Archive for April, 2017

(published every year on EFA® since 2012;  updated, incorporated, and republished here, 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 cite 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 cite 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 cite 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;  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;  literally, it has no internal use for GAAP compliance.

In the similarly nascent and outlying world of cost accounting methods that aim to support Lean Production, 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?  If you are a builder, 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.  Emphasizing 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

 

(variable costing and the Contribution Income Statement format are addressed at every Pipeline workshop™;  learn more here:  http://buildervelocity.com or http://saiconsulting.com/buildervelocity-pipeline-workshops/)

 

(published on EFA® every year since 2012;  updated, incorporated, and republished here, 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.

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

 

(variable costing and the Contribution Income Statement format are addressed at every Pipeline workshop™;  learn more here:  http://buildervelocity.com or http://saiconsulting.com/buildervelocity-pipeline-workshops/)

 

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

As evident from Part I, we clearly 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

 

(variable costing and the Contribution Income Statement format are addressed at every Pipeline workshop™;  learn more here:  http://buildervelocity.com or http://saiconsulting.com/buildervelocity-pipeline-workshops/)

 

“Risen”

Posted April 16, 2017 By Fletcher Groves

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

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.

Easter 2017 Ponte Vedra Beach, Florida

She dug her bare feet into still-wet sand, and felt the remnant of the past 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.

She smiled, as the morning sun, now just above the horizon, reflected on the water, on what was a warm and breezy mid-April 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 camera from its backpack, switched to manual mode, adjusted her aperture and exposure settings, and peered through the viewfinder.  Satisfied with her composition and settings, she released the shutter.

“ . . . photographs and still-frames of your mind”, she thought, as she reviewed her work.

Her thoughts turned to the pre-dawn darkness of the 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 particularly intense security of his tomb.  She recalled 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.

And, then her thoughts moved to a time, not far removed from the darkness of the days following the death of Jesus, as Peter and others asserted – for all to hear – that they were eyewitnesses to the effect of His resurrection and 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 Escape from Averageness® every year since 2009;  updated, incorporated, and republished, here as the first in a five-part series)

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 classified or associated 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?    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?    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?    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

 

(variable costing and the Contribution Income Statement format are addressed at every Pipeline workshop™;  learn more here:  http://buildervelocity.com or http://saiconsulting.com/buildervelocity-pipeline-workshops/)