Archive for February, 2018

(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 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 necessary 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/)

 

(published on Escape from Averageness® every year since 2009;  updated, incorporated, and republished, here as the first in the 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 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.

Here is 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.

These three examples of the problem with the NAHB COA Income Statement make our point:

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 construction line of credit 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/)

 

Pipeline Workshops™: RB Builders: Lessons from the Pipeline©

Posted February 11, 2018 By Fletcher Groves

Homebuilders should be able to determine, for themselves, how attuned they are to the critical tasks that enable them to thrive on the velocity side of economic return.  In furtherance of that end, we will make the RB Builders: Lessons from the Pipeline© business case – the same business case used at every Pipeline workshop™ – available to any builder that asks for it.

There are only two conditions:  (1) a builder has to state the intent of actually completing it;  (2) if a builder wants our methods and solutions, it has to share its results with us.

For the business case, contact me:  flgroves@saiconsulting.com

The offer comes with this warning:  as with everything else regarding Pipeline workshops™, this business case is challenging;  if you are up to that challenge, the following excerpt is taken from how the business case opens, followed by the nature of the questions its exercises require you to consider:

 

“It is the first quarter of 2018.  RB Builders is aiming to extend its reputation as a builder that thrives on both the margin and velocity sides of Return on Assets, by expanding into another geographical market, via the late-2017 acquisition of a fifth existing homebuilding operation.

“Like its predecessors, the newly-acquired building division has historically generated lower operating results and business outcomes than what RB Builders considers acceptable;  in fact, this is the worst-performing of all the acquisitions, from the standpoint of both margin and velocity.

“RB Builders is confident that it can continue its record for unifying, developing, and improving the capabilities of existing teams at acquired divisions, transforming them to ones that reflect the savvy, motivated, and mutually-accountable homebuilding team of the parent operation.

“This road has become a familiar path for RB Builders.

 

HISTORY OF RB BUILDERS:  Nine years earlier, at the beginning of 2008, and shortly after the end of the halcyon period known as the Age of Homebuilder Entitlement®, RB Builders had begun its own transformation process, with the objective of extracting itself from what it self-described as “the tar pits of averageness”.

“RB Builders had employed a program that used four initiatives (team-based performance compensation, operational and financial transparency, accounting procedures that connected operating performance to business outcomes, and a focused process of continuous improvement) to make massive strides.

“During the ensuing five-year period (2008-2012), annual Revenue had grown from $50 million to more $121 million;  the number of closings had increased, from 200 houses per year to 453 houses per year.  Despite the pressure on margins from increasing market share, overall Gross Margin had increased from 22% to 24%;  Gross Income had grown from $11 million to almost $30 million.

“Operating Expense had increased, from $8.5 million to $11 million, far less than the same-period percentage increase in Revenue.  As a result, RB Builder’s Net Income had risen six-fold, from $2.5 million to $16.5 million;  its Net Margin had almost tripled, from 5% to 14%.

“In 2008, RB Builder’s cycle time had been 180 days;  by the end of 2012, cycle time had been reduced to 65 days.  The average amount of work-in-process had been 100 houses under construction;  the company had reduced its average work-in-process to 80 houses under construction.  The reductions in cycle time and work-in-process occurred, despite a more than doubling of the annual number of closings.

“In 2008, RB Builders had targeted an inventory turn of 2.5x;  in 2012, RB Builders had been able to more than double its physical inventory turn, to 5.7x.  In 2008, it had turned the value of its assets two times;  in 2012, it turned the value of its assets almost five times.

“Because it had maintained margins while improving velocity, RB Builders saw its main barometer of economic return – Return on Invested Assets – increase almost six-fold during the five-year period, from 11% in 2008 to 64% in 2012.  In 2013, RB Builders had moved all of its raw land holdings and developed lot inventory off of its balance sheet, and into subsidiaries, which would have further increased Asset Turn – and ROIA – had those measures been restated.

“It had been a remarkable transformation.

“The four that RB Builders had previously acquired had now met – or were on-track towards meeting – their own two-year plans for increasing closings and Revenue without any increase in Operating Expense, while maintaining lower levels of work-in-process and operating under reduced construction lines of credit.

