Part IV: "Faced with the prospect of both fewer sales and lower margins"

(excerpted from The Pipeline)  

Note:  The Pipeline was written in mid-2007. The fact that it survived the past three years with its relevance intact is, you could argue, mere fortuitous insight, but it is also a testament to the immutable principles of production that it illuminates.

“Rather than ask where your heads disappeared to, let me just say that what you just described is not the reality with which we are dealing”, said the VP of Sales. “This coming year – 2008 – is going to be a challenge. So, what happens when we are faced with the prospect of both fewer sales and lower margins? What happens when the market is not going to allow us to use – to economically leverage, as you like to put it – all of this new-found production capacity?

“I agree that productivity and Throughput-killing variation is the problem when we are faced with an internal constraint, when we are faced with being our own worst enemy. Under those circumstances, “Max-T” is the right approach.

“But, what happens when we are faced with an external constraint?”

“Give us some idea of what you are talking about”, said the intrepid, results-based consultant. “Demand is elastic. How many sales, at what margin?”

“The numbers in the GI Baseline and GI Target are a couple of months old”, the VP of Sales replied. “They already reflect the expectation of a deteriorating market. We still might be able to achieve those numbers, but, since then, the market has deteriorated even further. It is precipitous. We are looking at the very real possibility of both fewer homebuyers and lower margins.”

“How few and how low?”, asked a sales representative.

“During 2007, we closed 200 homes, but we only sold 180 homes”, the VP of Sales said. “Not exactly the protective backlog of sales that we want. So, we were already seeing the pressure in the market. Our Revenue was $50 million, our average selling price was $250,000, and our Gross Income Margin was 22%. We kept those numbers in the baseline for 2008. However, the 2008 target is $60 million in Revenue, produced on 250 closings, with an average sales price of $240,000, and a Gross Income Margin of 21%. The higher productivity, higher utilization – whatever you want to call it – actually gives us more Gross Income in 2008 than we earned in 2007.

“However, now we are thinking maybe only 140 to 150 sales. We think that the average sales price will still be $240,000, but there will be more concessions. More concessions will result in lower margins, somewhere between 18% and 19%. If that scenario happens, we are looking at Revenue of $34.5 million, and Gross Income of $6.5 million.

“In case you missed it, our indirect, non-variable cost is budgeted at $8.5 million.

“That is an operating loss of $2 million, and, frankly, we do not know where the bottom of this recession is. It could get much worse.”

“Nevertheless, we need to talk about what we know now. What would you do?”, the intrepid, results-based consultant asked the VP of Sales. Glancing toward the CEO, silently with her eyes, she said, “Just let him answer.”

“We cannot afford to lose money. But – I cannot look at the people in this room, and suggest that we fire people whom we have developed and whom we care about, either”, said the VP of Sales. “Certainly not as our first resort.

“The market may not turn out to be this bad, but here is what I would do:

“The current job schedule says that we should be able to build our houses in an average of 120 days, and we have been given 100 units of work-in-process to produce as many closings as we can”, he said. “That calculates to 300 closings. Despite the challenges of the market, we need to find a way to get those 300 closings.

“Let me qualify part of that statement. The closings are important, but we need to produce as much Gross Income as we can, because that is all we get to keep from whatever Revenue we generate from those 300 closings.

“From a production standpoint, someone else will need to figure out how to beat 60 days out of the current cycle time. From a sales and marketing standpoint, to sell 300 homes, I believe we will need to drop our prices to an average of $230,000. I know, I know. It is a difficult decision. It is $10,000 below the target, and $20,000 below the baseline.

“Our margins would suffer, dropping to 15%, on average. We would need to become much more intuitive and instinctive in our adjustments, and learn to make decisions as fast and as frequently as necessary. We will have to fight for every sale. But – even with the lower margins – if we manage to sell, build, and close 300 homes, our Gross Income would be $10.4 million, produced on Revenue of $69 million. Our Net Income Margin would be less than 3%, but we would be profitable.

“Of course, like I said, it could get worse. Much worse.

“Could we find ways to extract more value, and therefore earn higher Gross Income Margins and generate additional Gross Income on every dollar of Revenue? I think so. Could we get our cycle times down to 90 days, and close 400 homes on the same amount of production capacity? Maybe. That is up to us. I am not sure that is what we would want to do right now. The resulting higher production would have even further implications on prices and margins.

“Still, I am starting to realize some things: First, higher velocity can overcome lower margins. Second, productivity gains are permanent.”

“In 2008, higher productivity is a case of survival. And – it may not be enough, if things get a lot worse”, said the intrepid, results-based consultant, writing as she spoke. “In the future, the ability to produce more – more closings, more Revenue, more Gross Income – on a finite and controlled amount of work-in-process and overhead will be one of the keys to sustainable competitive separation.

BREAKEVEN ANALYSIS

“This discussion raises a question”, she said, pointing to the board. “From both a production standpoint and a financial standpoint, at what point does RB Builders breakeven?

“Knowing the answer to that question gives you more insight than you can imagine.”