Part I: The NAHB Chart of Accounts Income Statement: Comparative, Compliant . . . and Utterly Useless.
(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:
- 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.
- 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.
- 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/)