Building a Better Budget
This CE course will cover the basics of creating a meaningful budget for your firm.
This CE course will cover the basics of creating a meaningful budget for your firm.
Budgets are a vital component of any firm’s operations, regardless of size. They increase awareness management gleans about the external economic environment in which their firm competes. But what makes one budget better than another? What are the elements that make a good budget and how can you improve your role in the budgeting process, while adding value to the finished product and to your firm or legal department? To be useful, there are certain elements any budget must have and principles one should always follow when establishing a budget. This CE course will review those elements.
CLM® Application Credit: Financial Management for Recertification toward the hours needed by Functional Specialists applying for the exam
CLM Recertification Credit: Financial Management
Preparing, debating, defending and finally approving budgets can be a tedious process. Even as a finance professional, this is one of my least favorite things to do. I’m much more comfortable with analyzing actual results than the predictive side of finance. My firm, however, strongly suggests I do both. I get it — a budget is a comprehensive financial plan used to both predict and guide an organization’s financial and operational goals over a period of time, normally its fiscal year.
Most law firm or legal department managers spend much of their time and energy focused internally on the day-to-day business operations. But budgets force us to look externally at things like changes in market competition. These can be indicative of how much consumers will be willing to pay for legal services, among other things. For example, changes in the market rates paid for legal secretaries, paralegals, associates and other administrative staff is also important to assess when budgeting.
We’ll look at how you can plan a budget that covers all these important facets.
First, in order for any budget to be useful, it must be reasonable or realistic. Sure, it would be nice to increase revenues by a factor of 10, but is it reasonable? A company with revenues of $10 million in 2019 isn’t likely to grow to $100 million in the absence of some extraordinary circumstances. So, while we would all like to see this type of top-line growth, it isn’t reasonable and, therefore, isn’t useful. While predictive by their very nature, budgets must still be grounded in facts.
They are also great tools for performance evaluation. Budgets are used to control costs and monitor progress toward stated law firm goals. Periodic comparisons of actual results to budgets (often monthly) can be the first indicator when financial performance goes counter to predicted results. Department managers or practice group leaders — working together with the rest of the management team — should be able to explain these variances to budget, including whether they are over or under budget. This early indication can be the difference between small adjustments to get back on track and an out-of-control financial spiral.
Additionally, budgets should be flexible. The old adage that “the only constant in life is change” rings true. In today’s business world, the rate of change is ever increasing, and the need to be flexible cannot be overstated. Changes in technology, business processes, operating environments and markets can throw the best laid plans into disarray. Managers need to quickly adapt to these changes, but resist the temptation to adjust budgets when they occur — only in rare situations should you adjust the budget. Recall that budgets are used to access and evaluate performance metrics. If these performance assessments point to necessary adjustments to operational goals and plans, those can be noted and explained without updating the actual budget.
Finally, budgets need to be clearly communicated to management and anyone who has influence or decision-making authority. Some firms make the mistake of not sharing the budget with the appropriate team members. In not doing so, they limit the likelihood of achieving expected results. The more organizational buy-in you get, the more potential for achieving success you have. Remember, the budget serves as both a goal and a guide for your firm.
Department managers or practice group leaders — working together with the rest of the management team — should be able to explain these variances to budget, including whether they are over or under budget.
Budgets also help to coordinate the planned activities across firms or legal departments. Seeking input from IT, marketing and all practice groups can make sure that everyone across administrative and legal departments is on the same page. For example, if one practice group is reporting a 30% increase in revenues, this may generate healthy budget discussions across the firm. How much additional marketing will be required to achieve this result? Will the increase be generated by existing staff? Or will headcount grow? If headcount grows, does that require additional software licenses and new hardware? Additional space? What are those costs, and how will we pay for or finance this planned growth?
All these questions would need to be answered and addressed from a financial budget standpoint in order to properly plan for them. Unfortunately, the answers don’t all lie in the same type of budget, so we’ll need to explore a few of the most common budgets to find all the answers.
The operating budget is the most common and perhaps the most used of the three budgets we’ll discuss. It deals with the day-to-day operations of the firm and should address anything appearing on the income statement.
These budgets look at total revenues, but should also be broken down into various components depending upon how firms compartmentalize their operations. For some, this could be done by physical location or region, while others may choose to view it by areas of practice. Some may do both, drilling down into various practice areas within each individual location.
Taken another step, the data could be mined further, looking at individual attorney performance within the two broader categories. The point is not which data classifications you use to break down the numbers — rather that you use some system that provides the most meaningful data for your firm to make the best, most informed decisions to keep moving forward. Problems can be isolated much more quickly and efficiently when looking at smaller subsets of data. Remedial action, if needed, can be more targeted, too. The use of cost centers is common and an easy way to categorize and allocate costs across whatever “compartments” your firm determines as most useful.
