Archive for February, 2014

“More Cowbell”

Posted February 25, 2014 By Fletcher Groves

(excerpted from an EFA post, of the same title, that appeared in February, 2013)

 

There is a perception about the advantage that rests with the size of balance sheets, particularly with cash and inventory, and with the capacity to borrow and the cost to borrow;  it is a perception that extends somewhat to overhead expense on income statements.  Size enables, but size also tends to foster a “more-with-more” mentality;  large homebuilding companies rarely exploit the advantages of becoming more productive, of embracing a “more-with-less” mental model.

The weapon of choice becomes more of what they have already:  more geography;  more communities, more inventory, more cash, more debt;  more resources, and more of the overhead that goes with them.

“More cowbell.”

The legendary Bruce Dickenson – yes, the Bruce Dickenson – would encourage us to “explore the space.”

The clearest image we have of homebuilding production – the best visual reference – is that of a pipeline, one in which size is defined by the amount of work-in-process the pipeline is designed to carry, in which cost is determined by what the production effort consumes, in which length is calculated as the pipeline’s cycle time, and in which capacity is defined as the rate of throughput a pipeline of that size can produce, with planned, finite, and controlled levels of overhead resources and work-in-process.

The amount of work-in-process a building company has to carry in order to generate its revenue is the more meaningful, more useful measure of its true size;  the relationship between revenue and operating expense is the classic measure of its productivity.  Using either work-in-process or operating expense as the truer indicator of size would discourage builders from aiming to be bigger companies.

It would convince them that they need to become faster, more productive, more profitable building companies;  it would enable them to better confront the current market and economic reality of having to “do marginally more with significantly less”.

 

The first Pipeline workshop will be held at the Ponte Vedra Inn and Club, Ponte Vedra Beach, Florida, on March 12-13, 2014.  Cost is $750.00.

Delivered by SAI Consulting.  Sponsored by BuilderMT and Big Builder (Hanley Wood).

Details:  www.buildervelocity.com

 

Pipeline Workshops: What’s your Production IQ?

Posted February 16, 2014 By Fletcher Groves

The fundamental understanding that emerges from the DuPont identity:  Remove the financial leverage (equity multiplier) from the equation, and economic return becomes a function of profitability (Return on Sales) and operating efficiency (Asset Turnover).  Economic return is margin x velocity;  it is a co-equal dependency.

Is margin proficiency necessary?  Yes.  Is it sufficient?  No.  Does it hold-forth the possibility of ever achieving sustainable competitive separation?  Absolutely not.

In the homebuilding industry, action on the velocity side of Return on Assets inexplicably takes a backseat to action on the margin side of ROA.  Pipeline workshops are aimed at changing that paradigm.  But, the motivation to attend a Pipeline workshop starts with the willingness to acknowledge and remedy what is a profound lack of knowledge regarding production principles and disciplines.

Think you know this stuff?  There’s one way to find out.  Take the test (answers at the bottom).

  1. The best image of a production system is a pipeline.  What is the measure of the pipeline’s size?  What is the measure of its capacity?  What is the measure of its length?  What is the measure of its cost?
  2. True or False:  Even-flow production is an outcome, not a mechanism.
  3. From an operational perspective, there are only three activities that answer the question:  “What happens to money?”  The terms for those activities can be used to fully express – and, therefore, link – the equations for productivity, cycle time, and inventory turn, to the equations for Net Income, and Return on Assets.  What are those terms?
  4. True or False:  A production system with balanced capacity across all resources will do a better job of optimizing the utilization of a system’s capacity than one where capacity is not balanced across all resources.
  5. In what three ways will any production system buffer (protect) itself from variation?
  6. True or False:  In job scheduling, the Critical Path Method (CPM) considers task dependency, but not resource contention.
  7. Calculating the duration (cycle time) of any production process requires the knowledge of two operational measures.  What are they?
  8. True or False:  Task durations (for example, the phases in a job schedule) should have enough safety to insure a high certainty of on-time completion.
  9. Lean Production views homebuilding as a build-to-order process.  Which resource does Lean recommend using to set the pace of production?
  10. True or False:  CCPM (Critical Chain Project Management) does not adjust the job schedule according to when phases finish, whether early or late.
  11. What three human behavioral tendencies tend to waste the time safety built into a schedule?
  12. As a matter of standard deviation, increasing the probability that a task will finish on-time, from 50% probability to a “highly certain” 95% probability, will cause the anticipated duration of the task to increase by a factor of how much?

Like any quiz, these questions represent but a very small portion of the production and business knowledge required to effectively manage homebuilding production, increase operating performance, generate higher Net Income, and improve Return on Assets.

Ultimately, every homebuilding company has to determine how it will manage production within a specific context, within the parameters that comprise its market, its product mix, its choice of an information/management technology system, its financial situation.

But, the ability to manage production starts – it starts – with an understanding of the underlying principles and disciplines.

It starts with what you learn in a Pipeline workshop.

