Archive for January, 2012

In Part I of this series, we reported on SAI’s Fall 2011 survey of CFOs regarding the format and the utilization of their company’s particular Income Statement in relation to the NAHB Chart of Accounts Income Statement.

According to the survey, 50% of respondents said their company’s Income Statement did not comply with the NAHB Income Statement, 40% said they had to produce multiple versions of their Income Statement, 20% used a Contribution Income format, and 40% said they performed some level of breakeven analysis. Between 40% and 60% reported compliance with NAHB-recommended placement of the following equivalent line items: Indirect Construction Cost, Selling Expenses (including Commissions), and Financing Costs.

Hardly a ringing endorsement and picture of conformity.

We noted that the NAHB Income Statement was acceptable as a traditional, GAAP-compliant, externally-focused, functionally-oriented classification of costs, but the effect of its functional cost allocation was to indiscriminately blend costs that are either variable or non-variable, in terms of how they behave in relationship to changes in Revenue volume. We said that this practice obscured cost behavior, and prevented the use of important management accounting tools.

Generally-speaking, we said, 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 variable costing.

But, don’t take our word for it.

As part of the survey, we asked CFOs for more than answers to survey questions; we asked for insight related to the structure of the NAHB Income Statement (i.e., line item accounts in series 300-900), as it relates to cost allocation (variable v. absorption) and management tools (breakeven, CVP, etc.).

This was from one of the CFOs, who is also a CPA:

“Homebuilding is often compared to manufacturing, but there are differences that need to be taken into account when developing an accurate costing method for management decision-making.

“In the manufacturing world, variable/direct costing allocates all costs directly associated with an activity, including variable manufacturing overhead, to inventory and cost of goods sold and treats fixed manufacturing overhead as an operating expense along with selling, general and administrative expenses. Absorption costing allocates all costs directly associated with an activity and all manufacturing overhead (variable and fixed) to inventory and cost of goods sold and treats selling, general and administrative expenses as an operating expense. Both approaches to costing have their drawbacks when applied to homebuilding.

“While absorption costing is necessary for GAAP basis external reporting, its usefulness in providing management information in making pricing decisions is limited, because it allocates fixed manufacturing overhead to inventory and cost of goods sold (costs that should not be considered when making a pricing decision), and does not allocate other variable costs such as selling expense, financing costs. Also, variable/direct costing is limited in its ability to provide useful pricing information to management, as it only allocates variable overhead to inventory and does not allocate other variable costs.

“A costing system that allocates all variable expenses to an activity would provide management with the most accurate information for making the proper pricing decision.”

He continued:

“The NAHB Chart of Accounts is designed for historical financial reporting. It is not a managerial accounting tool. NAHB would do its members a great service by developing guidance on cost and managerial accounting.

“Most manufacturers have two sets of accountants and two sets of statements – financial accountants and financial statements for historical financial reporting, and cost/managerial accountants and financial statements designed for internal management and individual pricing decisions.

“In my roles as both a CFO and a President of a homebuilding company, I am intimately familiar with both the strengths and weaknesses of the NAHB Chart of Accounts. It was a great tool for benchmarking our performance with other builders and to industry standards. It was interesting to benchmark our company, but the statements produced utilizing the NAHB Chart of Accounts were of no use when it came to making pricing decisions.

“In order to make informed pricing decisions, I created my own operating statements by community that allocated all variable costs that could be specifically identified with the individual unit that generated them and removed all fixed costs. In an environment of declining sales prices, rising costs, and a market that required substantial sales incentives, these operating statements were not only helpful, they were the key to our company’s survival.”


The thoughtful examination of any managerial accounting or cost accounting textbook validates this CFO’s statements.

To quote one:

“Financial accounting is mainly concerned with the historical aspects of external reporting . . . governed by generally-accepted accounting principles (GAAP). Management accounting, on the other hand, is concerned primarily with providing information to internal managers . . . charged with planning and controlling the operations of the firm . . . not subject to GAAP . . . one thing is clear from the NAA definition of management accounting: The major function of cost accounting is cost accumulation for inventory valuation and income determination. Management accounting, however, emphasizes the use of the cost data for planning, control, and decision-making purposes.” – Accounting Handbook, Barron’s, J. Siegel and J. Shim, 1990.

