Archive for March, 2016

(published on EFA® every year since 2012;  updated, incorporated, and republished here, as the third in a five-part series)

NAHB COA (capture)

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.

Their responses were 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, preventing the use of important management accounting tools.  In order to use Cost-Volume-Profit (CVP) – which includes breakeven analysis – we further noted that you 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 in every Pipeline workshop™;  after all, builders are in business to make money.  Learn more here:  http://buildervelocity.com or http://saiconsulting.com/buildervelocity-pipeline-workshops/)

 

“Risen”

Posted March 27, 2016 By Fletcher Groves

(updated and reposted on Escape from Averageness® every year, at Easter)

The intrepid, results-based consultant reclined into the natural seat, at the back edge of one of the dry-eddy pools, where the beach resumed its slope more steeply upward, toward the dunes.

She dug her bare feet into still-wet sand, and felt the remnant of last night’s high tide through her jeans and shirt.  It always felt good, she thought, as she rested her arms on her knees, gazed eastward, and studied the movement of sea and sky.

IMG_2485

Easter 2016, Ponte Vedra Beach, Florida

She smiled, as the morning sun, already well-above the horizon, finally emerged into what seemed the only break anywhere in the low-level rain clouds offshore, on what was a warm late-March morning in northeast Florida.

She was comfortable in her element.  A seventh-generation Floridian, she loved the waters and land of her native state.  She wished she could have seen for herself the remnant of the Cracker Florida her dad liked to tell her about – the mid-twentieth century Florida of his youth, as he would describe it:  Florida before air conditioning, interstate highways, and theme parks.

This was her routine, every year, on Easter morning.

She reached over and removed her 35mm SLR from its backpack case, switched the camera to manual, and adjusted her settings.

The resulting still-frame was a mental image, as much as a digital image.

Her thoughts went back to the pre-dawn darkness of that first Easter morning, to what the disillusioned friends and followers of the one they called Jesus of Nazareth must have been thinking.

By every rational explanation and every shred of evidence, this man of so much promise, in whom they had placed so much hope, was dead.

They had been eyewitnesses to that unquestionable death, and the effects of the torture that preceded it;  they had been witnesses to his burial, as well, and the intense security of his tomb.  She reminded herself that the term excruciating came from the Latin ex crucis, literally, “out of the cross”;  Roman crucifixions left nothing to the imagination.

For His friends and followers, this was certainly more than the physical death of one man;  for them, it was the death of all faith and hope.

Her thoughts moved to a time, not far removed from the darkness of the days following the death of Jesus, as Peter and others publicly asserted that they were the eyewitnesses to the effect of His resurrection and the actuality of His ascension.

Far from abandoning their faith and succumbing to hopelessness, they said they were willing to live their lives – to give their lives – for the lives of others, and for the faith and the hope that His crucifixion, death and resurrection gave all of them.

So it has been, that decision, she thought, for every Christian, ever since.  So it was for her.

She smiled again, and whispered.

“Risen”.

 

(published on EFA® every year since 2012;  updated, incorporated, and republished here, as the second in a five-part series)

NAHB COA (capture)

Clearly, we disagree with the cost allocation structure of the Income Statement recommended by the National Association of Home Builders in its Chart of Accounts:

The NAHB Chart of Accounts enables comparisons, complies with GAAP, allows consultants to give the same presentation every year at IBS.  But, to the extent that its Income Statement presents costs as anything other than a true delineation based on behavior in regard to Revenue, it is – from a management standpoint – utterly useless. 

It is useless, because it prevents a builder from understanding how it makes money.  

Strong words, purposely stated.

Reading that post and the posts that follow in this series should raise legitimate reservation, challenge conventional thinking and advice, regarding 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 CFOs, but the group included a number of Controllers and VPs of Finance.  It included large and small builders, 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.

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 did indeed produce 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 (a significant percentage of them, apparently, without the tool required to do so).

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

Q: Where do Indirect Construction Cost, Selling Expenses, and Financing Costs appear on your Income Statement, as part of Cost of Sales or part of Operating Expense)?

