Archive for June, 2010

Part III: The Cost of Variation and Long Cycle Time

Posted June 23, 2010 By Fletcher Groves

(excerpted from The Pipeline)

“So – how much do you think all of this variation is costing your company?”, asked the intrepid, results-based consultant. “Let me ask it two different ways: How much is the lack of productivity costing you? How much is chronically-long cycle time costing you?

“Variation, productivity, cycle time. They are all connected.”

“Our cycle time is 180 days, and we are doing it with 200 closings produced on 100 units of work-in-process”, said the CFO. “Without getting into an explanation of statistics, we have about a 50% variation from the standard of 120 days and a 100% variation from the cycle time we instinctively believe we should be achieving, which is 90 days.

“As you have taught us, a system will protect itself from variation and uncertainty with some combination of longer cycle time, higher work-in-process, and excess/unused capacity. Our cycle time is very long, which translates into a large buffer. Our work-in-process is where we planned it to be, and only 25% higher than the lowest amount it could possibly be, which is 80 units at a cycle time of 120 days. So, I do not think this is a case of RB Builders having a buffer of additional work-in-process.

“Here is the kicker:

“If we honestly believe we can produce 300 closings with our current production capacity, then we have a huge buffer of excess/unused capacity, which calculates into an overall utilization rate of 67%. In essence, we waste one-third of our capacity. As you have pointed out, that is hardly the picture of high productivity. The inability to utilize our capacity translates into significantly fewer closings. We are paying for the capacity and the work-in-process to produce 300 closings, but we only closed 200 homes. That is a gap of 100 closings.

“In terms of what all of this is costing us, there is clearly a cost associated with excess work-in-process and unused production capacity”, the CFO continued. “The additional, “beyond-necessary” work-in-process certainly makes us a bigger company than we need to be, and the excess/unused production capacity alone costs us over $2,800,000 a year.

“But – I do not think it is about cost. I think it is about opportunity. Unless we opt for cost-cutting and reducing overhead – a “same-for-less” proposition – then, I would say that it is “costing” us the opportunity of all the Gross Income on those 100 closings we missed in 2007. Our Gross Income Margin was 22%. We had $50 million in Revenue. If you divide that by the 200 closings that we achieved, the average sales price was $250,000. From there on out, the math is pretty simple.”

The CFO walked up to the erasable board, and wrote:

$250,000 X 22% X 100 = $5,500,000

“We gave up $5,500,000 in Gross Income.”

The conference room was completely silent. Everyone was aware of the Gross Income Baseline, Target, and Reserve, and the impact an additional $5,500,000 would have on the payout of Gross Income Milestones under the new results-based performance compensation plan RB Builders had just enacted.

The silence was broken by the words of the CEO.

“No. That calculation does not even scratch the surface”, he said. “What is the real cost?”

He walked to the front of the conference room.

“If all that this excessive variation, lack of productivity, and longer-than-necessary cycle time cost us was $5,500,000 in Gross Income, that would be bad enough”, bristled the CEO. “But – this is also $5,500,000 that would have dropped straight to our bottom-line, in the form of additional Net Income.

“In terms of the cost of our production capacity, utilizing it would have cost us nothing – zip, nada, zero. It is non-variable cost. It is overhead. We already paid for it.

“I am not finished with this issue.”

The CEO turned to the erasable board, picked up a marker, and added two more rows to the data table:

2005:
WIP = 100
CLOSINGS = 225
CYCLE TIME = 160

2007:
WIP = 100
CLOSINGS = 200
CYCLE TIME = 180

2008:
WIP = 100
CLOSINGS = 240
CYCLE TIME = 150

WIP = 80
CLOSINGS = 240
CYCLE TIME = 120

WIP = 100
CLOSINGS = 300
CYCLE TIME = 120

WIP = ?
CLOSINGS = ?
CYCLE TIME = 90

WIP = ?
CLOSINGS = ?
CYCLE TIME = 90

Turning and nodding at the data table on the board, he asked, “Forget the 180 day cycle time we have now. What do you think RB Builders would look like at a cycle time of 90 days, instead of the 120 days specified under our job schedules?

“It is a rhetorical question. For all of about five more seconds.”

The CEO made a quick calculation and filled in the Closing and WIP data that was missing from the table.

WIP = 60
CLOSINGS = 240
CYCLE TIME = 90

WIP = 100
CLOSINGS = 400
CYCLE TIME = 90

“We could go with virtually any combination – any strategy or tactic – of higher Throughput and lower work-in-process to achieve a 90 day average cycle time, but say that we elect to go with a tactic of “Max-T”, a tactic of generating maximum Throughput with a planned, finite, and controlled level of work-in-process. Forget 200 closings on WIP of 100 units, which would be the current cycle time of 180 days. Forget 300 closings on WIP of 100 units, which would be the cycle time specified in our construction schedules. What about 90 days? Although it is a valid option, set aside the idea of making RB Builders a smaller company – 240 closings, but reducing WIP to only 60 units. Focus on Max-T. What about 400 closings on WIP of 100 units?