To quote another:

“Although an Income Statement prepared in the functional format may be useful for external reporting purposes, it has serious limitations when used for internal purposes . . . the Contribution Income Statement emphasizes the behavior of costs, and therefore, is extremely helpful to a manager in judging the impact on profits, of changes in price, cost, or volume.” – Managerial Accounting, 10th Ed., McGraw-Hill Irwin, R. Garrison and E. Noreen, 2003.

To quote yet another, directed towards resolving the need for a company to prepare multiple sets of financial information:

“For companies committed to maintaining variable contribution information, there are two choices available . . . 1. maintain their accounting system on a full-absorption GAAP basis, with separate calculations and analysis of variable contribution information [or] 2. maintain their accounting systems on a variable contribution basis with a monthly reconciliation to GAAP . . . if the only real reason for maintaining full-absorption accounting is to satisfy external requirements, doesn’t it make more sense to use option 2 and perform simple month-end reconciliation to GAAP?” – The Measurement Nightmare: How the Theory of Constraints Can Resolve Conflicting Strategies, Policies, and Measures, APICS series, The St. Lucie Press, D. Smith, 2000.

The last preceding excerpt is consistent with the others; however, in fairness, it comes from Throughput Accounting (the emergent cost accounting methodology supporting Theory of Constraints), which places it outside the mainstream. Throughput Accounting uses a profit and loss statement to the right of even a Contribution Margin profit and loss statement, refusing to assign costs to inventory, and expensing product costs immediately; it literally has no internal use for GAAP compliance.

In the similarly nascent and outlying world of cost accounting methods that aim to support Lean, in its broadest sense, as a management system – as a business strategy, as an operating philosophy – the advice is more obtuse; Lean Accounting sees no conflict with GAAP, uses an operating statement that clearly mixes variable and non-variable costs, but nevertheless states these among its Lean Accounting Concepts and Principles: “2. Do not confuse a fixed cost for a variable cost” and “3. Eliminate absorption accounting for manufacturing transactions.” – The Real Numbers: Management Accounting in a Lean Organization, Managing Times Press, J. E. Cunningham, O. J. Fiume, E. Adams, 2003.


At best, comparison with “industry best practices” promotes a satisfaction with some sort of competitive equality, a settling for the expediency of the ideas of someone else. The real problem with best practices is that it stifles creativity and innovation, works against creating competitive advantage, and creates the illusion of continuous improvement.

GAAP-for-the-sake-of-GAAP? Compliance-for-the-sake-of-compliance? You manage every day; you only report periodically. You are not in the business of complying with generally-accepted accounting principles; you are in the business of making money. You need to do both, but compliance is a case of the tail wagging the dog.

Bottom-line: The two arguable attributes of the NAHB Chart of Accounts Income Statement – comparativeness-driven conformity and reporting-driven compliance – might be desirable, and to a degree necessary, but they are not a justification to sacrifice sound managerial accounting. You cannot properly and effectively manage a homebuilding operation using the cost allocations recommended in the NAHB Chart of Accounts Income Statement.


The readers of “Escape from Averageness” know that we disagree with the cost allocation structure of the Income Statement recommended by the National Association of Homebuilders in its Chart of Accounts.

As we said in these pages, back in 2009:

Yes – the NAHB Chart of Accounts permits comparisons with other builders. Yes – the NAHB Chart of Accounts complies with GAAP reporting requirements. Yes – it allows certain consultants to give the same presentation every year at IBS. However, to the extent that the NAHB Chart of Accounts presents its Income Statement as anything other than a true delineation of costs based on their behavior in regard to Revenue, it is utterly useless.

The NAHB COA Income Statement is useless because it prevents a builder from understanding how it makes money.

Those are strong words, and they are purposely stated.

