Part V: "Ex Disastrium, Scientia"

(excerpted from The Pipeline)

“Well, someone might as well ask the question”, said the intrepid, results-based consultant. “From both a production standpoint and a financial standpoint, at what point does RB Builders breakeven?”

“One of the advantages and benefits of allocating costs on the basis of how they behave in relation to Revenue is the ability to understand and use breakeven analysis”, replied the CFO. “But, I have to admit, before you came, we could not have answered that question. The RB Builders Income Statement was prepared according to the NAHB Chart of Accounts, which is to say that it was comparative, compliant . . . and utterly useless. Now, we also produce a Contribution Income Statement.

“According to the 2008 baseline budget, our breakeven point is 155 closings, based on Revenue of about $39 million. However, because of the way the market has deteriorated, the 2008 target budget has a higher production breakeven point; it requires closer to 170 closings, albeit on only slightly higher Revenue ($40.5 million).”

“How did you calculate that?”, asked the VP of Construction.

“Let me show you”, said the CFO, creating a new data table and adding the data to the first two columns. “This is what we have said, so far. Some parts we do not know yet.”

2008 BASE BUDGET
CLOSINGS = 200
REVENUE = $50,000,000
AVG. SP = $250,000
GROSS MARGIN = 22%
BREAKEVEN = 155 UNITS
BREAKEVEN REVENUE = $39,000,000

2008 TARGET BUDGET
CLOSINGS = 250
REVENUE = $60,000,000
AVG. SP = $240,000
GROSS MARGIN = 21%
BREAKEVEN = 170 UNITS
BREAKEVEN REVENUE = $40,500,000

2008 WORST-CASE
CLOSINGS = 140-150
REVENUE = $34,500,000
AVG. SP = $240,000
GROSS MARGIN = 18-19%
BREAKEVEN = ?
BREAKEVEN REVENUE = ?

2008 FULL CAPACITY UTILIZATION
CLOSINGS = 300
REVENUE = $69,000,000
AVG. SP = $230,000
GROSS MARGIN = 15%
BREAKEVEN = ?
BREAKEVEN REVENUE = ?

“Breakeven occurs at the point where overhead is completely absorbed”, he said, continuing to write as he spoke. “Overhead is absorbed through the generation of Gross Income, which is comprised of the proceeds that we get to keep from each closing. When you are dealing with averages, one way to figure the breakeven point is to take the average sales price of a home, multiply it by the Gross Margin Ratio, and then divide the resulting Gross Income per home into your overhead.”

BREAKEVEN = OVERHEAD / (AVG SP X GM%)
BREAKEVEN = $8,500,000 / ($250,000 X 22%) = 155

“That gives you the unit breakeven point, in other words, the breakeven point in terms of closings. The unit breakeven point in the 2008 Baseline is 155 closings.”

“Is there another way to look at breakeven?”, asked the intrepid, results-based consultant.

“Sure”, he said, writing on the board. “You can calculate the breakeven point in terms of Revenue. You calculate that by dividing overhead by the Gross Margin Ratio, which, by the way, is basically the same measure as Contribution Margin.

“Take the 2008 Baseline and Target we were just discussing.”

BREAKEVEN = OVERHEAD / GM%
BASELINE BREAKEVEN = $8,500,000 / 22% = $38,636,000
TARGET BREAKEVEN = $8,500,000 / 21% = $40,476,000

“Like I said, about $39 million and $40.5 million, respectively”, he said, pointing back to the data table. “Our overhead under both the 2008 Baseline and the 2008 Target is $8,500,000, but the resulting Gross Margins are different, so the breakeven points are different. In this case, the difference in the unit breakeven point is more substantial than the difference in the Revenue breakeven point.

“Overhead is the same thing as Operating Expense, which is comprised of all our indirect, non-variable costs. Overhead – or Operating Expense – is the cost of our production capacity.

“That gives you the breakeven number of closings, and the breakeven Revenue. Equally-important – since we cannot generate all of our closings and all of our revenue at once – is the breakeven rate.

