(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/)

 

      

Art Rutenberg

Posted April 1, 2017 By Fletcher Groves

“Art Rutenberg wants to know if you ever return your telephone calls?”

It was 1991, and the question came from Bill Kendall, then-EVP at Arthur Rutenberg Corporation and my direct report.  The question stung, because it was a sad truth.  Since then, I have had a policy of returning every telephone call (and replying to every e-mail message) within 24 hours.  Just one of the many lessons I learned from this man.

Professional Builder

Over the years, Art and I periodically met and spoke, exchanging our thoughts and ideas, discussing different opportunities, different perspectives.

He was always the same.

A few years ago, I sent him the draft on an Escape from Averageness® post that mentioned Arthur Rutenberg Homes, and I asked him if that was his recollection, as well.  As usual, he responded within a day.  His reply:  “Fletch, You can say anything you want about us so long as it is true. You have a better memory about these things than I do, so I’ll trust yours. Best, Art”.

In the Preface of both editions of The Pipeline: A Picture of Homebuilding Production©, I wrote this about Art Rutenberg:

“There are few people in the homebuilding industry from whom I have learned more than my former boss, Art Rutenberg, the always-accessible (he taught me that, too) chairman of Arthur Rutenberg Homes, Inc.

“I hope The Pipeline repays some of that debt, because ARH is a picture of consistency, discipline, and elegant systems integration on everything related to how much a franchisee makes on each home – and on absolutely nothing related to how many homes that franchisee can produce with a planned, finite, and controlled amount of production capacity.

“Art and I agree that we live our lives on opposite sides of the DuPont identity;  he is all about margin, and I am all about velocity.  The reality is, a homebuilding company needs both.

“He tells me my job is easy;  I ask him, if what I do is so easy, why isn’t he any good at it.

“I hope Art enjoys reading The Pipeline.”

I think Joanne Burton said it well:  “Art was a special guy, and will be missed by many.”

 

Art Rutenberg, founder of Arthur Rutenberg Homes, died March 31, 2017.

 

      

Architecture: Elegance and Allusion

Posted March 29, 2017 By Fletcher Groves

(first posted on Escape from Averageness® in June, 2012, reposted in April, 2014)

After I was a commercial banker – and before I was a management consultant – I was a homebuilder.  There was a stint with Arthur Rutenberg Corporation, but the majority of my time in homebuilding coincided with my role as an in-fill residential developer.  The driving force – the focus of my energy and interest – was always residential architecture;  residential architecture, broadly and generally, but, particularly and specifically, the residential architecture of my native state of Florida and of the South.

An energy and interest in architecture is not enough to be a homebuilder or run a homebuilding company;  it is necessary (at least, desirable), but it is not sufficient.  I realize that, and I am fine with it;  my avocation does not need to be my vocation.

I like the consulting work that I do, I like that my clients are largely homebuilding companies, and – after all – I can build my own house anytime that I need to satisfy the tangible expression of my creative drive (everyone warned my wife, when we were married thirty-five years ago, that I would sell every home we ever had out from underneath her).

One of the qualities, or attributes, that I sought in the homes that my companies offered were designs that were hallmarks of elegance:  design and finish that was refined, dignified, tasteful;  more to the point, design and finish that was simple, suitable to its purpose, easily-built, enduring, appropriate;  plans that recalled the accuracy and practicality of master builders;  plans where fenestration, for example, made sense – worked – from a design standpoint.

The other attribute I sought was allusion:  an indirect reference and meaningful interpretation of historical design;  plans and materials that were native, indigenous, particular, familiar, informal, plainly simple;  designs that were re-collective, what is termed vernacular.

Ron Haase (Prof. Emer., University of Florida School of Architecture), on the matter of allusion, in his book Classic Cracker: Florida’s Wood-Frame Vernacular Architecture:

“ . . . architecture requires that we understand the potential in historic allusion, and how this idea differs significantly from that of historic illusion.  Illusion, after all, is mere copy, often shallow and only skin deep.  As such, it presents itself at a mockery of its historic precedent.  Historic allusion, on the other hand, digs deeper into the essential meaning of the precedent.  It is more critical in its response and more open-ended in its interpretation.  It takes the form of a metaphor heightening our awareness of its relationship to the original.  By doing so, we link history to the present and build a bridge of community across time.”

Elegance and Allusion:  two complementary design terms that are largely absent from the description and reality of the plan portfolios of most homebuilding companies.

Excuse from this discussion, homes built for individuals who can afford to build anything they want;  they have the right to do that, even if those custom, one-off designs are little more than indulgent expressions of personal net worth and affluence, and statements of their own perceived significance.

Excuse from this discussion, also, builders – like Art Rutenberg – who singlehandedly defined their own style of architecture (even if that style has now edged into luxury and illusion).

Instead, focus on what remains, on what is the vast production-to-semi-custom span of the builder spectrum.

In that group, I see little of the design thinking that I have described.  Instead, I see complicated designs with impractical layouts and difficult dimensions.  I see plans with purposeless space, both size and volume.  I see plans with design elements that make no sense.  I see plans with no coherent scale.  I see fenestration without a working purpose.  I see a thoughtless confusion of style, with no connection to geography or history.  I see plans that offer a shallow illusion of architectural style, not a meaningful, interpretive allusion.

The point is not a strict typological adherence.  The point is that there is benefit in preserving the logic and order of the design elements found in various styles, be it formal (Georgian, Federal, Greek Revival) or vernacular (dogtrot, shotgun, i-house) or regional (saltbox, single house).  The point is that there is benefit in reflecting the indigenous materials of a region.  There was, after all, practical reasons homes were built in this manner;  today, Lean design shares the same practical interests, in simplified roof designs, common dimensions, single plate heights, multiple floors sharing smaller footprints and roof areas.

There is no distinctiveness in shallow illusion.  Rather, allusion helps, particularly if it promotes regional distinctness.  And – distinctiveness resonates;  therefore, it sells.

Finally, there is a difference between inspiration and old-fashioned;  plans need to live for today, but harken to the past.

That elegance and allusion is still there, if we take the time to look for it;  it is still there, if we make the effort to create it.

 

Architectural Treasures of Early America Series is a ten-volume series (The National Historical Society, 1987) from material originally published in 1930 as The White Pine Series of Architectural Monographs.

American Vernacular (J. Kemp, Viking Penguin, 1987)

A Field Guide to American Architecture (C. Rifkind, Bonanza, 1980)

The Houses of St. Augustine (D. Nolan, Pineapple Press, 1995)

The American Builders Companion (A. Benjamin, Dover, 1827 orig., 1969)

Legacy from the Past (Colonial Williamsburg Foundation, 1971)

Charleston: Homes and Gardens (E. Davis, J. Iseley, Legacy, PSOC, 1975)

Historic Savannah (M. Bell, J. Iseley, Historic Savannah Foundation, 1982)

Plantations of the Low Country (Wm. Baldwin, A. Baldwin, J. Iseley, Legacy, 1985)

Caribbean Style (S. Slesin, S. Cliff, et al, Clarkson Potter, 1985)

Classic Cracker: Florida’s Wood-Frame Vernacular Architecture (R. Haase, Pineapple Press, 1992)