For anyone headed to the 2012 IBS in Orlando next month, planning on attending certain events on the Organizational and Business Management track, reading that post and what follows should be thought-provoking – should provoke the exercise of legitimate reservation, should challenge current conventional thinking and advice.

Start by reading that April, 2009 post here

This past Fall, 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 the Chief Financial Officers of their company, but the group included a number of Controllers and Vice Presidents of Finance. It included both large and small builders, both 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 with the NAHB Income Statement format. 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 used 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.

Regarding the more critical issue of the assignment/allocation of costs:

Q: Where do the following equivalent line items appear on your Income Statement (either as a part of Cost of Sales or a part of Operating Expense): Indirect Construction Cost, Selling Expenses (including Commissions), and Financing Costs?

— 50% reported that they allocated Indirect Construction Cost to Cost of Sales (where NAHB insists it should be, despite the fact that it is, in effect, a non-variable cost that should be allocated to Operating Expense).

— 60% said they allocated Selling Expense (including Commissions) to Operating Expense (where it should be, insists NAHB, notwithstanding the fact 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 if the LIP balance never varies; and, 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 arguments for treating aspects of Indirect Construction Cost, Selling Costs, and Financing Costs as a Cost of Sales (a direct, variable cost), and there are arguments for treating parts of them as an Operating Expense (an indirect, non-variable cost); the variable portion should be Cost of Sales, and the non-variable portion 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 indiscriminately blend costs that are either variable or non-variable, in terms of how they behave in relationship to changes in Revenue volume. This practice obscures cost behavior, and it prevents the use of important management accounting tools. Generally-speaking, 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 variable costing.

But, don’t take just our word for it.

Next: CFO and academic insight into the problems with the NAHB Chart of Accounts Income Statement.


Thoughts on Tebow

Posted January 14, 2012 By Fletcher Groves

Back in 2008, a group of my Tampa buddies and I were playing golf at Timuquana Country Club (a great Donald Ross course) in Jacksonville, Florida, during what has become an annual outing that involves as much golf as you can humanly play in a three-day period.

We were playing an extra nine holes, in what basically amounted to a seven-man scramble in order to finish before sunset. There was a threesome behind us, so we waved them through. One of our guys asked, “Isn’t that Tim Tebow?”

Sure enough, it was Tebow, playing with some equally-large guys. Since both of our daughters went to Nease, that automatically gives me Tebow Access. So – when they pulled up to the 9th tee, I introduced myself to Tim, informed him Lauren was our daughter, explained the Nease connection, all of that.

“That name sounds familiar”, Tim said.

I thought to myself, “It should sound familiar. She has more state championship rings than you do.”

I will offer these observations about Tebow’s golf game: He plays left-handed, his address is about one and a-half seconds, and he hits the ball a long way.


Tebow-mania. I don’t think I have seen anything like this. It’s more than just a football player, it’s more than the fortunes of an NFL football team and a season. As such, I think everyone struggles to put it into a context. I don’t think that context is somehow about determining whether God cares which team wins a football game, continues winning football games, wins a Super Bowl, etc.

What all of this should make us ponder, is what Brent Curtis and John Eldredge advise, which is to ask, “Hmm. I wonder what God is up to in this?”

Whatever it is, it transcends Tim Tebow.

Yet, people love him, and people hate him, people want him to succeed, and people want him to fail. Not just in football, but in life.

I think Tim would do well to remind folks – indeed, to remind himself – of the words attributed to another athlete. Eric Liddell was the gold medalist in the 400 meters at the Paris Olympics in 1924. He died in a Japanese internment camp in China in 1945, while serving as a Christian missionary.

Whether or not the Denver Broncos beat the New England Patriots: “In the dust of defeat as well as the laurels of victory there is a glory to be found if one has done his best.”

In terms of what really matters: “We are all missionaries. Wherever we go we either bring people nearer to Christ or we repel them from Christ.”


(excerpted from The Pipeline)

“So – what do we mean by the term “productivity”?”, asked the intrepid, results-based consultant. “How do you increase productivity? What does it mean to become more productive?”

Do you always ask the same question differently?”, asked the CEO. “Or – do you just ask different questions the same way?”