“What happens?”

The CFO handled the question. “Well, if our Gross Income Margin remains the same – which it likely would not, because of price elasticity of supply and demand – then we would generate an additional $11 million in Gross Income, every penny of which, as you point out, drops straight to our bottom-line in the form of additional Net Income.

“Which means that our unwillingness – or our inability – to do anything about the current level of variation that drives our long cycle times is costing RB Builders as much as $11 million in Net Income every year. That is a lot of money.”

“Yeah”, said the CEO. “Even for a company that would then have $100 million in Revenue. I want everyone to be clear. Our 2008 baseline is $50 million in Revenue, from which we expect to produce $11 million in Gross income and $2,500,000 in Net Income. Our 2008 target is $60 million, producing $12.5 million in Gross Income and $3.4 million in Net Income. As all of you realize, all of our very-considerable bonuses are tied to the Gross Income Reserve that represents the difference between the baseline and the target.

“By appearance, this kind of performance would be over-the-top. But – if we pull it off – it means that instead of progressively splitting a GI Reserve of $1,500,000 three-ways between our owners, Retained Earnings, and all of us, dropping our cycle time from 180 days to 90 days means we get to split a GI Reserve of $12.5 million.

“And – you know what?

“Despite the fact that its Revenue had doubled, RB Builders would be the same size company. It would have the same amount of WIP, the same overhead, the same working capital requirement, the same level of debt.”

The Intrepid, Results-Based Consultant says "I Do"

Posted June 16, 2010 By Fletcher Groves

The intrepid, results-based consultant gazed lazily at the white sand and the water beyond, and thought, it would definitely take a lot of this to kill you. She sighed contentedly, recalling the last 72 hours.

The planning had been thoroughly intense. Or, perhaps it had just been intensely thorough, she wasn’t sure. Whatever. Her wedding had come together just the way she had dreamed. The June weather in Northeast Florida had cooperated, for the most part. The boys had enjoyed the ritual marriage event known as Wedding Party Golf. The rehearsal had been fun. The flowers had miraculously come together. The church was beautiful. The service was reverent, and rich with meaning and promise. The music was awesome. There had been tears of laughter, tears of sentiment, and tears of complete joy. The reception had been perfect. Bob Cummings and the Reflections were everything they were expected to be.

Her sister had been a flawless Maid of Honor. Her Mom had been the model of composure, beauty, and grace. Her new in-laws had been the picture of gracious acceptance and support.

Her Dad had defied all odds, by managing to hold himself together.

The intrepid, results-based consultant was undone by all that her marriage represented. Two families joined together. Life-long friendships, some of forty-plus years, honored. Four generations of fraternity brothers, groomsmen, sorority sisters, bridesmaids, friends, and extended members of both families who had traveled thousands of miles, just to be there. A cloud of witnesses that stood – and would continue to stand, collectively and individually – with them, by them, and for them, for the rest of their lives. There was the pang of absence for those who had gone before; the ones they always loved, still missed, and would never forgot, but whom they would one day joyfully see again.

It was the promise, challenge, and adventure of a life to be built, and a lifetime to be spent, together. Permanently. Inseparably.

For sure, there would be good times and bad times in the years to come. There would be easy times and hard times. There would be gains and losses. There would be joy and sorrow. There would laughter and tears. There would be planning; there would be spontaneous-ness. There would be children. There would be careers and career changes. There would be changes in priorities and focus. There would be memories made. There would be legacies formed.

There would be times when they knew each other’s thoughts; there would be times when they did not think they were from the same planet.

There would be mistakes. There would be grace. There would be forgiveness offered, and forgiveness accepted.

And, through it all, there would be love, honor, and respect.

The intrepid, results-based consultant turned her head to the side, pushed her sunglasses to the end of her nose, and looked at the handsome young man reclined on the beach beside her.

She smiled, and thought to herself, “My Dad would think this is “utterly cool””.

And, she would be utterly right.

(inspired and excerpted from The Pipeline)

One of the sales representatives looked at the superintendent, and just laughed. “Which one of the Productionally-Transmitted Diseases would you like to have? PTD, she owns you.”

The intrepid, results-based consultant smiled politely. “In a previous session”, she said, “someone said RB Builders closed 200 homes in 2007, on an average work-in-process of 100 houses, which is also the baseline for 2008. But, everyone also agreed that the system should be capable of producing 240 closings on 100 units of work-in-process. Later, someone else mentioned that the building schedules averaged 120 days.”

Moving to the erasable board, she wrote the following data in a table:

2005:
WIP = 100
CLOSINGS = 225
CYCLE TIME = ?

