Do You Need Timesheets to Determine Profitability?

Tom Kane of the Legal Marketing Blog posted Has Your Firm Tamed that Damn Billable Hour Yet? last week. He says,

• You can’t make a profit on fixed fees unless you know what your costs are;
• You can’t know what your costs are unless you know how much time (and other dollars) are consumed by the matter; and
• There is no way to know how much time is being spent on matters if you don’t keep track of hours!

Duh!

Tom isn't alone in thinking this way. But I challenge that 'Duh!' the idea that you need timesheets to determine profitability. I left a comment on Tom's post issue because I think it's one of the huge misconceptions that lawyers buy into - you need timesheets to determine whether you're proftiable.

It just happens that there's been a heated discussion about this very issue on a couple of legal list-serves over the past few weeks. Some of the discussion focused on calculating the profitability of a fixed fee engagement vs. the profitability of the same engagement when billed hourly. Other portions of the discussion revolved around overall profitability.

Here's an example of how the timesheet as measure of actual time (and therefore a component of profit) falls apart in terms of comparing fixed fees vs. hourly:

At this point I shave my billing quite a bit. I may spend four hours on something and then I think it really should have only taken me two hours and I end up billing for one hour because the client's total bill seems a little high.

The above is an actual quote from a lawyer participating in one of the list-serve discussions. Many other lawyers chimed in that they do the same. Whether they admit it or not, there are lawyers and law firms that add time to a bill even if they didn't spend the time - it may be unethical, but it isn't uncommon.

Whether they realize it or not, the lawyer that adjusts the bill up or down is actually looking at what they think the value of the service is to the client - so they adjust their time up or down to adjust the fee to be more in line with what they 'think' the value should be. The result? Often the fee charged really has nothing to do with the hours that were 'actually' spent on the engagement, even in an hourly context.

Of course, if you want to track profitability of an individual matter that's been billed on an hourly basis, what you'd really be looking at is the earned hourly rate, ,which takes into account that you worked three extra hours than you billed for.

But what happens if you're not billing hourly, but you're keeping timesheets anyway because you think it's the only way to measure profit (particularly in comparison to what you 'would have' charged if you were billing hourly)?

When you compare the hours reflected on the timesheet with what you were actually paid by a client on a fixed fee engagement, what adjustments do you make to the time on the timesheet? Do you mark down or mark off (or mark up) the same time that you 'would have' if you were billing hourly? Or are you simply multiplying hours by the rate you 'would have' charged? Can you really make an accurate determination of profitability this way?

Next, consider the difference between billing hourly and getting paid after the work is performed with billing on a fixed fee basis and getting paid up front. With the hourly bill, there's no guarantee that the client is going to pay your entire fee. In other words, the fee *paid* may also not be in line with the time spent. Do you take that into consideration when you're making your profitability comparison, or are you just assuming that if you had billed hourly based on your timesheets, that the client 'would have' paid the full amount?

Again, if you're determining profitability on an hourly billed matter, what you're actually paid (as opposed to what you charged) will be factored into your earned hourly rate. But the hours that you spend on client work aren't the only hours you work. If you really want to determine profitability, and you really think that time is a component of profitability, you have to take into account all of your hours. The problem is that a good number of those hours aren't allotted to any particular client, so they won't be factored into the equation when determining profitability of an individual matter.

For those of you that think that timesheets are a valuable tool to determine profitability - are you keeping track of all of your 'non-billable' time, whether it's tied to a specific engagement or not? If time is such a big factor in profitability, when you're considering the overall profitability of your practice (as opposed to the 'profitability' of an individual matter or engagement), you have to take all of that 'non-billable' time into account.

How do you measure the profitability of the hours you spend doing business development? Do hourly billing lawyers consider all of the hours spent reviewing timesheets and adjusting your bills in your profitability equation? Are you considering mentoring, staff management and other time in your profitability assessment?  Even lawyers that say that they keep track of their nonbillable time don't do so as meticulously as they do with their 'billable' time. How do you account for all of the time that isn't reflected on a timesheet?

