Archive for June, 2014

Part VII: Breakeven

Posted June 29, 2014 By Fletcher Groves

(excerpted from The Pipeline: A Picture of Homebuilding Production, originally posted on Escape from Averageness in July 2010, updated and reposted here)

“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.  “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 an internal 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 of $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.  “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 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.”

“Do you have 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, by dividing overhead by the Gross Margin Ratio, which is basically the same 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

“About $39 million and $40.5 million, respectively”, he said, pointing back to the data table.  “Our overhead under both the 2008 Baseline or 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.”

 

(The Pipeline: A Picture of Homebuilding Production is available on the publisher website (virtualbookworm.com), and the author website (thepipelinebook.com), as well as amazon.com, barnesandnoble.com, and booksamillion.com)

 

(excerpted from The Pipeline: A Picture of Homebuilding Production, originally posted on Escape from Averageness in July 2010, updated and reposted here)

“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.  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.  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’s 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 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 – gives us more Gross Income in 2008 than we earned in 2007.

“Now, we are thinking maybe only 140 to 150 sales.  We are thinking 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 $6,500,000.

“Our indirect, non-variable cost is budgeted at $8,500,000.

“That is an operating loss of $2,000,000, and, frankly, we do not know where the bottom of this recession is.  It could get much worse.”

“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, her eyes said, “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 first resort.

“The market may not turn out to be this bad, but here’s 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.

“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%;  that is an average margin;  some houses we might make more, some houses we might make less.  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 $10,400,000, 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 earn higher Gross 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.  It is up to us.  I am not sure that is what we would want to do right now.  The resulting higher production would have severe implications on margins.

“I am starting to realize some things:  higher velocity can overcome lower margins;  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 – to produce more closings, more Revenue, more Gross Income – with a planned, finite, and controlled amount of work-in-process and overhead will be one of the keys to sustainable competitive separation.

“This discussion raises a question.  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.”

 

(The Pipeline: A Picture of Homebuilding Production is available on the publisher website (virtualbookworm.com), and the author website (thepipelinebook.com), as well as amazon.com, barnesandnoble.com, and booksamillion.com)

 

Part V: “What is the real cost?”

Posted June 15, 2014 By Fletcher Groves

(excerpted from The Pipeline: A Picture of Homebuilding Production, originally posted on Escape from Averageness in June 2010, updated and reposted here)

“That calculation does not even scratch the surface”, the CEO 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”, he said.  “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 that capacity 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.”

He 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 days

 2007:

  • WIP = 100
  • CLOSINGS = 200
  • CYCLE TIME = 180 days

2008:

  • WIP = 100
  • CLOSINGS = 240
  • CYCLE TIME = 150 days

 

  • WIP = 80
  • CLOSINGS = 240
  • CYCLE TIME = 120 days

 

  • WIP = 100
  • CLOSINGS = 300
  • CYCLE TIME = 120 days

 

  • WIP = ?
  • CLOSINGS = ?
  • CYCLE TIME = 90 days

 

  • WIP = ?
  • CLOSINGS = ?
  • CYCLE TIME = 90 days

 

Turning and nodding at the data table on the board, he said, “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.”

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 days

 

  • WIP = 100
  • CLOSINGS = 400
  • CYCLE TIME = 90 days

 

“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?

“It is a valid option, perhaps a necessary option, but set aside the idea of making RB Builders a smaller company – 240 closings, but reducing WIP to only 60 units.  Focus on Max-T.  Focus on 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 could 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 $3,400,000 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.

“That would be tough, given the economy and housing market we are facing in 2008.  But, if we succeed in reducing our cycle time from 180 days to 90 days, it means we get to progressively split a GI Reserve of $12.5 million instead of a GI Reserve of $1,500,000.

“And, you know what?

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

 

(The Pipeline: A Picture of Homebuilding Production is available on the publisher website (virtualbookworm.com), and the author website (thepipelinebook.com), as well as amazon.com, barnesandnoble.com, and booksamillion.com)

 

Part IV: The Cost of Variation

Posted June 8, 2014 By Fletcher Groves

(excerpted from The Pipeline: A Picture of Homebuilding Production, originally posted on Escape from Averageness in June 2010, updated and reposted here)

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

The intrepid, results-based consultant paused, then decided to rephrase the question.  “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.

“According to you, a system will protect itself from variation and uncertainty with some combination of longer cycle time, higher work-in-process, and excess/unused capacity.  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 a utilization rate of 67%;  in essence, we waste one-third of our capacity.

“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”, said the CFO.  “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 – I would say that it is ‘costing’ us the opportunity of the Gross Income on those 100 closings we missed in 2007;  our Gross Income Margin was 22%;  we had $50 million in Revenue;  we had 200 closings, which makes the average sales price $250,000;  the rest of 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?”

 

(The Pipeline: A Picture of Homebuilding Production is available on the publisher website (virtualbookworm.com), and the author website (thepipelinebook.com), as well as amazon.com, barnesandnoble.com, and booksamillion.com)

 

Part III: ”Quite the Poster Child”

Posted June 1, 2014 By Fletcher Groves

(excerpted from The Pipeline: A Picture of Homebuilding Production, originally posted on Escape from Averageness in June 2010, updated and reposted here)

“Remember our discussions on margin and velocity?”, she asked.  “This is where that comes into play.  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 house we close, and velocity is about how many houses 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 identity shows when calculating Return on Assets, Gross Income is a composite of margin and velocity.  We want the best blend of both;  margin and velocity 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, like when we are facing an external (market) constraint as opposed to 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 – allow us to economically leverage – that capacity.  We can control truly-variable direct costs and 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 final, halcyon days of the ‘Age of Homebuilder Entitlement’”.

“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 days

2007:

  • WIP = 100
  • CLOSINGS = 200
  • CYCLE TIME = 180 days

2008:

  • WIP = 100
  • CLOSINGS = 240
  • CYCLE TIME = 150 days

 

  • WIP = 80
  • CLOSINGS = 240
  • CYCLE TIME = 120 days

 

  • WIP = 100
  • CLOSINGS = 300
  • CYCLE TIME = 120 days 

 

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

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

The intrepid, results-based consultant gazed intently at everyone around the room, and then asked,  “Based on your interpretation of the data in the table, exactly how and where do you think RB Builders’ production system is buffering itself from all of this variation?

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

 

(The Pipeline: A Picture of Homebuilding Production is available on the publisher website (virtualbookworm.com), and the author website (thepipelinebook.com), as well as amazon.com, barnesandnoble.com, and booksamillion.com)