“The question was about productivity”, she said, ignoring the interruption. “Any thoughts?”

“Well, if adding production capacity is a “more-for-more” proposition, I suppose improving productivity would be a “more-for-less” proposition”, said the second superintendent. “Or, at least, a “more-for-the-same” proposition.”

“Not bad”, she said. “So – what does this “more-for-less” idea look like? How do you measure productivity?”

Turning to the CEO, she smiled and said, “Don’t wear yourself out.”

The CEO smiled and replied, “Productivity is the relationship between what is produced and what has to be consumed in order to produce it.”

“That’s right”, she said, continuing the list.


“From any managerial standpoint – operations, manufacturing, production, or otherwise; from any industry standpoint – auto manufacturing, homebuilding, or any other industry; from any enterprise standpoint – Toyota, RB Builders, or anyone else; from any expert or business leader standpoint – Peter Drucker to Eli Goldratt to Taiichi Ohno, the conventional, accepted formula for calculating Productivity is Revenue divided by Operating Expense.”

She moved back to the erasable board at the front of the conference room, selected the blue erasable marker, and wrote:


“Less commonly, you will also find productivity expressed as the ratio between the “input” and the “output” of a process”, she said. “Either one will do, but the first formula fits best with the correct understanding of what it means to “make money”. We will talk about that later.”

She continued, “Under either formula, productivity is about what is produced and what is consumed. The “what is produced” part is pretty clear; we understand what is meant by “output”. What about “input”? What is it that is consumed? Is it an asset, or is it a resource?”

“Assets are converted or transformed. Resources are consumed”, said the CFO. “Inputs are expenses, just like the first formula.”

“That’s right”, said the intrepid, results-based consultant. “It is an expense. But – what type of expense is it? Is input a fixed cost – like Operating Expense or overhead – or, is it a variable cost?”

Turning, she wrote:


“Earlier, you used the terms “direct, variable cost” and “indirect, non-variable cost” to describe cost behavior”, the CFO said. “I could quibble that direct/indirect and variable/non-variable refer to different characteristics dealing with objects and behavior. But – I agree – that ties with the idea that consumption of a resource would make input an indirect, non-variable cost, as opposed to direct, variable costs, which are really more like contra-assets associated with our work-in-process. In fact, those direct, variable costs don’t even become expenses until after we close the job out.

“Like a lot of other homebuilding companies, RB Builders has not clearly separated those costs, but there are clear advantages to variable costing.”

“I agree”, said the CEO.

“What about us?”, asked the second superintendent. “The argument can be made that the cost of a superintendent is a direct cost, but clearly not a variable cost. The same could be said about construction interest, albeit for different reasons. So – what am I?”

“You are an incredibly valuable resource that happens to be a non-variable cost”, said the CFO. “But – you”, he said, looking at the first superintendent and grinning. “You are a totally worthless, soon-to-be-eliminated-thus-no-longer-non-variable cost.”

“I agree”, said the CEO.

The intrepid, results-based consultant put the erasable marker down, and waited until the laughter died down and she again had everyone’s attention.

“We have talked – briefly, at different times – about how costs are classified”, she said. “We mentioned it in the discussion about the cost of the pipeline. It is part of managerial accounting, more a part of the business principles and disciplines you will be learning than the production principles and disciplines you have been learning.

“We will address it further, down the road, because it does impact so many areas of management. For now, it will be enough for you to just remember this: In order to understand productivity and production capacity, you must understand how costs behave, and how you manage those costs on the basis of that behavior.

“Control your direct costs, because they vary in accordance with Revenue. Leverage your indirect costs, because they are more-or-less fixed, and you incur them regardless of how well you utilize those resources.”


Part II: Margin x Velocity

Posted January 4, 2012 By Fletcher Groves

(excerpted from The Pipeline)

“The amount of work-in-process – size – is very connected to the issue of capacity, the issue of productivity, the issue of speed; well, not just speed, but velocity”, the CFO continued. “It’s very connected to everything we are learning. In the end, it is all very connected to business outcomes – to profitability, economic return, and cash generation.”

