Archive for July, 2010

Part V: "Ex Disastrium, Scientia"

Posted July 25, 2010 By Fletcher Groves

(excerpted from The Pipeline)

“Well, someone might as well ask the question”, said the intrepid, results-based consultant. “From both a production standpoint and a financial standpoint, at what point does RB Builders breakeven?”

“One of the advantages and benefits of allocating costs on the basis of how they behave in relation to Revenue is the ability to understand and use breakeven analysis”, replied the CFO. “But, I have to admit, before you came, we could not have answered that question. The RB Builders Income Statement was prepared according to the NAHB Chart of Accounts, which is to say that it was comparative, compliant . . . and utterly useless. Now, we also produce a Contribution Income Statement.

“According to the 2008 baseline budget, our breakeven point is 155 closings, based on Revenue of about $39 million. However, because of the way the market has deteriorated, the 2008 target budget has a higher production breakeven point; it requires closer to 170 closings, albeit on only slightly higher Revenue ($40.5 million).”

“How did you calculate that?”, asked the VP of Construction.

“Let me show you”, said the CFO, creating a new data table and adding the data to the first two columns. “This is what we have said, so far. Some parts we do not know yet.”

2008 BASE BUDGET
CLOSINGS = 200
REVENUE = $50,000,000
AVG. SP = $250,000
GROSS MARGIN = 22%
BREAKEVEN = 155 UNITS
BREAKEVEN REVENUE = $39,000,000

2008 TARGET BUDGET
CLOSINGS = 250
REVENUE = $60,000,000
AVG. SP = $240,000
GROSS MARGIN = 21%
BREAKEVEN = 170 UNITS
BREAKEVEN REVENUE = $40,500,000

2008 WORST-CASE
CLOSINGS = 140-150
REVENUE = $34,500,000
AVG. SP = $240,000
GROSS MARGIN = 18-19%
BREAKEVEN = ?
BREAKEVEN REVENUE = ?

2008 FULL CAPACITY UTILIZATION
CLOSINGS = 300
REVENUE = $69,000,000
AVG. SP = $230,000
GROSS MARGIN = 15%
BREAKEVEN = ?
BREAKEVEN REVENUE = ?

“Breakeven occurs at the point where overhead is completely absorbed”, he said, continuing to write as he spoke. “Overhead is absorbed through the generation of Gross Income, which is comprised of the proceeds that we get to keep from each closing. When you are dealing with averages, one way to figure the breakeven point is to take the average sales price of a home, multiply it by the Gross Margin Ratio, and then divide the resulting Gross Income per home into your overhead.”

BREAKEVEN = OVERHEAD / (AVG SP X GM%)
BREAKEVEN = $8,500,000 / ($250,000 X 22%) = 155

“That gives you the unit breakeven point, in other words, the breakeven point in terms of closings. The unit breakeven point in the 2008 Baseline is 155 closings.”

“Is there another way to look at breakeven?”, asked the intrepid, results-based consultant.

“Sure”, he said, writing on the board. “You can calculate the breakeven point in terms of Revenue. You calculate that by dividing overhead by the Gross Margin Ratio, which, by the way, is basically the same measure as Contribution Margin.

“Take the 2008 Baseline and Target we were just discussing.”

BREAKEVEN = OVERHEAD / GM%
BASELINE BREAKEVEN = $8,500,000 / 22% = $38,636,000
TARGET BREAKEVEN = $8,500,000 / 21% = $40,476,000

“Like I said, about $39 million and $40.5 million, respectively”, he said, pointing back to the data table. “Our overhead under both the 2008 Baseline and the 2008 Target is $8,500,000, but the resulting Gross Margins are different, so the breakeven points are different. In this case, the difference in the unit breakeven point is more substantial than the difference in the Revenue breakeven point.

“Overhead is the same thing as Operating Expense, which is comprised of all our indirect, non-variable costs. Overhead – or Operating Expense – is the cost of our production capacity.

“That gives you the breakeven number of closings, and the breakeven Revenue. Equally-important – since we cannot generate all of our closings and all of our revenue at once – is the breakeven rate.

“In terms of the scenarios we have been discussing, breakeven in our worst case scenario occurs at around 190 closings, which is at about $46 million in Revenue. That is because we are trying to absorb the same amount of overhead with smaller Gross Margins. It requires more closings, which can become a vicious cycle, with a lot of margin pressure. Anyway, in the worst case scenario, the point at which we fully absorb our overhead occurs at a rate of about 16 closings per month. Of course, we have the production capacity to start and close 25 houses a month.”

