(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/)