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 a non-variable cost that should be allocated to Operating Expense;
  • 60% said they allocated Selling Expense, including Commissions, to Operating Expense (where NAHB insists it should be), notwithstanding 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 the LIP balance never varies; 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 reasons for treating aspects of Indirect Construction Cost, Selling Costs, and Financing Costs as a Cost of Sales, and there are reasons for treating parts of them as an Operating Expense;  whatever is variable should be Cost of Sales, whatever is non-variable 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 blend variable and non-variable costs.

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 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 every Pipeline workshop™;  after all, builders are in business to make money.  Learn more here:  http://buildervelocity.com or http://saiconsulting.com/buildervelocity-pipeline-workshops/)

 

(published on Escape from Averageness® every year since 2009;  updated, incorporated, and republished, here as the first in a five-part series)

NAHB COA (capture)

The NAHB Chart of Accounts enables builder-to-builder comparisons, complies with GAAP reporting requirements, and allows consultants to give the same presentation every year at IBS.  But, to the extent that its Income Statement presents costs as anything other than a true delineation based on behavior in regard to Revenue, it is – from a management standpoint – utterly useless.

It is useless, because it prevents a builder from understanding how it makes money.

The ability to generate cash, make a profit, and produce an economic return depends on an understanding of cost classification.  How costs are associated (or classified) according to structural hierarchy, cost objects, and behavior.

Does it matter how costs are classified?  Does it matter where they are incurred, what caused them to be incurred, or whether they vary in relationship to anything?

Yes – it certainly does matter.

Costs are the most operative part of a home builder’s Income Statement, and an understanding of how costs are allocated and classified provides a basis of operational insight that is otherwise missing.  Understanding where costs are incurred and whether they are incurred directly or indirectly is important, but the distinguishing characteristic of costs is behavior.

The Operative Question:  Does the cost vary with the volume of Revenue, or does it not?

Cost behavior presents a builder with the truest picture of what its production capacity costs, where its breakeven point lies, and how it analyzes changes in costs, production levels, and margins.

Not only the truest picture, but the only picture.

At the core of variable costing is the understanding that costs have attributes, and those costs cannot be managed as if their attributes don’t exist.

Builders need to control their direct, variable costs – the costs that should be “above the line” on their Income Statement;  they need to either reduce the cost, or extract maximum value from having incurred it.  Simultaneously, they need to leverage their indirect, non-variable costs – the costs that should be “below the line” on their Income Statement;  those are costs expected to be incurred regardless of the Revenue the cost generates;  the objective should be to produce as much Contribution as possible, from having incurred the cost in the first place.

Controlling and extracting value from direct, variable costs is how a builder improves margin;  leveraging indirect, non-variable costs is how it increases velocity.  Economic return is Return on Assets;  ROA is margin x velocity;  it is velocity acting upon margin.  

Builders must distinguish between variable and non-variable costs, to have any picture of breakeven, the rate at which it absorbs overhead.  If Cost of Sales contains non-variable costs, and Operating Expense contains variable costs, that understanding of breakeven is destroyed.

Three examples of the problem with the NAHB COA Income Statement:

(1)  It treats Indirect Construction Cost as a cost 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.  Do Indirect Construction Costs generally vary according to Revenue?  No.  For the most part, they are non-variable costs that will be incurred regardless of the Revenue produced.

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

(3)  It treats Financing Costs as an Operating Expense, but it 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 LOC never varied. Is this typically the case?  No.  Are loan fees non-variable costs that do not fluctuate with volume?  Typically, no.

Bottom-line:  Report your financial condition and meet your tax reporting obligations, as required.  Mindlessly compare your company with other builders, if you choose.  But – give yourself cost information that guides your operating decisions.

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

 

(this issue is addressed in every Pipeline workshop™;  after all, builders are in business to make money.  Learn more here:  http://buildervelocity.com or http://saiconsulting.com/buildervelocity-pipeline-workshops/)

 

Pipeline Workshops™: Critical Chain Project Management

Posted March 6, 2016 By Fletcher Groves

One of the areas we single-out for deeper discussion in a Pipeline workshop™ – what we call Velocity Accelerators – deals with the imperative of replacing the current method used to schedule jobs;  actually, the current method used to schedule a portfolio of jobs.