The CFO filled in the missing data for the last two columns.

2008 BASE BUDGET
CLOSINGS = 200
REVENUE = $50,000,000
AVG. SP = $250,000
GROSS MARGIN = 22%
BREAKEVEN = 155 UNITS
BREAKEVEN REVENUE = $39,000,000

2008 TARGET BUDGET
CLOSINGS = 250
REVENUE = $60,000,000
AVG. SP = $240,000
GROSS MARGIN = 21%
BREAKEVEN = 170 UNITS
BREAKEVEN REVENUE = $40,500,000

2008 WORST-CASE
CLOSINGS = 140-150
REVENUE = $34,500,000
AVG. SP = $240,000
GROSS MARGIN = 18-19%
BREAKEVEN = 190
BREAKEVEN REVENUE = $46,000,000

2008 FULL CAPACITY UTILIZATION
CLOSINGS = 300
REVENUE = $69,000,000
AVG. SP = $230,000
GROSS MARGIN = 15%
BREAKEVEN = 246
BREAKEVEN REVENUE = $56,600,000

“Obviously, at only 140 to 150 closings – 12 closings per month – and $34.5 million in Revenue, we would be below the breakeven point in both closings and Revenue, which means we would be losing money.

“But, if we can somehow find a way to more fully-utilize our production capacity – which we will pay to have anyway, unless we cut our overhead – and somehow find a way to close more homes, albeit at considerably lower margins, we would breakeven at 246 closings and $56.6 million in Revenue. That occurs at 20-21 closings a month, a rate also well below the 25 closings-per-month we have the capacity to produce.

“And, while we are talking about breakeven rates, I hope it reinforces the importance of even-flow production”, said the intrepid, results-based consultant, looking at the VP of Construction and VP of Sales. “We cannot be all over the map each month with sales, starts, and closings, and with WIP.”

“Is there any kind of housing market in which demand does not respond to lower sales prices?”, asked a sales representative. “What happens if we reduce the sales price – give more concessions, endure lower margins – and there are insufficient sales? Is there a limit to how far we can drop prices? In other words, what happens if we build it, we drop the ticket prices, and they still do not come?”

“There is always that possibility”, said the VP of Sales. “But – we still have to price to the market. That is not in our control. To the extent that we extract value, with better margins as the outcome, we do have some control. On the other hand, from what I am hearing, the gains from higher productivity are permanent, and the speed/velocity that enables those gains is something we can always control.”

The intrepid, results-based consultant turned to the sales representative. “To answer your question, if the situation gets bad enough, higher productivity becomes moot”, she said. “RB Builders would have excess – and probably unusable – capacity. In that case, higher productivity might not seem as urgent, or as attractive.

“If we cannot make some combination of higher margin and higher velocity work for us, we might have to take RB Builders out of gear, and glide to some sort of safe landing. A controlled crash would be a better description. Like Apollo 13. Forget the moon, just get the Odyssey and her crew home.”

“Perhaps”, said the CEO. “But, I am determined that we come out of this situation with a level of sustainable competitive separation. I refuse to accept the sacrifice of having endured this much pain without having something to show for it. Higher productivity might not seem as urgent, right now, but it will someday. I want RB Builders to emerge a much faster and more agile homebuilding company.

“Forget “industry best practices”. We need to do better than that, because we would be foolish to believe that our competition will forever come from who it comes from now. Someday, the homebuilding industry is going to change, and that change will as likely come from without, as from within.”

“Ex Disastrium, Scientia”, said the intrepid, results-based consultant, smiling at her adaptation of NASA trivia.

“Learn from adversity, learn from failure, learn from mistakes.

“But – own the outcome.”

(excerpted from The Pipeline)  

Note:  The Pipeline was written in mid-2007. The fact that it survived the past three years with its relevance intact is, you could argue, mere fortuitous insight, but it is also a testament to the immutable principles of production that it illuminates.

“Rather than ask where your heads disappeared to, let me just say that what you just described is not the reality with which we are dealing”, said the VP of Sales. “This coming year – 2008 – is going to be a challenge. So, what happens when we are faced with the prospect of both fewer sales and lower margins? What happens when the market is not going to allow us to use – to economically leverage, as you like to put it – all of this new-found production capacity?

