Archive for January, 2013

Building Urgency Towards Results

Posted January 27, 2013 By Fletcher Groves

(initially published on EFA on August 14, 2011, under the same title;  republished here, as part of Above Average: The Best of Escape from Averageness, 2009-2012®)

This is a summary of the initial projects and schedule we recommended on an engagement with one of our clients.  It is a picture of the type of urgent, focused, rapid-results process of continuous improvement that is one of our two major requirements for working with clients (and being compensated) on the basis of the progress achieved toward a specific financial outcome (the other requirement is having a team-based performance compensation plan tied to the financial results of the improvement process, so that everyone (including us) has a financial stake in the outcome).

These recommendations flowed from an upfront assessment of the client’s current situation – from this client’s “current reality”, as we like to term it.  This happened to be about a $60 million, semi-production builder that starts a large percentage of inventory/spec homes, and has significant lot positions across a large number of communities in which it is the only builder.  Recommendations of this sort are always specific to the situation and the period, and reflective of the business model.

However, the principles and insights don’t change.

In this particular situation, there was very little time with which to work;  inside of 60 days, from the time the company’s current reality was pegged, until the team-based performance compensation plan was intended to kick-off, and most of these projects needed to be completed in time to coincide with the start of that compensation arrangement.

Here they are:

P-1:  Produce a Contribution Income Statement and conduct a breakeven analysis on every community, shelve the communities that are unviable in the current situation, shelve the less-viable communities that would only rob other more-viable communities of needed resources (be it financial resources or human resources), focus the available resources, and set aggressive new sales targets fueled by lower sales prices.  Moreover, make it do-or-die, and drop the sales prices in advance of any demonstrated improvements in margin or velocity.

Timeframe:  14 days.

P-2:  Refine the product (plan) portfolio.  Cull the product portfolio for the remaining active communities to remove the plans that do not sell.  Fix the budget errors in the remaining plans, and start extracting more value (value = revenue – cost of sales).  Find a way to generate higher Gross Income (on prices that have already been set lower).

Prerequisite:  P-1 complete.

Timeframe:  42 days.

P-3:  Begin to drive significantly higher levels of traffic, conversion, and sales, by any means necessary, except by spending more money.  Find a way to get it done.

Prerequisite:  P-1 complete.

Timeframe:  49 days.

P-4:  Revamp the front-end of the value delivery process – the Contract-to-Start process – in order to increase its capacity and reduce its duration.

Prerequisite:  P-2 complete.

Timeframe:  7 days.

P-5:  Attack velocity in the Start-to-Completion process, by setting much more aggressive targets – shorter job task durations with no hidden safety, a project (job) portfolio with all resource contention resolved, thereby producing shorter cycle times that will, in turn, result in an increased rate of periodic closings, generated with a planned, finite, and controlled amount of work-in-process and production capacity.

Prerequisite:  P-2 complete.

Timeframe:  92 days.

Five projects.  Four and one-half months.

At stake?  The difference between the baseline and the target budgets formed a Gross Income Reserve of almost $2.3 million, to be paid-out over the next year, upon the achievement of progressive Gross Income milestones, equally divided between distributions to owners, an increase in retained earnings, and performance compensation to all teammates.

When we initially discussed the requirements with the client, this is exactly what I told them:

“If I were you, I would come up with a series of short, targeted projects, prioritized and sequenced according to whatever is the biggest constraint to wherever you have chosen to go, and I will tell you right now, it needs to be expressed as – and focused on achieving – a specific business outcome.  Give it top-down leadership, but tap into broad, bottom-up involvement.  Create a strong sense of mutual accountability, responsibility, and rewards.  Focus on achieving rapid results.  Learn by doing.  Build long-term capability.”

If it was a different client, in a different situation, under different economic circumstances, it would have no doubt required a different plan.  But – whatever the situation – this is the type of urgency that continuous improvement needs to foster.