Most lawyers think keeping track of time helps them with profitability assessments because they can look at the revenue received and divide it by the amount of time spent on the engagement, but what does that do? It gives you the idea that you 'make' $x per hour, or that it 'cost' you x hours in order to make $y. How, exactly does that show whether you were 'profitable?' What is the actual 'cost' to you of those hours?

In other words, if you believe that time is a cost, is it a fixed cost? If you aren't billing hourly, how do you determine how much an individual hour is worth? Are all hours worth the same in calculating profitability? Is the hour spent cultivating a client relationship worth the same as an hour spent preparing a letter or cross-examining a witness? What about an hour spent filling out timesheets? Or an hour surfing the internet? Do you calculate the value of an hour in terms of what revenue that particular hour could bring in, or do you calcuate it in other ways - such as the stress it may have caused, or the perceived difficulty of that task for you? And what about hours spent that might bring revenue from more than one source? How do you calculate the profitability of those hours? Does an hour spent on something you enjoy cost the same as an hour spent on a task you loathe? How does that play into the profitability equation?

All business owners, whether they're professionals or not, have the same number of hours in a day, a week, a month or a year to work with. Time is a limited resource for everyone - lawyers are not unique in that regard. So how do other businesses tell if they're profitable without keeping timesheets?

The truth is that profitability has nothing to do with time. The money that the firm pays to its employees, associates and partners are costs. The time itself is only a cost to the individual lawyer, not to the firm or the practice. And even then, as demonstrated above, the 'cost' of every hour isn't fixed. And I'd be willing to bet that most lawyers have a good handle on how much time they spend working, whether they're keeping timesheets or not.

Comments

[Kevin Houchin]

I like flat fees, without tracking hours, and have made better profits each month than I ever did worrying about the billable hour.

Revenue - Expenses = Profit

(Nowhere does that say "hour"). :-)

I'm now teaching other lawyer who work with small businesses & start-ups how to implement flat fee programs of their own. It works. It changes lives. It makes happy lawyers.

[Allison Shields]

Tom:

You're right - I went off on a bit of a tangent on your post because there had been so much discussion about timesheets in recent weeks. But the fact remains that most lawyers think that the only way to keep track of their costs is by keeping timesheets, and those that no longer keep timesheets have attested that tossing their timesheets hasn't hindered their ability to determine profitability. Keeping timesheets to determine costs puts too much emphasis on both time and costs, and not enough emphasis on the true 'stock in trade' of a lawyer, which is their knowledge and ability to use that knowledge.

While I don't disagree that the amount of time a lawyer has to devote to a particular matter is one of the costs to the firm in providing their services, I don't think that time is the most important factor, nor do I necessarily agree that if 'more time is spent than should be, it is time that cannot be spent on other income producing matters.' Often, time spent on one matter provides value on other matters as well - by educating the lawyer about a particular issue, matter, industry or client. And often that knowledge or skill can be leveraged for use with another client or another matter.

And, while I agree that time is a cost, I still don't think it's necessarily the most important cost - as long as the firm is providing value to the client, and the client is paying for that value. And while too much 'dead work unit time' and not enough 'work unit time' as you've called them may create a problem, the real difficulty is in determining what is enough time and what isn't - there are certainly instances where DWUT can outweigh (or even far outweigh) WUT and the firm can still be profitable. But where the emphasis is so heavily weighted toward time, it's difficult to conceive of those situations, or to innovate and reward people based on results.

[Tom Kane]

Sorry for the delay in responding as I was on travel with limited access to the Internet.

Thanks for the mention, but unfortunately you misunderstood my post. My post wasn’t about timesheets. It was about costs, costs to the law firm to render legal services on a fixed fee basis. I did not even mention timesheets. I really don’t care how one determines their labor and other costs, but determine them they must, if they are to charge clients by a flat fee and make a profit.

My mechanic doesn’t keep timesheets, but he charges me according to how long it will take him to repair my transmission or timing belt, plus parts. How does he do that? He knows from experience. Actually he cheats most of the time. He uses an industry-wide manual that tells him how long it will take to do a certain job on a specific model car. But the point is the same. He KNOWS (or is close to knowing) based on experience (his or others in the industry) what it will take in labor (time) to do the job.