When considering revenue growth, you may want to first look at the current or immediate past year, as past performance can be a good indicator of future results. It isn’t perfect, but I find it a very good starting point. As a next step, dig into the revenue sources and determine which are likely to repeat, which may go away, and which are likely to grow in the coming year. Factors to consider as you look at these three buckets are industry trends, political or regulatory drivers, rate sensitivity, etc. All these factors can be evaluated through discussion with attorneys or practice group leaders.
For example, if your firm is increasing rates by $25 per hour across the board, you may look at the total hours billed last year (or projected for the coming year) to properly account of the projected revenue increase. It’s pretty simple math, but can be easily overlooked in the hustle to get something out to your partners or management team. Be conservative when budgeting revenues.
When it comes to expenses, budget fixed expenses first. Many of these will be known, as they don’t adjust year over year. Some, like escalation clauses in leases, may increase annually, but they are formulaic and therefore already fixed. Parking, support or maintenance contacts may also fall into this category.
For variable expenses, you will need input from several sources. Hopefully, this will include your marketing department. They should have a handle on projected marketing efforts for the upcoming year and can help with this. Another significant area is technology. Discussions with your in-house technology team or your contracted IT partner should focus around equipment upgrades, new or updated software rollouts, licenses, server replacement and telephone equipment, support, and leasing contracts. As you review planned expenditures, don’t forget to include costs for retraining employees.
When considering revenue growth, you may want to first look at the current or immediate past year, as past performance can be a good indicator of future results.
Budgets should take into account as much as you know about the year for which you are budgeting. For example, if you know your firm plans to bring in new associates in the fall, be sure to include this in the budget. Assume new associate offers have already been extended and accepted, and start dates are October 1 of the coming year. Your budget needs to reflect three months of salary costs for the new associates, appropriate amounts for insurance and other benefits that align with any waiting periods for eligibility, any per-employee added costs and appropriate onboarding costs. You’ll also need to consider revenue increases associated with the new fee earners.
The capital expenditures, or CapEx, budget is used to plan and evaluate needs for investments in your firm’s physical assets. Once again, this should be a process involving everyone on the management team. For many law firms, some of the most significant expenditures are for fixed assets. This could be a new or upgraded telephone system, new computer servers, updated desktops, laptops, furniture, a build-out on leased space and a plethora of other items. Anything that would be capitalized on the balance sheet as opposed to being expensed on the income statement belongs in this budget.
Economic recessions or depressions can lead to slow paying clients, aging accounts receivables and reduced cash inflow. Taking time to assess and predict these results can often help firms negotiate more lenient payment terms with suppliers, banks and others who have extended credit to your firm.
Plans to remodel an office or acquire new office space would definitely be accounted for in the CapEx budget. Firms will likely break this down into smaller components, often using the same classifications used in the operating budget, be it location, practice area or department, etc. Once your firm determines what level of investment is planned, they must then determine how to pay for the investment.
Will operations generate sufficient cash to meet current operating expenses such as salaries and overhead? Plus will there be enough left over to fund the capex budget? Will short- or long-term financing be required? These are questions best answered in the cash flow budget.
The cash flow budget is used to convert accrual accounting back to cash basis accounting, and something management can use to predict cash balances. Firms use this information to determine whether they have enough net working capital to operate during a specified period of time. Positive or excess working capital can be invested to maximize earnings, or used to repay other debt and thus reduce interest expense. Conversely, if a deficit cash flow is forecast, firms may need to consider financing options such as increasing operating lines of credit.
You should also review payment terms extended to firm clients and what the collection history has been. Analyze the overall economic conditions driving your market, too. Economic recessions or depressions can lead to slow paying clients, aging accounts receivables and reduced cash inflow. Taking time to assess and predict these results can often help firms negotiate more lenient payment terms with suppliers, banks and others who have extended credit to your firm.
On the other hand, an economic expansion can lead to quicker payment and having too much idle cash on hand. Management may choose to distribute some of the cash to shareholders and invest in the short term or to simply finance the CapEx expenditures with cash on hand.
So, where do you begin the process? Two of the most common approaches to budget building are the top-down and bottom-up approaches. As the names describe, the top-down approach begins the highest level, and pushes information down to the various business units, locations, practice group or whatever business segments used in the firm. This normally begins with top level management determining what the overall firm goal is and then asking segments what they will do to achieve these goals.
Conversely, a bottom-up approach normally begins with the lowest level segments reporting their forecasted goals up through firm hierarchy. Attorneys may report individual plans to practice groups, who then report to geographic location cost centers, who then report to corporate or overall firm management. Once compiled, the firm uses this data as a starting point for the budget, often challenging or rejecting some aspects of the budget. This process may force business segments to reassess and resubmit revised plans for the period.
Regardless of the methodology used, the final budgets should be seen as collaborative projects with input from all management team members. This approach not only results in a better, more useful finished product, but it also creates ownership in the process and resulting budget. Everyone involved has a stake in working to meet budget expectations. And when the operating, CapEx and cash flow budgets all work together and your firm has the buy-in from the entire management team, your chances of success go up dramatically. Don’t overlook these financial tools and their benefits.
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