“Dumas”, said one of the sales representatives, looking at a superintendent. “Do you know the difference between speed and velocity?”

“There is no difference”, replied the superintendent. “As long as I can still run circles around you.”

“Velocity is a vector measure”, said the sales representative. “Unlike speed, velocity has direction; it’s speed with a purpose. So – when you’re going around in circles – you don’t have velocity, you just have speed.”

The VPs of Sales and Construction looked at each other.

The VP of Sales spoke first. “At the break, we were talking about margin and velocity being the two components of the financial measure RB Builders uses for economic return: Return on Assets. The measure of margin is Return on Sales, while the measure of velocity is Asset Turn. I am focused on margin.”

“I am focused on velocity”, said the VP of Construction. “We would like to know more about the relationship between margin and velocity. How they work together, and where they create conflict.”

“Return on Invested Assets is a composite measure of economic return”, said the intrepid, results-based consultant. “The formula for ROIA, or the broader measure of ROA, for that matter, is basically margin x velocity. It is a reflection – and an outcome – of both the margin we earn, and the velocity we generate. Return on Sales is the margin part, and Asset Turn is the velocity part; margin and velocity work together to produce economic return. Margin is how much money we make on every home we close, and velocity is about how many homes we can build and close. However, while economic return – ROIA – is a composite of both measures, margin and velocity are driven by different aspects of the business.

“Margin is marketing-related. It is a reflection of product development, marketing, and sales, a matter of upstream and downstream marketing, a reflection of pricing, costs, job budgets and trade partnering, a function of floor plans, elevations, options, specifications, and communities, a reflection of “buying low and selling high”. From a monetary standpoint – from a managerial cost standpoint – margin is about extracting value from direct, variable costs; it is about exploiting Cost of Sales.

“Categorically, these costs are in each house budget. If you build the house, you incur the cost; if you don’t build the house, you don’t incur the cost. There’s more to it than this, but – basically – if the cost doesn’t add or create value, you shouldn’t incur the cost.

“Velocity is focused on production. It is a function of job scheduling, production planning, and project management, a reflection of productivity and production capacity, a reflection of the inherent relationship between Inventory and Throughput, a matter of “doing more and better with the same or less”. From a monetary standpoint – from a managerial cost standpoint – velocity is about leveraging indirect, non-variable costs, about leveraging Operating Expense, or what is commonly termed overhead.

“Categorically, you’re going to incur these costs regardless of how many houses you build, so get more out of it.

“The limitation to higher margins is usually in the market, and we characterize market constraints as being external. On the other hand, the limitation to higher velocity is generally production-related, and we characterize production constraints as being internal. However, except under dire circumstances, we are not forced to choose between efforts to increase Return on Sales and efforts to increase Asset Turn. As I said, margin and velocity are driven by different aspects of the business, and they don’t necessarily react or adversely affect each other.

“It’s usually not a choice. It’s usually about both”, she said. “For example, the way RB Builders wants to partner with suppliers and sub-contractors involves both margin and velocity.

“RB Builders and its trade-partners want to find ways to share in the increased value they jointly extract from the houses they build and sell. That’s about margin. At the same time, they want to benefit from the shorter cycle times and higher productivity that results from better scheduling and coordination, from allocating production resources more effectively, from finding ways to increasingly do ‘more with less’. That’s about velocity.

“And – margin and velocity both benefit from efforts to wring waste and non-value-adding work out of the system.

“It’s not about choosing to focus on either margin or velocity. It’s about choosing to attack both margin and velocity”, she repeated. “It’s a two-pronged attack. Everyone at RB Builders has a dog in this fight. In fact, that is the beauty of Throughput. It increases as a result of both higher margins – from generating more income on every job – and higher velocity – from generating more closings in every community.

“Throughput does not distinguish between Revenue earned by higher margins or Revenue earned by higher velocity. Throughput is Throughput. Gross Income is Gross Income. Contribution Margin is Contribution Margin. Money is money.

“It’s about higher margins and higher velocity, not higher margins or higher velocity.”