 

Part V: Groves and Shinn: The Debate Over Costing

Posted January 20, 2013 By Fletcher Groves

(initially published on EFA on April 16, 2012, simply as “The Debate Over Costing”, incorporated and republished here, as the last in a five-part series;  part of Above Average: The Best of Escape from Averageness, 2009-2012)

 

On the Builder discussion group on LinkedIn, I had this exchange with Shinn Consulting’s Emma Shinn, on whether costs on the NAHB Chart of Accounts Income Statement should be allocated according to the rules of absorption costing or the rules of variable costing.  The matter of how the NAHB Income Statement allocates costs was the subject of an April 2009 post on “Escape from Averageness”.  It was also the subject of a subsequent two-part series of posts in January 2012, summarizing the results of a CFO survey we conducted on the subject of the NAHB Income Statement preceding the 2012 International Builders Show (IBS).

Here is the exchange, in its entirety:

Emma:  I do respectfully disagree with your assessment of the NAHB Chart of Accounts – the purpose of the Chart is to provide a structure for collecting financial information in an organized and meaningful way.  It provides builders the capabilities to produce reports that are meaningful and that will guide them in their decision-making process.  In no way does it deter or hinder the contribution margin analysis you talk about.  In fact, it facilitates such analysis as it provides the classification of cost and expenses in a way that facilitates the identification of the variable and fixed components.  The contribution margin analysis does not deter from the analysis of the traditional income statement and the valuable information it provides to the builders.  The contribution margin analysis does provide an expanded view and I agree with you in that builders can benefit from also looking at the income statement from this point of view as it refines further the behavior of fixed vs. variable cost and expenses.  However, your assessment of the NAHB Chart of Account is unfounded and could not be farther away from the reality of what the purpose of the Chart is set up to be.

Fletcher:  Emma, you don’t have to take my word for it. As part of the survey, we asked CFOs for insight related to the structure of the NAHB Income Statement (i.e., line item accounts in series 300-900), as it relates to cost allocation (variable v. absorption) and management tools (breakeven, CVP, etc.).

This an excerpt from one CFO:

“I am intimately familiar with both the strengths and weaknesses of the NAHB Chart of Accounts.  It was a great tool for benchmarking our performance with other builders and to industry standards.  It was interesting to benchmark our company, but the statements produced utilizing the NAHB Chart of Accounts were of no use when it came to making pricing decisions.”

The thoughtful examination of any managerial accounting or cost accounting textbook validates this CFO’s statements.

Emma:  Once again, I respectfully disagree with that assessment.  There is nothing in the chart of accounts that prevents a company from preparing a statement utilizing other analytical tools.  The income statement you call the “NAHB Income Statement” is the standard income statement presented in any accounting principles class.  If you want to do further analysis for specific managerial considerations, that is always highly encouraged.  However, I again say the NAHB Chart of Accounts vs. the charts of accounts I normally encounter in my reviews of builders’ operations facilitates further analysis;  it does not preclude the analysis.

Accounting, in my view, is primarily a management tool and we continue to encourage builders to view it as a very powerful means to help direct their management decisions.  That is not to take away the role accounting also plays in reporting results to third parties, such as lenders and investors.

Fletcher:  Emma, the NAHB COA Income Statement has a lot of attributes.  However, there is a difference between what something “does not deter or hinder” or “does not preclude”, on the one hand, and what it positively, proactively enables, on the other.

That may be all our differing views are about.  However, here are two of the specific points made on the matter, posted on SAI’s “Escape from Averageness” weblog in April 2009:

“The NAHB COA Income Statement treats Indirect Construction Cost as one of the costs that is deducted from Revenue to determine Gross Profit (the only difference between Gross Margin and Gross Profit is the inclusion of Indirect Construction Cost).  But – do Indirect Construction Costs vary according to Revenue?  Probably not.  For the most part, they are non-variable costs that will most likely be incurred regardless of the Revenue produced.”

“The NAHB COA Income Statement treats Selling Expenses (including Real Estate Commissions) as an Operating Expense, as a part of overhead.  Anything allocated to Selling Expense, therefore, should be a non-variable cost.  Is that the case?  No.  The bulk of Selling Expense is a variable cost.”

Emma – some of the CFOs in the survey were very out-spoken on this issue, and the shortcomings of absorption costing are well-documented.

 

Readers can decide for themselves.

 

(initially published on EFA on January 18, 2012, updated, incorporated, and republished here, as the fourth in a five-part series;  part of Above Average:  The Best of Escape from Averageness, 2009-2012)

 

“The NAHB Chart of Accounts is designed for historical financial reporting.  It is not a managerial accounting tool.  NAHB would do its members a great service by developing guidance on cost and managerial accounting.