 

NEWLY-ACQUIRED DIVISION:  Near the end of 2017, RB Builders acquired this, its fifth homebuilding operation.  Ths acquisition was considered a departure from RB Builders’ M&A pattern;  this new division has a different product offering, in a different price range.

In its final year of independent operation, the division had closed 32 houses, and generated $12.8 million in Revenue;  with almost $10.8 million in Cost of Sales now reflecting only its direct, variable costs, the operation had generated just over $2.0 million in Gross Income, producing a 16% Gross Margin.

With its $1.5 million in Operating Expense now reflecting only its indirect, non-variable costs, the newly-acquired operation had produced $550,000 in Net Income, resulting in a 4.3% Net Income Margin.

Since it carried an average work-in-process of 20 houses under construction throughout 2017, the division had a calculated cycle time of 225 days (despite job schedules that were typically 150 days);  32 closings and average work-in-process of 20 houses under construction meant the newly-acquired building operation turned its physical inventory 1.6 times in 2017.

Adopting the policy of RB Builders, and moving all of its raw land holdings and developed lot inventory off its balance sheet and into subsidiaries, the newly-acquired building operation showed a restated average work-in-process of $4.56 million  (the average per-unit LIP balance of $228,000 represented an average lot takedown of $120,000 and a fully-funded LIP balance of $336,000, or 84% of the $400,000 average sales price).

Revenue of $12.8 million gave it an asset turnover ratio of 2.8x.  For 2017, with its Net Margin of 4.3% and its restated asset turn of 2.8x, the new operation had achieved an ROIA of just over 12%.

 

As the management team of the newly-acquired division, here are the questions the interrelated business case exercises raise for you:

Q;  How will you address a mandate that your newly-acquired division increase its annual closings by more than 50% over a two-year period, with less work-in-process, a smaller line of credit, and the same amount of overhead?

Q:  How will you use Building Information Modeling (BIM) to improve both the margin and velocity sides of economic return?

Q:  What accounting practices will calculating the breakeven aspect of Cost-Volume-Profit require?

Q:  How will you build a savvy, motivated, mutually-accountable homebuilding team?  A team that understands the business of homebuilding as much as it does the homebuilding business?  One in which every teammate has a significant financial stake in the outcome?

Q:  What about RB Builders’ contention that variation – evidenced by your 2017 cycle time – is costing your newly-acquired division between $700,000 and $1.1 million in lost Net Income every year?  Are they correct in asserting it?  Keep in mind, in 2017, your division only had Net Income of $550,000.

Q:  How will you implement Epic Partnering™ (RB Builders’ program/process for creating relationships-arrangements of compelling mutually-shared interests) with your suppliers and subcontractors?  What are the attributes of the partnering relationship?  What are the components of the partnering program?  What does a transformational partnering process look like?  Is vertical integration an option to consider?

Q:  How will you use Business Process Improvement (BPI) to remove non-value-adding work and make the remaining value-adding work flow faster, more evenly, more smoothly, with fewer mistakes and rework?

Q:  How will you use Critical Chain Project Management to reduce your job schedules from 150 days to 121 days, while also assuring more reliable job completion dates?

Take our offer.  Request the business case.  When you have completed it, grade yourself.  How did you do?  Were you able to answer the questions?  Were you able to solve the problems?  If you find as unacceptable – let’s call it your “degree of attunement” – you should come to the next Pipeline workshop™.

 

Come.  Participate.  Learn.

RB Builders: Lessons from the Pipeline© is the underlying business case study used at every Pipeline workshop™.  The next workshop is being held February 28 – March 1, 2018, at the Ponte Vedra Inn and Club, in Ponte Vedra Beach, Florida.

Cost is $895.00;  for team pricing, inquire here (flgroves@saiconsulting.com).

Delivered by SAI Consulting and Continuum Advisory Group.

Sponsored by BUILDER, BuilderMT, and Specitup.

Details:  www.buildervelocity.com

 

There is an underlying context – an underlying business logic – to everything we teach in a Pipeline workshop™.  However, since the focus has been on the principles and disciplines of homebuilding production, we have not given that context – that business logic – the attention it deserves;  the “what” and the ‘how-to” receive more attention than the “why” and the “want-to”.

So – this Velocity Accelerator® is a deeper-dive into context and business logic, into two crucial disciplines that work together, inseparably:  Open-Book Management and Team-Based Performance Compensation.

