Archive for January, 2014

(initially published on EFA on January 18, 2012, updated, incorporated, and republished here, every year, as the third in a five-part series)

 

In the preceding post, we reported on an SAI 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.

In 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 industry 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;  in order 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 3000-9000), 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

 

(this issue is addressed at a Pipeline workshop;  learn more here:  http://buildervelocity.com or http://saiconsulting.com/buildervelocity-pipeline-workshops/)

 

(initially published on EFA on January 17, 2012, updated, incorporated, and republished here, every year, as the second in a five-part series)

 

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 – from a management standpoint – 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 2014 International Builders Show in February, planning on attending sessions on the Business management and Operations track, reading that post and the posts that follow in this series should raise legitimate reservation, and challenge conventional thinking and advice, regarding any session extolling this method of cost allocation.

Several years ago, 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.

Then, 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?

On this multi-point question, 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 becomes, 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 volume.  This practice obscures cost behavior, and it prevents the use of important management accounting tools.  Generally-speaking, in order to use Cost-Volume-Profit (CVP) – which includes breakeven analysis – you 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

 

(this issue is addressed in a Pipeline workshop;  learn more here:  http://buildervelocity.com or http://saiconsulting.com/buildervelocity-pipeline-workshops/)

 

(initially published on EFA on April 12, 2009, updated and republished here, every year, as the first in a five-part series)

 

Yes – the NAHB Chart of Accounts permits comparisons with other builders.  Yes – the NAHB Chart of Accounts complies with GAAP reporting requirements.  Yes – the NAHB Chart of Accounts 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 – from a management standpoint – utterly useless.

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

The ability to generate positive cash flow, make a profit, and produce a satisfactory economic return begins with an understanding of cost.  An understanding of how costs are classified or associated according to structural hierarchy and cost objects, but most importantly, an understanding of how they are classified according to behavior.

Why does it matter how costs are classified?  All of the costs of building a home and running a building company are accounted for in the calculation of residual Net Income, right?  As long as the classifications don’t change, they are still comparable, right?  So – what does it matter where they are incurred, what caused them to be incurred, or whether they move in relationship to anything?

And – even if it does matter – why start with costs?

It starts with an understanding of cost, because costs are the most operative part of a building company’s Income Statement, and a deep, intuitive, and instinctive understanding for how costs are allocated and classified provides a basis of operational insight that cannot be acquired through any other means.

Understanding where costs are incurred and whether they are incurred directly or indirectly is marginally important, but the truly distinguishing characteristic of costs is how they behave.  The operative question:  Does the cost vary with the volume of an activity, or does it not? 

Cost behavior is so distinctive, because it presents a building company with the truest picture of what its production capacity costs, where it achieves (and passes) breakeven, and how it analyzes changes in costs, production levels, and margins.  Not only is it the truest picture, it is the only picture.  It requires a variable costing approach to managerial accounting.

There is no more vital understanding to have – in all of managerial accounting – than an understanding of variable costing and the Contribution Income Statement format.  This is true, regardless of how the financial statements of a building company are reported or presented.  It is true, regardless of the quest for comparativeness to support the industry’s fascination with meeting “industry best practices”.  It is true, regardless of the talking heads at IBS telling builders that all they need to do is just stay between the lines.

At the core of the variable costing approach is the understanding that all costs are not created with the same attributes, and, therefore, cannot be managed the same way.  There is a reason why builders need to differentiate between variable and non-variable costs.

Builders need to control direct, variable costs, the costs that are “above the line” on their Income Statement;  they need to reduce the cost and/or extract maximum value from having incurred it.  On the other hand – and at the same time – they need to leverage their indirect, non-variable costs, the costs that are “below the line”.  Those are costs builders expect to incur regardless of the Revenue the cost generates, and they want to produce as much output (Revenue, Gross Income) as they can, from having incurred the cost in the first place.

A building company has to control and extract value from its direct, variable costs;  that is how margins increase.  At the same time, it has to leverage its indirect, non-variable costs;  that is how velocity increases – how productivity increases, how production capacity is utilized as fully as possible.  It bears repeating that the preferred measure of economic return – namely, Return on Assets – is margin x velocity;  it is velocity acting upon margin.

A building company has to distinguish between variable and non-variable costs, in order to have a picture of breakeven, of the rate at which it absorbs overhead.  If its Cost of Sales contains non-variable costs, and its overhead contains variable costs, that understanding is destroyed.

That is the problem with the NAHB COA Income Statement.  Three examples, in point:

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?  Obviously not.  The bulk of Selling Expense is a variable cost.

The same argument could be made (albeit less strenuously) regarding Financing Costs, which the NAHB COA Income Statement also treats as an Operating Expense.  However, construction interest would only be a non-variable cost, if a builder had its construction lines of credit fully-drawn every day of the accounting period, or if the LIP balance on the lines of credit never varied.  Are loan fees non-variable costs that do not fluctuate with volume?  Clearly, they are not.

My advice?  Report your financial condition and your tax obligations, as required.  Compare your building company with other building companies, if you choose.  But – give yourself cost information capable of guiding your operating decisions.

Next:  Part II:  The Problem with the NAHB Chart of Accounts Income Statement

 

(this issue is addressed at a Pipeline workshop;  learn more here:  http://buildervelocity.com and http://saiconsulting.com/buildervelocity-pipeline-workshops/)

 

Grace in the Wilderness

Posted January 8, 2014 By Fletcher Groves

“The people who survived the sword found grace in the wilderness;” – Jeremiah 31:2

EFA - Grace in the Wilderness

Jeremiah 31 is an obscure passage of scripture.  In terms of biblical commentary, it doesn’t receive significant treatment;  it seems little more than a brief account of how God restored the remnant of Israel that had been banished to wander in the desert as the result of their disobedience;  not the first time that had happened, wouldn’t be the last.

However, the picture within the passage, the image of grace found in the wilderness, has a particular meaning for me.

In his commentary on this passage, Matthew Henry makes two observations.  First:   “ . . . the love of God . . . is an everlasting love . . . those whom God loves with this love, he will draw to himself, by the influences of his Spirit upon their souls.”  Second:  the predictions in this passage “ . . . figuratively describe the conversion of sinners to Christ.”

January 8, 1974.  I closed my eyes, and simply said, “I give up.”  The two-year struggle for my soul ended forty years ago, today.

The struggle didn’t end so much in victory, or even in surrender (that would come later);  at the time, it was more like a capitulation, a submission that involved a sense of both relief and resentment.  I had tried every way I could to opt-out of salvation.  In the end, the only defense left was pride, and I was unwilling to let that be the justification for continuing to stand in defiance of Truth.

At the time I accepted Jesus Christ as my Savior, I didn’t know where that decision would lead me;  I didn’t know what would change about my life.  I didn’t know all the ways that God would change my heart.  I didn’t know how much He would increase my understanding of faith, of grace, of mercy, of justification, of sanctification;  I did not anticipate the profound handprint of His providence;  forty years later, the Cross of Jesus Christ is immeasurably larger than anything I could have then imagined, anything I could have comprehended, anything I could have beheld.

At the time, I just knew that I couldn’t stay where I was, in an empty, desolate spiritual wilderness from which there seemed to be no way out, only space in which to wander aimlessly, endlessly, pointlessly.

In order to be found, grace has to be imparted.  It’s impartation is totally unmerited, wholly-sufficient, the result of a love that is given without condition.  But – it is also imparted as something else.  The struggle that lead to my salvation is a testament – as John Calvin reminds us – to the irresistible nature of that grace.