Chain

The nature of the workflow in homebuilding production is project portfolio management.  Yes, there is workflow performed in processes, but those processes are generally embedded, enabling, and supporting;  process workflow is different than project workflow.

The process of building a home – what we call the Start-to-Completion process – is actually the management of multiple projects that share resources.  It is the structuring and the management of a portfolio of job schedules, with interdependencies and interactions of tasks and resources.

The current method of project scheduling is known as the Critical Path Method (CPM), which evolved from the Program Evaluation and Review Technique (PERT) in the 1950s;  it has been in existence for more than sixty years;  it is the method used in every homebuilding ERP suite.

PERT and CPM were designed for programs with large, complex structures (Polaris weapons system, Manhattan Project), but the Critical Path Method has become the de facto standard for scheduling all types of projects:  construction, aerospace/defense, software development, product development, research.

The problem with CPM is that it was not designed for managing a portfolio of projects, and it was not designed to function in environments where velocity is important, where faster cycle time and higher inventory turns are critical drivers of business outcomes.

Where it must contend with variation and uncertainty, CPM offers only a buffer of additional time – individual task durations lengthened to protect the completion date of each task, but not necessarily the completion date of the project.

For the most part, builders are oblivious to the effects of variation on their production system.  The cost of variation is always the same:  it is the Gross Income lost from all of the closings that never occurred, from houses that were never built with the capacity they paid to have;  for a profitable builder, it is Gross Income that would have become Net Income, and ultimately, Net Profit.

Moreover, CPM considers task dependency (the predecessor-successor relationships of tasks) in its work breakdown structure, but it does not resolve resource contention;  it does not consider situations in which tasks of different projects (jobs) depend on the availability of resources that do not have sufficient capacity to meet the demand being placed upon them.

These two factors – dealing with variation and resolving resource conflict – should be anathema to builders.

CPM was not designed to contend with the production environment homebuilding presents.  It is not the problem (the problem is variation and resource conflict), but CPM is benign to the solution.  ProChain Solutions’ Rob Newbold (Project Management in the Fast Lane) told me that he would go further, saying:  “CPM supports values that perpetuate the problems of homebuilders.”

Which brings us to Critical Chain Project Management.

Developed in 1997, Critical Chain addresses task dependency and resource contention, and it replaces padded durations intended to protect task completion dates with buffers that protect the completion date of the project/job;  CCPM is much more aware of system constraints.  Most importantly, Critical Chain reduces the duration of projects – the cycle time of houses under construction.

Consider this exercise from one of the RB Builders: Lessons from the Pipeline© business case studies used in a recent Pipeline workshop™:

RB Builders’ newly-acquired division has a construction schedule of 120 calendar days, but its actual cycle time is 180 calendar days.  There is wide agreement that it should be able to build its homes in far-less than 120 days, because the schedule reflects “highly certain” task durations.  Switching from CPM to CCPM would reduce the schedule from 120 days to 96 days, cutting the schedule by 20% with no diminution of confidence;  it would reduce the actual 180 day cycle time by almost 50%.

Critical Chain Project Management does more than just reduce the length of construction schedules.  It also specifies a set of rules preventing behaviors that consume (and waste) the safety built into task durations.  It installs a release mechanism that pulls starts into the system and keeps work-in-process at the levels required to produce faster cycle times.

It implements simple, visual tools to manage production.

Builders can put a number of these practices into place without changing the scheduling algorithms from Critical Path to Critical Chain.  But, it will not be a complete solution until management technology catches up.

Come.  Participate.  Learn.

 

Critical Chain Project Management is one of two velocity accelerators (Epic Partnering™ is the other) that will be presented during the next Pipeline workshop™, held March 16-17, 2016, at the Ponte Vedra Inn and Club, in Ponte Vedra Beach, Florida.

With attendees from both BuilderMT and Hyphen Solutions, it should be an interesting discussion.

Sponsored by BUILDER and BuilderMT.

Cost is $850.00.

Details:  www.buildervelocity.com