“In my roles as both a CFO and a President of a homebuilding company, I am intimately familiar with both the strengths and weaknesses of the NAHB Chart of Accounts.  It was a great tool for benchmarking our performance with other builders and to industry standards.  It was interesting to benchmark our company, but the statements produced utilizing the NAHB Chart of Accounts were of no use when it came to making pricing decisions.”

So said, in part, one of the CFOs participating in SAI’s Fall 2011 survey regarding the format and the utilization of their company’s particular Income Statement in relation to the NAHB Chart of Accounts Income Statement.

The thoughtful examination of any managerial accounting or cost accounting textbook validates this CFO’s statements.

To quote one:

“Financial accounting is mainly concerned with the historical aspects of external reporting . . . governed by generally-accepted accounting principles (GAAP).  Management accounting, on the other hand, is concerned primarily with providing information to internal managers . . . charged with planning and controlling the operations of the firm . . . not subject to GAAP . . . one thing is clear from the NAA definition of management accounting:  The major function of cost accounting is cost accumulation for inventory valuation and income determination.  Management accounting, however, emphasizes the use of the cost data for planning, control, and decision-making purposes.”

Accounting Handbook, Barron’s, J. Siegel and J. Shim, 1990.

To quote another:

“Although an Income Statement prepared in the functional format may be useful for external reporting purposes, it has serious limitations when used for internal purposes . . . the Contribution Income Statement emphasizes the behavior of costs, and therefore, is extremely helpful to a manager in judging the impact on profits, of changes in price, cost, or volume.”

Managerial Accounting, 10th Ed., McGraw-Hill Irwin, R. Garrison and E. Noreen, 2003.

To quote yet another, directed towards resolving the need for a company to prepare multiple sets of financial information:

“For companies committed to maintaining variable contribution information, there are two choices available . . . 1. maintain their accounting system on a full-absorption GAAP basis, with separate calculations and analysis of variable contribution information [or] 2. maintain their accounting systems on a variable contribution basis with a monthly reconciliation to GAAP . . . if the only real reason for maintaining full-absorption accounting is to satisfy external requirements, doesn’t it make more sense to use option 2 and perform simple month-end reconciliation to GAAP?”

The Measurement Nightmare: How the Theory of Constraints Can Resolve Conflicting Strategies, Policies, and Measures, APICS series, The St. Lucie Press, D. Smith, 2000.

The last preceding excerpt is consistent with the others;  however, in fairness, it comes from Throughput Accounting (the emergent cost accounting methodology supporting Theory of Constraints), which places it outside the mainstream.  Throughput Accounting uses a profit and loss statement to the right of even a Contribution Margin profit and loss statement, refusing to assign costs to inventory, and expensing product costs immediately;  it literally has no internal use for GAAP compliance.

In the similarly nascent and outlying world of cost accounting methods that aim to support Lean, in its broadest sense, as a management system – as a business strategy, as an operating philosophy – the advice is more obtuse;  Lean Accounting sees no conflict with GAAP, uses an operating statement that clearly mixes variable and non-variable costs, but nevertheless states these among its Lean Accounting Concepts and Principles:  “2. Do not confuse a fixed cost for a variable cost” and “3. Eliminate absorption accounting for manufacturing transactions.”

The Real Numbers: Management Accounting in a Lean Organization, Managing Times Press, J. E. Cunningham, O. J. Fiume, E. Adams, 2003.

At best, comparison with “industry best practices” promotes a satisfaction with some sort of competitive equality, a settling for the expediency of the ideas of someone else.  The real problem with best practices is that it stifles creativity and innovation, works against creating competitive advantage, and creates the illusion of continuous improvement.

GAAP-for-the-sake-of-GAAP?  Compliance-for-the-sake-of-compliance?  You manage every day;  you only report periodically.  You are not in the business of complying with generally-accepted accounting principles;  you are in the business of making money.  You need to do both, but compliance is a case of the tail wagging the dog.