“I agree that productivity and Throughput-killing variation is the problem when we are faced with an internal constraint, when we are faced with being our own worst enemy. Under those circumstances, “Max-T” is the right approach.

“But, what happens when we are faced with an external constraint?”

“Give us some idea of what you are talking about”, said the intrepid, results-based consultant. “Demand is elastic. How many sales, at what margin?”

“The numbers in the GI Baseline and GI Target are a couple of months old”, the VP of Sales replied. “They already reflect the expectation of a deteriorating market. We still might be able to achieve those numbers, but, since then, the market has deteriorated even further. It is precipitous. We are looking at the very real possibility of both fewer homebuyers and lower margins.”

“How few and how low?”, asked a sales representative.

“During 2007, we closed 200 homes, but we only sold 180 homes”, the VP of Sales said. “Not exactly the protective backlog of sales that we want. So, we were already seeing the pressure in the market. Our Revenue was $50 million, our average selling price was $250,000, and our Gross Income Margin was 22%. We kept those numbers in the baseline for 2008. However, the 2008 target is $60 million in Revenue, produced on 250 closings, with an average sales price of $240,000, and a Gross Income Margin of 21%. The higher productivity, higher utilization – whatever you want to call it – actually gives us more Gross Income in 2008 than we earned in 2007.

“However, now we are thinking maybe only 140 to 150 sales. We think that the average sales price will still be $240,000, but there will be more concessions. More concessions will result in lower margins, somewhere between 18% and 19%. If that scenario happens, we are looking at Revenue of $34.5 million, and Gross Income of $6.5 million.

“In case you missed it, our indirect, non-variable cost is budgeted at $8.5 million.

“That is an operating loss of $2 million, and, frankly, we do not know where the bottom of this recession is. It could get much worse.”

“Nevertheless, we need to talk about what we know now. What would you do?”, the intrepid, results-based consultant asked the VP of Sales. Glancing toward the CEO, silently with her eyes, she said, “Just let him answer.”

“We cannot afford to lose money. But – I cannot look at the people in this room, and suggest that we fire people whom we have developed and whom we care about, either”, said the VP of Sales. “Certainly not as our first resort.

“The market may not turn out to be this bad, but here is what I would do:

“The current job schedule says that we should be able to build our houses in an average of 120 days, and we have been given 100 units of work-in-process to produce as many closings as we can”, he said. “That calculates to 300 closings. Despite the challenges of the market, we need to find a way to get those 300 closings.

“Let me qualify part of that statement. The closings are important, but we need to produce as much Gross Income as we can, because that is all we get to keep from whatever Revenue we generate from those 300 closings.

“From a production standpoint, someone else will need to figure out how to beat 60 days out of the current cycle time. From a sales and marketing standpoint, to sell 300 homes, I believe we will need to drop our prices to an average of $230,000. I know, I know. It is a difficult decision. It is $10,000 below the target, and $20,000 below the baseline.

“Our margins would suffer, dropping to 15%, on average. We would need to become much more intuitive and instinctive in our adjustments, and learn to make decisions as fast and as frequently as necessary. We will have to fight for every sale. But – even with the lower margins – if we manage to sell, build, and close 300 homes, our Gross Income would be $10.4 million, produced on Revenue of $69 million. Our Net Income Margin would be less than 3%, but we would be profitable.

“Of course, like I said, it could get worse. Much worse.

“Could we find ways to extract more value, and therefore earn higher Gross Income Margins and generate additional Gross Income on every dollar of Revenue? I think so. Could we get our cycle times down to 90 days, and close 400 homes on the same amount of production capacity? Maybe. That is up to us. I am not sure that is what we would want to do right now. The resulting higher production would have even further implications on prices and margins.

“Still, I am starting to realize some things: First, higher velocity can overcome lower margins. Second, productivity gains are permanent.”

“In 2008, higher productivity is a case of survival. And – it may not be enough, if things get a lot worse”, said the intrepid, results-based consultant, writing as she spoke. “In the future, the ability to produce more – more closings, more Revenue, more Gross Income – on a finite and controlled amount of work-in-process and overhead will be one of the keys to sustainable competitive separation.

BREAKEVEN ANALYSIS

“This discussion raises a question”, she said, pointing to the board. “From both a production standpoint and a financial standpoint, at what point does RB Builders breakeven?

“Knowing the answer to that question gives you more insight than you can imagine.”