Archive for August, 2009

The Velocity Side of Return on Assets

Posted August 15, 2009 By Fletcher Groves

In a recent weblog entry (“There’s No Longer Room To Cut – It Is Time To Start Growing”), Jamie Pirrello (Big Builder Contributing Editor) makes a number of points about the current reality faced by privately-capitalized builders. John McManus (Big Builder Editor in Chief) adds his comments on the Housing Crisis weblog.

Those points are, chiefly, that (1) builders have cut as much overhead as they can, (2) they need top line (revenue) growth, (3) in a period of lower demand, they must take market share from someone else, and (4) taking market share from someone else requires differentiation born of superior talent delivering superior value.

John concludes that the need to have the right product in the right price position in the right location with the right process and the right vendor structure, supported and sold by the right team is a tall order for privately-capitalized builders, particularly as a competitive strategy.

Undoubtedly. But – is that a sufficient strategy?

In what currently passes as the housing market, builders may be more consumed with liquidity and cash flow, but the reason they are in business is not about survival. It is about economic return, which also takes into consideration profitability. The most widely-accepted measure of economic return (Return on Assets) is a function of both margin (Return on Sales) and velocity (Asset Turn). ROA is not just about how much a homebuilding company makes on each house it builds; it is also about how many houses it can build with what it spends every year for its production capacity.

The mental model of the homebuilding industry in good times is “More-for-More”. More Revenue, more income, in exchange for more of everything else – more capacity (non-variable cost), more investment (land, models, work-in-process), more cash. In challenging times, the mental model becomes “Less-for-Less” – less Revenue, less income, as a result of less capacity, a slower burn rate, and (maybe) less investment. A more-for-more proposition is always about size and growth; a less-for-less proposition is always about cutting costs.

However, neither of these mental models (more-for-more; less-for-less) have anything to do with the velocity side of economic return, or have anything to do with higher productivity.

The mental model of higher productivity is “More-for-Less” – more Revenue, more income, with less capacity and less investment. It seeks more-for-less, but it would settle for more-for-the-same. If a homebuilder does not go after higher productivity – if it will not tackle the velocity side of Return on Assets – it is left with only higher margins with which to carve out any sustainable competitive separation. Since the market determines the price, all that that builder can do is to try to increase the margin by extracting more value from his variable costs.

Builders do need to extract – to create – as much value as they can, with better designs, better quality, better pricing, fewer defects, better locations.

Higher margins are necessary, but they are not sufficient.

Builders need velocity. They need to turn their work-in-process faster, which will result in faster cycle times. They need to increase productivity.

And, what – you ask – is “productivity”? From any managerial standpoint – operations, manufacturing, production, or otherwise; from any industry vertical standpoint – auto manufacturing, homebuilding, or any other industry; from any enterprise standpoint – Toyota, or anyone else; from any expert or business leader standpoint – Drucker to Goldratt to Ohno, the conventional, accepted formula for calculating productivity is Revenue divided by Operating Expense.
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The only way a homebuilding company can lower its price breakeven point in a margin-constrained housing market is to leverage its capacity – to increase the amount of Revenue it can generate with the same level of Operating Expense.

Skeptical about the application to the homebuilding industry? Join the crowd. The broad efforts to increase productivity and capacity utilization get scant attention when the perception is the homebuilding industry has excess capacity (another worthwhile topic that I will get around to someday).

For now, consider the following simple scenario:

Same local housing market, two builders in direct competition, each has the same dollar value of overhead, which they will spend regardless of how many houses they sell and build. Builder A has a cycle time of 150 days; Builder B has a cycle time of 90 days. Builder A turns his work-in-process 2.4x per year; Builder B turns his work-in-process 4.0x per year. Builder A can build 20 houses a month and breaks even at 19 houses a month. Builder B also breaks even at 19 houses, but can build 34 houses a month. Same margins, completely different Net Income scenarios, because every dollar of Gross Income above the breakeven point drops straight to both builders’ bottom-line. But – which builder can push it to the hard deck?

Because of its higher productivity, Builder B is in a much better position to compete on margin, an advantage that works in both good markets and bad markets. With 60% more Revenue, most would consider Builder B to be a much bigger homebuilding company. But, it is not. Builder B is the same size as Builder A, when the measure of size is capacity.

Productivity is a much more sustainable basis for creating competitive separation, because it is so much harder to achieve. There is always a risk in generalizing, but the homebuilding industry, as a whole, lacks the resolve and discipline to do the hard work required by more-for-less. And, that, ostensibly, is why the publics have the advantage over privately-capitalized builders. The publicly-capitalized builders have better access to cash and financing.

But, better access to cash and financing only creates financial capacity; it does not create production capacity. It does not make publicly-capitalized builders more productive. Arguably, the homebuilding industry owns no production capacity, because builders generally do not do any of the value-creating work; at best, they do value-enabling work. Unless it is a craft builder, a homebuilding company merely strip mines the value stream (selective, tactical vertical integration; yes – another story).

And, so, it becomes a matter of geographic expansion, a quest for market share, and competing on margin, because that is all they have.

I do not believe the single family run-rate (as John puts it) will remain at a place-keeping 550,000 units; the demographics support much higher long-term demand. In some ways, a return to normal demand would be the worst movement that could happen, because, if it comes soon enough, it will allow a return to business-as-usual.