Bottom-line:  The two arguable attributes of the NAHB Chart of Accounts Income Statement – comparativeness-driven conformity and reporting-driven compliance – might be desirable, and to a degree necessary, but they are not a justification to sacrifice sound managerial accounting.  You cannot properly and effectively manage a homebuilding operation using the cost allocations recommended in the NAHB Chart of Accounts Income Statement.

 

Next:  Part V:  Groves and Shinn:  The Debate Over Costing

 

 

(initially published on EFA on January 18, 2012, updated, incorporated, and republished here, as the third in a five-part series;  part of Above Average:  The Best of Escape from Averageness, 2009-2012)

 

In the previous post, we reported on SAI’s Fall 2011 survey of CFOs regarding the format and the utilization of their company’s particular Income Statement in relation to the NAHB Chart of Accounts Income Statement.

According to the survey, 50% of respondents said their company’s Income Statement did not comply with the NAHB Income Statement, 40% said they had to produce multiple versions of their Income Statement, 20% used a Contribution Income format, and 40% said they performed some level of breakeven analysis.  Between 40% and 60% reported compliance with NAHB-recommended placement of the following equivalent line items:  Indirect Construction Cost, Selling Expenses (including Commissions), and Financing Costs.

Hardly a ringing endorsement and picture of conformity.

We noted that the NAHB Income Statement was acceptable as a traditional, GAAP-compliant, externally-focused, functionally-oriented classification of costs, but the effect of its functional cost allocation was to indiscriminately blend costs that are either variable or non-variable, in terms of how they behave in relationship to changes in Revenue volume.  We said that this practice obscured cost behavior, and prevented the use of important management accounting tools.  In order to use Cost-Volume-Profit (CVP) – which includes breakeven analysis – we further noted that you generally must have a Contribution Income Statement;  to have a Contribution Income Statement, you must use variable costing.

But, don’t take our word for it.

As part of the survey, we asked CFOs for more than answers to survey questions;  we asked for insight related to the structure of the NAHB Income Statement (i.e., line item accounts in series 300-900), as it relates to cost allocation (variable v. absorption) and management tools (breakeven, CVP, etc.).

This was from one of the CFOs, who is also a CPA:

Homebuilding is often compared to manufacturing, but there are differences that need to be taken into account when developing an accurate costing method for management decision-making.

“In the manufacturing world, variable/direct costing allocates all costs directly associated with an activity, including variable manufacturing overhead, to inventory and cost of goods sold and treats fixed manufacturing overhead as an operating expense along with selling, general and administrative expenses.  Absorption costing allocates all costs directly associated with an activity and all manufacturing overhead (variable and fixed) to inventory and cost of goods sold and treats selling, general and administrative expenses as an operating expense.  Both approaches to costing have their drawbacks when applied to homebuilding.

“While absorption costing is necessary for GAAP basis external reporting, its usefulness in providing management information in making pricing decisions is limited, because it allocates fixed manufacturing overhead to inventory and cost of goods sold (costs that should not be considered when making a pricing decision), and does not allocate other variable costs such as selling expense, financing costs.  Also, variable/direct costing is limited in its ability to provide useful pricing information to management, as it only allocates variable overhead to inventory and does not allocate other variable costs.

“A costing system that allocates all variable expenses to an activity would provide management with the most accurate information for making the proper pricing decision.”

He continued:

The NAHB Chart of Accounts is designed for historical financial reporting.  It is not a managerial accounting tool.  NAHB would do its members a great service by developing guidance on cost and managerial accounting.

“Most manufacturers have two sets of accountants and two sets of statements – financial accountants and financial statements for historical financial reporting, and cost/managerial accountants and financial statements designed for internal management and individual pricing decisions.

“In my roles as both a CFO and a President of a homebuilding company, I am intimately familiar with both the strengths and weaknesses of the NAHB Chart of Accounts.  It was a great tool for benchmarking our performance with other builders and to industry standards.  It was interesting to benchmark our company, but the statements produced utilizing the NAHB Chart of Accounts were of no use when it came to making pricing decisions.

“In order to make informed pricing decisions, I created my own operating statements by community that allocated all variable costs that could be specifically identified with the individual unit that generated them and removed all fixed costs.  In an environment of declining sales prices, rising costs, and a market that required substantial sales incentives, these operating statements were not only helpful, they were the key to our company’s survival.”