“In terms of the scenarios we have been discussing, breakeven in our worst case scenario occurs at around 190 closings, which is at about $46 million in Revenue. That is because we are trying to absorb the same amount of overhead with smaller Gross Margins. It requires more closings, which can become a vicious cycle, with a lot of margin pressure. Anyway, in the worst case scenario, the point at which we fully absorb our overhead occurs at a rate of about 16 closings per month. Of course, we have the production capacity to start and close 25 houses a month.”

The CFO filled in the missing data for the last two columns.

2008 BASE BUDGET
CLOSINGS = 200
REVENUE = $50,000,000
AVG. SP = $250,000
GROSS MARGIN = 22%
BREAKEVEN = 155 UNITS
BREAKEVEN REVENUE = $39,000,000

2008 TARGET BUDGET
CLOSINGS = 250
REVENUE = $60,000,000
AVG. SP = $240,000
GROSS MARGIN = 21%
BREAKEVEN = 170 UNITS
BREAKEVEN REVENUE = $40,500,000

2008 WORST-CASE
CLOSINGS = 140-150
REVENUE = $34,500,000
AVG. SP = $240,000
GROSS MARGIN = 18-19%
BREAKEVEN = 190
BREAKEVEN REVENUE = $46,000,000

2008 FULL CAPACITY UTILIZATION
CLOSINGS = 300
REVENUE = $69,000,000
AVG. SP = $230,000
GROSS MARGIN = 15%
BREAKEVEN = 246
BREAKEVEN REVENUE = $56,600,000

“Obviously, at only 140 to 150 closings – 12 closings per month – and $34.5 million in Revenue, we would be below the breakeven point in both closings and Revenue, which means we would be losing money.

“But, if we can somehow find a way to more fully-utilize our production capacity – which we will pay to have anyway, unless we cut our overhead – and somehow find a way to close more homes, albeit at considerably lower margins, we would breakeven at 246 closings and $56.6 million in Revenue. That occurs at 20-21 closings a month, a rate also well below the 25 closings-per-month we have the capacity to produce.

“And, while we are talking about breakeven rates, I hope it reinforces the importance of even-flow production”, said the intrepid, results-based consultant, looking at the VP of Construction and VP of Sales. “We cannot be all over the map each month with sales, starts, and closings, and with WIP.”

“Is there any kind of housing market in which demand does not respond to lower sales prices?”, asked a sales representative. “What happens if we reduce the sales price – give more concessions, endure lower margins – and there are insufficient sales? Is there a limit to how far we can drop prices? In other words, what happens if we build it, we drop the ticket prices, and they still do not come?”

“There is always that possibility”, said the VP of Sales. “But – we still have to price to the market. That is not in our control. To the extent that we extract value, with better margins as the outcome, we do have some control. On the other hand, from what I am hearing, the gains from higher productivity are permanent, and the speed/velocity that enables those gains is something we can always control.”

The intrepid, results-based consultant turned to the sales representative. “To answer your question, if the situation gets bad enough, higher productivity becomes moot”, she said. “RB Builders would have excess – and probably unusable – capacity. In that case, higher productivity might not seem as urgent, or as attractive.

“If we cannot make some combination of higher margin and higher velocity work for us, we might have to take RB Builders out of gear, and glide to some sort of safe landing. A controlled crash would be a better description. Like Apollo 13. Forget the moon, just get the Odyssey and her crew home.”

“Perhaps”, said the CEO. “But, I am determined that we come out of this situation with a level of sustainable competitive separation. I refuse to accept the sacrifice of having endured this much pain without having something to show for it. Higher productivity might not seem as urgent, right now, but it will someday. I want RB Builders to emerge a much faster and more agile homebuilding company.

“Forget “industry best practices”. We need to do better than that, because we would be foolish to believe that our competition will forever come from who it comes from now. Someday, the homebuilding industry is going to change, and that change will as likely come from without, as from within.”

“Ex Disastrium, Scientia”, said the intrepid, results-based consultant, smiling at her adaptation of NASA trivia.

“Learn from adversity, learn from failure, learn from mistakes.

“But – own the outcome.”