spend a lot of time building budgets for every function, for both the cost and revenue sides of the ledger. And then they hold periodic “re-forecast” reviews to address the inevitable changes that take place, such as revenue for Product A coming in under budget, revenue for Product B trending well above budget, personnel costs below plan, supply chain costs above plan, and so on. Imagine it’s late November and Big Co. has just concluded its final re-forecast session of the year and all changes have been noted and locked in.
Smith & Jones LLP, is one of Big Co.’s trusted law firms, and has been handling a thorny litigation matter for the better part of a year. The firm sends Big Co. an invoice for $55,000, which is $15,000 more than the relationship partner estimated at the last budget review meeting in September. There has been no update since. The invoice reflects billable hours conducted in September and October, and because of the usual delays in collecting daily time entries and the arduous pre-bill review process, the invoice isn’t sent to the client until late November. The General Counsel is aghast and reacts pretty strongly, even though the invoice reflects reasonable fees for legal work that was essential to achieving a favorable outcome in the litigation, though admittedly this includes some work that the firm did not anticipate back in September. The billing partner is baffled by the GC’s reaction, because the firm achieved the outcome that Big Co. wanted. Let’s examine the chain of events this delayed over-billing triggers.
First, the GC’s compensation includes a meaningful portion based on the ability to remain within budget. Had the GC been aware of the potential over-billing even a few weeks earlier, she could have worked with the Chief Financial Officer to shift priorities and funds to address the need. Now, sadly, the GC is likely to lose some personal compensation because the surprise occurred so late in the fiscal year… there goes the shore house rental next summer! Secondly, the GC has to visit the CFO with hat in hand and sheepishly admit that she didn’t really have a handle on the legal budget that was reviewed in exhaustive detail mere weeks before. By contrast, her colleagues managing Big Co.’s supply chain were able to reasonably estimate the immensely variable costs of shipping, manufacturing and labor, and her colleagues managing Sales were able to forecast revenue in a very competitive marketplace within a small margin of error.
What options does the CFO have at his disposal to deal with the overage? Most good CFOs employ clever hedging strategies that can produce emergency funds in a pinch. But so late in the fiscal year, there aren’t a lot of options. He can consider a layoff, but to net $15,000 in payroll savings in the coming month, after severance costs, would require a fairly sizable layoff of junior employees, or showing the door to a highly compensated individual or two. But Big Co. doesn’t relish the optics of conducting a layoff in the middle of the holiday season, so that option is off the table. The CFO then looks at other expenditures to see what can be eliminated, but his insistence that every function phase the budgets precisely means that no functional budget has any excess unspent funds at this late date. So we have to look at generating new revenue to cover the shortfall.
Let’s imagine Big Co. operates with a gross margin of 10%. This means that to cover a $15,000 expense overage, it must generate $150,000 in gross revenue. If Product A has a unit price of $10,000, Sales must move 15 new units in the next four weeks. Of course we can’t forget the 5% commission associated with the sale of each new unit, so we need to bring in another $7,500 in revenue, for a total of 16 units, to cover this cost. As it turns out, the sales cycle for Product A is typically 3 months, and the Sales team has by this point in the year picked all the low hanging fruit. To move new units in the compressed time frame of one month requires an additional 5% commission incentive and a 10% price break. Now we need to sell 18 units to cover the legal invoice over-billing. But let’s not forget that revenue for Product A can’t be recognized all at once. This product has a revenue recognition schedule of 50% at sales closing and 50% at final delivery, which is typically 6 months later. Since only half the revenue can be immediately recognized, now we must sell nearly 40 units or almost $350,000 in the next four weeks. Imagine the delight of the Vice President of Sales when the CFO calls to demand 40 additional sales of Product A with less than a month left in the fiscal year, a period which includes a fair amount of down time due to the holidays.
The CFO is not pleased with the GC’s performance; the Sales VP is extraordinarily displeased with the GC — the department that already slows down every sale by requiring grueling contract reviews; the GC’s family is unhappy because the summer break will now consist of a staycation; and the GC is unlikely to retain Smith & Jones LLP again because of this transgression. Yet the the billing partner remains blissfully unaware, because in his mind the firm achieved the desired outcome through good lawyering, which is what should matter most to the client. Had the partner alerted the GC in September, or even October, that some additional wrinkles in the litigation would incur some additional hours, then this overage could have been addressed in the re-forecast exercise. Had the firm employed some process improvement techniques to reduce the delays between posting time and invoicing, the GC would have had an early warning. Had the firm relied on a budget and legal project management tools, the deviation from the expected course would have been obvious to all immediately, not months later.
When I walked through this anecdote with the partners at my workshop, I relied on several pages of a flip chart, lots of barely legible scribbling and some off-the cuff calculations. We had some fun doing the math and acting out the reactions of the various parties. But make no mistake, this is a deadly serious issue. As a Chief Legal Officer reported in a client interview I conducted for a law firm client some months ago when we discussed billing policies, “The first time a law firm makes the mistake of over-billing without notice, I’ll scold them and give them another shot. If they do it again, I’ll write down the invoice and simply refuse to pay it. If they do it a third time, I will not use the firm again and I make it a point to tell my colleagues in other companies of my experience.” I asked the CLO if he tells firms when they’re fired under these circumstances. “Never,” he declared. “They probably assume they’re still on the short list but that I just don’t have any relevant matters. Or maybe they assume some competitor has undercut them on price. Rarely do they even call to find out why I haven’t hired them lately. And those that do call, I don’t have the time to explain how their delays and over-budget fees complicate my life. Instead I just tell them their rates are no longer competitive.”
Law firm leaders, as you look at your own operations, it’s important to know the consequences of your firm’s actions. Like the butterfly flapping its wings and causing a tsunami a world away, do your actions — or inactions — create devastation that you never see or hear?
Timothy B. Corcoran delivers keynote presentations and conducts workshops to help lawyers, in-house counsel and legal service providers profit in a time of great change. To inquire about his services, contact him at +1.609.557.7311 or at firstname.lastname@example.org.