2007:
WIP = 100
CLOSINGS = 200
CYCLE TIME = ?

2008:
WIP = 100
CLOSINGS = 240
CYCLE TIME = ?

“Someone calculate RB Builders’ cycle time”, she said. “How many days?”

After a minute, the sales representatives looked up from her calculator, and said, “If I am doing this right, I calculate that, in 2005, our cycle time was 160 days. In 2007, it was 180 days. And, for 2008, we are targeting 150 days.”

The intrepid, results-based consultant completed the cycle time column with the calculated cycle times, but added two more rows with identical values.

2005:
WIP = 100
CLOSINGS = 225
CYCLE TIME = 160

2007:
WIP = 100
CLOSINGS = 200
CYCLE TIME = 180

2008:
WIP = 100
CLOSINGS = 240
CYCLE TIME = 150

WIP = ?
CLOSINGS = ?
CYCLE TIME = 120

WIP = ?
CLOSINGS = ?
CYCLE TIME = 120

“Okay”, she said. “Tell me what your production system looks like with a cycle time of 120 days.”

“There are two ways to look at it”, said the superintendent. “We could be closing 240 homes with 80 units of work-in-process. Or – we could be closing 300 homes with 100 units of work-in-process.”

The intrepid, results-based consultant added the new calculations.

2005:
WIP = 100
CLOSINGS = 225
CYCLE TIME = 160

2007:
WIP = 100
CLOSINGS = 200
CYCLE TIME = 180

2008:
WIP = 100
CLOSINGS = 240
CYCLE TIME = 150

WIP = 80
CLOSINGS = 240
CYCLE TIME = 120

WIP = 100
CLOSINGS = 300
CYCLE TIME = 120

“Remember the earlier discussions on margin and velocity?”, she asked. “This is where that thinking works. There are two ways RB Builders can increase the amount of Throughput – the amount of Gross Income – it generates. Margin is how much money we make on every home we close, and velocity is about how many homes we can build and close in a period.”

On the erasable board, she wrote:

MARGIN
VELOCITY

“Most of the time, there are improvement opportunities that permit us to attack margin and velocity simultaneously”, she said. “Much like the DuPont formula shows when calculating economic return (Return on Assets), Gross Income is a composite of both margin and velocity. We want the best blend of margin and velocity. They do not often conflict, even though there are sometimes tradeoffs, and times when we might be better served focusing more on the one than the other.

“On occasion, we are forced to make a choice on where to focus, more when we are facing an external (market) constraint than when we are facing an internal (production) constraint. What’s the difference? Where was the constraint in 2004-2005? The constraint was in your production system. It was an internal constraint.

“The velocity part of the choice decision lies in how well RB Builders is utilizing its true production capacity”, said the intrepid, results-based consultant. “The margin part is determined by the condition of the housing market, and whether that market is going to allow us to use – to economically leverage – that capacity. We can control truly-variable direct costs, and we can extract more value, but – at the end of the day – the market dictates the price you get for a house.

“And, a lot of people are thinking 2008 might be that kind of year – imagine – barely a year removed from the recent, final, halcyon days of the “Age of Homebuilder Entitlement””, she said.

“The point is, we have to learn to manage this relationship. We have to find the best blend of margin and velocity, the composite that generates the greatest amount of Throughput. We have to generate the greatest amount of Gross Income that we can, given the reality of our playing field, given the parameters imposed by the market.”

2005:
WIP = 100
CLOSINGS = 225
CYCLE TIME = 160

2007:
WIP = 100
CLOSINGS = 200
CYCLE TIME = 180

2008:
WIP = 100
CLOSINGS = 240
CYCLE TIME = 150

WIP = 80
CLOSINGS = 240
CYCLE TIME = 120

WIP = 100
CLOSINGS = 300
CYCLE TIME = 120

“Back to the issue of variation and uncertainty”, she said, gesturing towards the data table, and then looking toward the VP of Construction. “Earlier, you noted a widely-accepted sense that RB Builders should be capable of building every house in less than 90 days.

“Not 180 days, not 150 days, not 120 days”, she said, pointing to each number.

“In 90 days.”

She wrote the following questions on the board:

WHERE IS VARIATION BEING BUFFERED?
WHAT DOES VARIATION COST?

“Variation is the deviation from the standard. Variation can be applied to duration. It can be applied to cycle time. The standard cycle time is 120 days, and some of you think it should be 90 days. However, it takes you anywhere between 150 to 180 days to build your houses. Quite a bit of deviation from the standard, I should say.

“Your cycle time is quite the poster child for your lack of productivity.”

The intrepid, results-based consultant gazed intently around the room, and then asked, “Considering both your gut-instinct and your interpretation of the data in the table, exactly how and where do you think RB Builders’ production system is buffering itself – protecting itself – from all of this variation and uncertainty?

“And – how much do you think this variation is costing your company?”