Archive for March, 2019

(published on EFA® every year since 2012;  updated, incorporated, and republished here, as the second in a five-part series;  Part I was published earlier, in February)

As evident from Part I, we 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. 

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.

A number of 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 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 necessary 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

 

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It was the first quarter of 2019.  RB Builders was aiming – once again – to extend its reputation as a builder that thrives on both the margin and velocity sides of Return on Assets, by expanding into a new geographical market, via the late-2018 acquisition of its sixth existing homebuilding operation.

In terms of market segment, this newly-acquired division was in-line with all but one of the previously acquired operations.  Like its predecessors, it had historically generated operating results and business outcomes that are lower than what RB Builders considers acceptable.  And, like its predecessors, this new building operation had acceptable current land/lot positions.

Early-on, RB Builders had completed the newly-acquired division’s conversion to the enterprise management technology system and started the conversion of its business and operating processes;  With this latest acquisition, RB Builders was confident that it could continue its record for unifying, developing, and improving the capabilities of existing teams at the builders it had acquired, transforming them into teams that reflected its own savvy, motivated, and mutually-accountable homebuilding team.

This road had become a familiar path for RB Builders.  

HISTORY OF RB BUILDERS:  Just over a decade earlier, at the start of 2008, and shortly after the end of the halcyon period known as the Age of Homebuilder Entitlement®, RB Builders had begun its own transformation process, with the objective of extracting itself from what it self-described as “the tar pits of averageness”.

Along the way, there had been a number of initiatives, some dealing with workflow, one dealing with scheduling, some dealing the value stream and trade partnering, others dealing with product.

As a result of this program, RB Builders had made massive strides.

During the ensuing five-year period (2008-2012), figured on a same company basis, annual Revenue had grown from $50 million to more than $121 million, an increase of almost 250%.  During the same period, the number of closings had increased more than 225%, from 200 to 453 houses per year.  Despite margin pressure, overall Gross Margin had increased slightly, from 22% to 24%;  as a result, RB Builders’ Gross Income had out-paced Revenue, growing by more than 250%, from $11 million to almost $30 million.

During this five-year period, Operating Expense had increased 30% (from $8.5 million to $11 million), far less than the same-period increase in Revenue.  As a result, RB Builder’s Net Income had risen from $2.5 million to $16.5 million, more than six times what it had been before the company began its transformation;  Net Margin had almost tripled, from 5% to 14%.

In 2008, RB Builder’s cycle time had been 180 days;  by the end of 2012, cycle time had been reduced to 65 days.  In 2008, the average amount of work-in-process had been 100 houses under construction;  by the end of 2012, the company been able to reduce its average work-in-process to 80 houses under construction, despite closing more than twice as many houses.

In 2008, RB Builders had targeted an inventory turn of 2.5x, which was actually an improvement from 2007;  in 2012, by keeping its work-in-process at 80 houses and closing 453 houses, RB Builders had been able to more than double its physical inventory turn, from 2.5x to 5.7x.

In 2008, RB Builders had been able to turn the value of its financial assets twice;  in 2012, it turned the value of its assets almost five times.  Because it had managed to maintain margins while improving velocity, RB Builders saw its main barometer of economic return (Return on Invested Assets) increase almost six-fold during the five-year period, from 11% in 2008 to 64% in 2012.

In 2013, RB Builders moved all of its raw land holdings and developed lot inventory off of its balance sheet and into subsidiaries, a move which would have further increased Asset Turn – and ROIA – had those two measures been restated to reflect the remaining assets.

By any measure, it had been a remarkable transformation.

The five divisions that RB Builders had previously acquired have all met – or remain solidly on-track towards meeting – their own multi-year plans for significantly increasing closings and Revenue, all without incurring any increase in Operating Expense, all the while maintaining lower levels of work-in-process and operating under reduced construction lines of credit.

 

NEWLY-ACQUIRED DIVISION:  Near the end of 2018, RB Builders acquired this, its sixth homebuilding operation.  Unlike the preceding year’s acquisition, this acquisition was considered very much in-line with RB Builders’ M&A pattern, because of similar product offerings, in the same price range.