Next:  Part IV:  Academic insight into the problems with the NAHB Chart of Accounts Income Statement

 

(initially published on EFA on January 17, 2012, updated, incorporated, and republished here, as the second in a five-part series;  part of Above Average:  The Best of Escape from Averageness, 2009-2012)

 

From Part I of this series, readers of Escape from Averageness know that we disagree with the cost allocation structure of the Income Statement recommended by the National Association of Homebuilders in its Chart of Accounts:  

Yes – the NAHB Chart of Accounts permits comparisons with other builders.  Yes – the NAHB Chart of Accounts complies with GAAP reporting requirements.  Yes – it allows certain consultants to give the same presentation every year at IBS.  However, to the extent that the NAHB Chart of Accounts presents its Income Statement as anything other than a true delineation of costs based on their behavior in regard to Revenue, it is utterly useless.

The NAHB COA Income Statement is useless because it prevents a builder from understanding how it makes money.

Strong words, purposely stated.

For anyone headed to the 2013 IBS in Las Vegas later this month, planning on attending certain events on the Business Operations track, reading that post and what follows in this series should be thought-provoking – should provoke the exercise of legitimate reservation, should challenge conventional thinking and advice.

In the Fall of 2011, we surveyed a group of CFOs in the homebuilding industry, on the matter of the NAHB COA Income Statement, in order to learn more about the format and the utilization of their company’s particular Income Statement.  Most of the survey participants were the Chief Financial Officers of their company, but the group included a number of Controllers and Vice Presidents of Finance.  It included both large and small builders, both publicly-held and privately-held companies.  It included SAI clients.

First – we inquired about the format and use of their particular Income Statements:

Q: Does the format of your Income Statement comply with the NAHB Chart of Accounts?  50% said their Income Statement does not comply with the NAHB Income Statement format.  

Q: How many versions of your Income Statement do you produce?  40% said they produced multiple versions.

Q: Do you use any version of your Income Statement prepared in a Contribution Income Statement format?  20% said they used a Contribution Income Statement.

Q: Do you analyze breakeven on either a community or enterprise basis?  40% said they used breakeven analysis or other CVP tools.

Regarding the more critical issue of the assignment/allocation of costs:

Q: Where do the following equivalent line items appear on your Income Statement (either as a part of Cost of Sales or a part of Operating Expense): Indirect Construction Cost, Selling Expenses (including Commissions), and Financing Costs?  50% reported that they allocated Indirect Construction Cost to Cost of Sales (where NAHB insists it should be, despite the fact that it is, in effect, a non-variable cost that should be allocated to Operating Expense).  60% said they allocated Selling Expense (including Commissions) to Operating Expense (where it should be, insists NAHB, notwithstanding the fact that Commissions are clearly a variable cost that should be allocated to Cost of Sales).  40% responded that they allocated Financing Cost to Operating Expense (where NAHB insists it should be, except that construction-related Interest only behaves like a non-variable (fixed) cost if the construction line of credit is fully-drawn all the time, or if the LIP balance never varies;  and, loan fees are legitimately a part of overhead only if they are non-variable costs that do not fluctuate with the volume of Revenue).

The fact is, there are arguments for treating aspects of Indirect Construction Cost, Selling Costs, and Financing Costs as a Cost of Sales (a direct, variable cost), and there are arguments for treating parts of them as an Operating Expense (an indirect, non-variable cost);  the variable portion should be Cost of Sales, and the non-variable portion should be Operating Expense.  The problem is, if you have to ascribe it fully to one-of-two categories, the costing method of the NAHB-recommended Income Statement is absorption costing, not variable costing.

The NAHB Income Statement is acceptable as a traditional, GAAP-compliant, externally-focused, functionally-oriented classification of costs, but the effect of functional cost allocation is to indiscriminately blend costs that are either variable or non-variable, in terms of how they behave in relationship to changes in Revenue.  This practice obscures cost behavior, and it prevents the use of important management accounting tools.  In order to use Cost-Volume-Profit (CVP) – which includes breakeven analysis – you generally must have a Contribution Income Statement;  to have a Contribution Income Statement, you must use a variable costing approach.

But, don’t take just our word for it.

Next:  Part III:  CFO insight into the problems with the NAHB Chart of Accounts Income Statement