The efforts of a homebuilding company to improve operating performance and business outcomes will fail to achieve what is possible, if it does not succeed first in creating a homebuilding team that works toward commonly-held and commonly understood business goals, versus being a collection of so-called teammates working toward their individual goals.

What would be crucially missing, is an underlying business logic that forms the necessary context for understanding everything else.

That is the role of Open-Book Management.

In order to become the savvy, motivated, mutually-accountable homebuilding team required to effectively compete in the business world, everyone on the team has to learn the “business” of homebuilding, they have to understand their individual responsibilities as part of the overall team, and they have to understand what is at stake, individually and collectively.

And – not just understand the business outcome that is at stake;  teammates must each have a personal stake in that business outcome.

That is the role of Team-Based Performance Compensation.

Open Book Management flows from the work Jack Stack did in the 1980’s as CEO at Springfield Remanufacturing Corporation to rescue this former International Harvester (Navistar) division from almost certain bankruptcy.  Following a 99% leveraged employee buyout, Stack opened the company’s books and made it everyone’s business to improve performance.

Stack recounted that effort in two books (The Great Game of Business and A Stake in the Outcome);  John Case reported on open-book thinking in other industries and companies, in two other books (Open Book Management and The Open Book Experience).

And, in Open Book Management, Case described how Steve Wilson developed the basics of OBM-inspired Team-Based Performance Compensation at Mid-States Technical Staffing Services (now part of Modis);  Wilson subsequently described this work in a publication, titled The Bucket Bonus Plan.

 

We take a very specific approach in our application of the principles of Open Book Management and Team-Based Performance Compensation.

We advise our clients to be transparent (open).  We urge them to demonstrate candor (have the courage to tell and hear the truth) in the constant internal disclosure of operating and financial data, whether in meetings, or through dashboards and heads-up displays.  We advise our clients to impart business literacy (understanding) to teammates, so that those teammates understand the business of homebuilding, not just the homebuilding business, through the teaching of business and production principles.

We advise our clients to adopt a team-based approach to performance compensation, by way of a progressively-weighted milestone plan centered on achieving targeted performance above a baseline in a specific business outcome impacted by the actions of every single teammate.  We urge an approach that is simple, easy to understand;  visible, transparent;  compelling;  fast, frequent;  self-funding, paid from income the company would not have otherwise generated.

In terms of compensation – we urge our clients to make it significant, meaningful.  In terms of participation, we urge them to make it all-inclusive.

We tell them that their Team-Based Performance Compensation Plan should provide only for winners or losers, not winners and losers.  It should give the right to lead and to demand results;  it should give the desire to be lead to deliver results.

Savvy.  Motivated.  Mutually-Accountable.  Team.

 

Come.  Participate.  Learn.

Open-Book Management and Team-Based Performance Compensation is one of the five Velocity Accelerators® highlighted (together with Critical Chain Project Management, Epic Partnering™, Building Information Modeling, and Business Process Improvement) at the next Pipeline workshop™, February 28 – March 1, 2018, at the Ponte Vedra Inn and Club, in Ponte Vedra Beach, Florida.

Cost is $895.00;  for team pricing, inquire here (flgroves@saiconsulting.com).

Delivered by SAI Consulting and Continuum Advisory Group.

Sponsored by BUILDER, BuilderMT, and Specitup.

Details:  www.buildervelocity.com

 

“The absence of business logic is simply astounding.”

Posted February 4, 2018 By Fletcher Groves

(originally published on EFA® in February 2010 under the same title;  updated and republished in April 2013, as part of our retrospective Above Average: The Best of Escape from Averageness®, 2009-2012;  published again here, as part of the explanation of one of the Velocity Accelerators® for the upcoming Pipeline Workshop™ No. 9)

McKinsey and Company

The intrepid, results-based consultant smiled and shook her head, in a combination of amusement and disbelief.  It was yet another sobering reminder that RB Builders, early in this process, was capable of coming to bewildering conclusions, the latest of which centered around the company’s intentions for its team-based performance compensation plan.

The Gross Income Participation Pool – the GIPP – had been a prerequisite to her firm agreeing to become involved in a client-consultant partnering arrangement with RB Builders in the first place.  In fact, it had been one of three stipulations, including a requirement that the company’s internal financial statements reflect a variable costing approach, and a requirement that any existing improvement initiatives be subordinated to the company’s new constraint-focused, rapid-results continuous improvement process.