Although they don’t have an industry manual to call upon (the U.S. Supreme Court took care of that by striking down minimum fee schedules in Goldfarb vs. Virginia State Bar (1975)), law firms (hopefully) have enough past experience on the costs associated with the types of matters for which they are pitching clients.

A lawyer’s time is very important to the cost factor in any firm. As Abraham Lincoln said “A lawyer’s time (cost) and advice (value) is his stock and trade.”(parentheticals are mine) So, a professional’s time (labor) is the major factor in a law firm’s cost of providing legal services. It isn’t the only cost involved. Let’s call the others “parts” – overhead (i.e., rent, staff salaries, etc.), court reporter, expert witness fees, etc. etc. I referred to them as “and other dollars” in my post. All must be considered in determining the actual costs of rendering legal services to clients. Based on a firm’s experience on earlier files, it should be able to ascertain the labor costs necessary on a particular matter.

You raise many interesting questions in your comparing hourly billing to fixed fees. IMHO it only complicates the issue relating to flat fees. I like fixed fees because, if a firm knows its true costs, it can make more money in the long run. The reason is simple. A firm can charge the same fee for like matters to clients no. 2, 3 and beyond, while expending a fraction of the time it took for client No. 1.

I disagree that the “cost of every hour isn’t fixed.” Using a lawyer as an example, their hourly cost to the law firm is based on their salary, plus benefits, and overhead attributed to them for putting them in a chair, divided by 2080 hours or 260 days per year (excluding weekends). The firm pays that whether they work on one matter or dozens. Those are the costs of labor to the law firm. The labor costs on a given matter is based on which and how many laborers are used to render the legal services in question.
I would concede that you don’t need timesheets to determine the hourly cost of labor. The CFO can tell you that using the above formula. But to determine your profitability (revenues minus costs of labor and parts) on a fixed fee matter, you do have to know by some method what part of your costs, including labor costs (time) went into that specific matter to know if it was profitable.

Okay, so now the firm has a handle on how much labor time (let’s call that “work unit time” (WUT) and parts it will take (based on experience or “good” guess work) for a given matter, it can set a fixed fee based on the amount of profit the firm wants to make. (Whether a client will agree to pay that amount is a separate issue.)

Now, let’s look at what we’ll call “dead work unit time”(DWUT). It is time spent on what is often referred to as nonbillable time (marketing, administration, management, training, mentoring, taking smoking or coffee breaks, time goofing off on the Internet, etc. etc. etc.). Whether a firm’s time is WUT or DWUT is of no concern to a client as long as their matter is dealt with properly and they receive value for their fixed fee. But, it is of great concern to the law firm’s managers when it comes to profitability as to how much of a lawyer’s time is WUT vs. DWUT. If at year’s end there is too much DWUT and too little WUT, the firm will be unprofitable and in deep trouble.

The reason to track time on a matter is to ensure that labor costs of WUT matters are not out of line, and the firm is not losing money by the lawyers spending more time on a matter than what was budgeted for in the flat fee. If more time is spent than should be, it is time that cannot be spent on other income producing/WUT matters.

As to the overall profitability of the firm in any given year, one only hopes that WUT matters far outnumber DWUT. So, the purpose of tracking time is to find out how much of the law firm’s labor costs are recovered by that specific matter’s fee. Whether timesheets are needed to track the hours, days, weeks, or whatever in labor costs, I can’t say for sure. But, I haven’t heard a better suggestion in terms of getting at least close to what the accurate costs of a fixed fee engagement are.

Whether a prospective client likes your fixed fee based on your firm’s costs plus profit is not the point either. If they don’t like it, they won’t pay it and hire another firm. That doesn’t change the basic economics involved. If a firm’s flat fee is too high, it will need to adjust either its costs or its profits. It can’t know if it needs to do that unless it has a handle on whether its fixed fees are profitable. And if it doesn’t know that, it should consider changing its name to “Whiteacre & Blackacre, Auto Shop.”