 

The first Pipeline workshop will be held at the Ponte Vedra Inn and Club, Ponte Vedra Beach, Florida, on March 12-13, 2014.  Cost is $750.00.

Delivered by SAI Consulting.  Sponsored by BuilderMT and Big Builder (Hanley Wood).

Details:  www.buildervelocity.com

 

Answers:  (1) size is a reflection of the amount of work-in-process, capacity is the rate of output produced with a planned, finite, and controlled amount of work-in-process, length is cycle time, cost is all of the indirect, non-variable expenses associated with overhead;  (2) True;  (3) money generated through sales is called Throughput, money invested in whatever will be turned into Throughput is known as Inventory or Investment, and money spent turning Inventory into Throughput is called Operating Expense;  (4) False;  (5) higher work-in-process, longer duration, or excess capacity;  (6) True;  (7) work-in-process and throughput, expressed in units;  (8) False;  (9) the most capacity-constrained resource;  (10) True;  (11) Student Syndrome (wait to start until too late), Parkinson Law (expand to time allowed), and multi-tasking (dividing work between multiple jobs);  (12) factor of 1.64, reciprocal of .61; four out of every 10 days in the schedule are safety to assure on-time completion.

 

Annual new home sales are currently at a level that is 35% below the average of the past 50 years – and there is, nonetheless, a shortage of skilled construction labor.  Over the next several years, annual new home sales are expected to increase 87% from their current level – and there is, already, a shortage of skilled construction labor.   

It scares the hell out of you, doesn’t it?

I agree whole-heartedly with those who make the valid argument that the homebuilding industry needs to take collective action to help solve this problem, by increasing the supply of skilled construction trades.  However, there are vast opportunities for improving this situation that have nothing to do with increasing the supply of skilled construction trades.  As a component of overall production capacity, a significant portion of the existing supply of skilled construction labor is wasted outright, as a result of the industry’s archaic production practices.

Relying on an increase in the availability of skilled construction trades is part and parcel with the larger mindset problem that has plagued this industry for time immemorial:  focus on margin and increase production capacity.

This penchant for relying on the ability to increase production capacity, at will, is not the same as finding the means to increase productivity.  Simply dialing-up more production capacity is a “more-for-more” proposition – the answer to more revenue and more output is more of everything else – more production capacity, more resources, more plans, more steps, more complexity, more reports, more money, more starts, more work-in-process.

We subscribe to a different proposition, a very different mental model of what homebuilding production should be:  “more-for-less”.  The answer to more revenue and more output is to find ways to produce that revenue and output with less of everything else – less waste, less rework, fewer non-value-added steps, a simpler operating model, fewer-but-better measures, fewer-but-better resources, a smaller-but-more-intelligent portfolio of plans, less money, less work-in-process, and fewer excuses.  And, there are some areas where we want more;  beyond more revenue and more output, we would like more speed, higher velocity, higher quality, more accountability, more focus, more involvement, more partnering.

When I first started making the argument for a focus on velocity, the proposition was “do more with what you already have”;  it was essentially a “more-for-the-same” proposition;  a classic productivity argument.  In the halcyon years known as the Age of Homebuilder Entitlement, a “more-for-the-same” proposition was the appropriate solution.

I think what builders have to confront, right now, is the market and economic reality of having to “do marginally more with significantly less”;  essentially, it is a “do-the-same-with-less” proposition.

True, sustainable competitive separation is the result of doing what your competition simply will not do, what they cannot do.  Things that are too tough, that require too much rigor, too much discipline, too much resolve.  Margin is important, but it is not the difficult part;  margin is the more natural part, where builders’ inclination lies.

True, sustainable competitive separation requires much more;  it requires doing the difficult part, the part to which builders are less-inclined.  It requires continually and relentlessly finding ways to become more productive, finding ways to do more with less.  It requires being as proficient on the velocity side of Return on Assets as the margin side of ROA.

That’s what a Pipeline workshop is all about.

Pipeline workshops are a two-day immersion into the production physics – into the principles and disciplines – that enable homebuilders to thrive on the velocity side of economic return, that enable builders to thrive on the velocity side of Return on Assets.

 

The first Pipeline workshop will be held at the Ponte Vedra Inn and Club, Ponte Vedra Beach, Florida, on March 12-13, 2014;  cost is $750.00.

Delivered by SAI Consulting.  Sponsored by BuilderMT and Big Builder (Hanley Wood).

For more details:  www.buildervelocity.com

 

Part V: Groves and Shinn: The Debate Over Costing

Posted February 5, 2014 By Fletcher Groves

(first published on EFA on April 16, 2012, under the title “The Debate Over Costing”;  incorporated and republished here, every year, as the last in a five-part series)

 

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.

 

(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 18, 2012, updated, incorporated, and republished here, every year, as the fourth in a five-part series)

 

“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 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 of the preceding excerpts 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 that is an outlier to even a Contribution Margin P&L, by 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

 

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