The GIPP was new.  It was intentionally designed to replace RB Builders’ longstanding practice of paying individual bonuses based on multiple measures, and consisted of a team-based approach focused on performance related to a single business outcome, specifically, increases generated in Gross Income above a specific baseline.

Under the GIPP, the baseline performance was referred to as the Gross Income Baseline, while the stretch-budgeted performance was dubbed the Gross Income Target.  The difference between the GI Baseline and the GI Target was referred to as the Gross Income Reserve.

The GI Reserve was to be paid out progressively, based on the achievement of a predetermined number of “bonus buckets”, called Gross Income Milestones.  The aggregate teammate share of the GI Reserve represented one-third of the GI Reserve, while the remaining two-thirds was allocated evenly between distributions to owners and retained earnings.

Now, however, the GIPP was getting push-back from one of RB Builders’ recently-hired Regional Vice Presidents, saying the plan should be scrapped.

“The housing market has improved, but we still have credit facilities that we have to restructure, repay, and replace, and now we need land and building lots;  the bottom-line is, we have better uses for that cash”, he explained.

The intrepid, results-based consultant’s thought to herself, “The Gross Income Participation Pool is an established prerequisite.  This guy’s assertion doesn’t have any merit, but even if it did, it was too late in the planning schedule to consider changing it, let alone cancelling and replacing it.

She was having none of it.

“Where did you get this stupid idea?”, she asked.

“It is the best approach to a situation that remains very challenging and uncertain”, he confidently replied.  “We cannot justify bonuses in this economy, in this housing market;  we are fortunate just to have our jobs.  I have nothing against bonuses in better times, just not now.”

“So, you just want to cancel the GIPP?  YOU CANNOT BE SERIOUS!”

“Channeling your inner McEnroe?”, asked the CEO.

The intrepid, results-based consultant stared at the CEO, her impassive expression clearly communicating her thought:  “Where did you find this guy?”

She turned her attention back to the Regional VP.

“Let me get this straight.  You are concerned that your division will be unable to meet its debt service obligations, or find land, if it rewards performance above its baseline?”, she asked, rhetorically.  “Really?  Where is the money supposed to come from?

“The GIPP will not have paid out anything unless there is a reserve created by performance that exceeds the baseline.  You do realize that the GIPP is completely self-funding, that it does not cost the division or RB Builders’ owners one-red-cent?

“You do understand that, right?

“For the most part, all of the land and building lots acquired are kept off-balance sheet.  With in-place limitations on work-in-process and management controls on non-variable expenses”, she continued, “is there any likely scenario under which additional Gross Income will result in less cash flow?

“On baseline alone, RB Builders is profitable, operating above breakeven, correct?  So – is there any likely scenario under which every cent of that additional Gross Income will not drop straight to the division bottom-line?  Where it can be utilized for – oh, I don’t know, say – debt restructuring, or distributed to teammates and owners before it became retained earnings?

“I can understand being careful with important decisions in uncertain times.  I can understand increased diligence in determining a baseline that reflects current reality.  I can understand having a more progressive structure to the payouts, so that each successive milestone is worth more.  I can understand adjusting the distribution of the reserve between teammates, owners, and retained earnings, in order to provide more money to meet extraordinary debt service requirements.

“I can understand – but not agree with – the fear that would drive your flight to a supposedly-safer outcome, like Net Income.

“But, to deny yourselves – you, your teammates, your owners – the opportunity and motivation to do better?  To preserve your shared livelihoods?  To secure your collective futures?  That, I do not understand.

“The absence of business logic is simply astounding.”

 

Come.  Participate.  Learn.

Open-Book Management and Team-Based Performance Compensation is one of the five Velocity Accelerators® highlighted (together with Critical Chain Project Management, Epic Partnering™, Building Information Modeling, and Business Process Improvement) at the next Pipeline workshop™, February 28 – March 1, 2018, at the Ponte Vedra Inn and Club, in Ponte Vedra Beach, Florida.

Cost is $895.00;  for team pricing, inquire here (flgroves@saiconsulting.com).

Delivered by SAI Consulting and Continuum Advisory Group.

Sponsored by BUILDER, BuilderMT, and Specitup.

Details:  www.buildervelocity.com