For managerial accounting purposes, RB Builders had insisted that this new division (like all of its acquisitions) convert to a Contribution Income Statement format based on a variable costing approach to cost allocation.

In its final year of independent operation, the division had closed 66 houses, and generated $16.5 million in Revenue;  with the little more than $13.5 million in restated Cost of Sales now reflecting only its direct, variable costs, the operation had generated just under $3.0 million in Gross Income, producing an 18% Gross Margin.  With its $1.8 million in restated Operating Expense now reflecting only its indirect, non-variable costs, the operation had produced almost $1.2 million in Net Income, resulting in a 7.1% Net Income Margin.

Since it carried an average work-in-process of 33 houses under construction throughout 2018, the division had a calculated cycle time of 180 days (despite job schedules that typically called for 120 day completions);  66 closings with an average work-in-process of 33 houses under construction also meant that the division had turned its physical inventory twice (2.0x) in 2018.

Adopting what had become another of RB Builders’ mandates, and moving all of its raw land holdings and developed lot inventory off its balance sheet and into subsidiaries, the newly-acquired building operation showed a restated average work-in-process of $4.62 million  (the average per-unit LIP balance of $140,000 consisted of a $75,000 average lot takedown and a $205,000 fully-funded LIP balance (100% of cost, 82% of the $250,000 average sales price).

Revenue of $16.5 million gave it an asset turnover ratio of just under 3.6x.  For 2018, with its Net Margin of 7.1% and its restated asset turn of 3.6x, the new operation had achieved an ROIA of just over 25%.

As the management team, here are the questions the business case exercises raise for you:

Q;  How will you address a mandate that your newly-acquired division increase its annual closings by close to 25% over a two-year period, with less work-in-process, a smaller line of credit, and the same amount of overhead?

Q:  How will you use Building Information Modeling (BIM) to improve both the margin and velocity sides of economic return?  What will your ROBIMI (Return on Building Information Modeling Investment) be?

Q:  What cost accounting practices will need to change in order for you to the type of operating decisions that drive the targeted economic outcomes?

Q:  How will you create a savvy, motivated, mutually-accountable homebuilding team?  A team that understands the business of homebuilding as much as it understands the homebuilding business?  How will you give every teammate a significant financial stake in the outcome?  What is the baseline, target, and payout reserve?

Q:  How will you answer RB Builders’ contention that variation – evidenced solely by your 2018 calculated cycle time – is costing your division almost $1.5 million per year in lost Net Income, an outcome that will persist each and every year, until it is addressed.  A fact to keep in mind:  in 2018, your division had Net Income of less than $1.2 million. Is what they are asserting even possible?

Q:  How will you implement Epic Partnering™ (RB Builders’ program/process for creating relationships-arrangements of compelling mutually-shared interests) with your suppliers and subcontractors?  What are the attributes of the partnering relationship?  What are the components of the partnering program?  What does a transformational partnering process look like?  Is vertical integration an option to consider?

Q:  As you analyze it, are you willing to consider replacing, over time, your fully-outsourced building model (requiring a larger, shallower geographic footprint) with a fully-integrated building model (which requires a narrower, deeper footprint)?

Q:  How will you use Business Process Improvement (BPI) to remove non-value-adding work and make the remaining value-adding work flow faster, more evenly, more smoothly, with fewer mistakes and rework?  How will you build a shorter, straighter pipe?

Q:  Can you use Critical Chain Project Management to reduce your job schedules from 150 days to 121 days, while also assuring more reliable job completion dates?

You can always ask us to send you the business case.  You can complete it, grade it, and figure out how well – or how poorly – you did.  Were you able to answer the questions?  Were you able to solve the problems?

If you find as unacceptable – what we’ll call it your “degree of attunement” – you should come to the upcoming Pipeline workshop™.

 

Come.  Participate.  Learn.

RB Builders: Lessons from the Pipeline© is the underlying business case study used at every Pipeline workshop™.  The next workshop is being held March 20-21, 2019, at the Ponte Vedra Inn and Club, in Ponte Vedra Beach, Florida.

Cost is $895.00;  for team pricing, inquire here (flgroves@saiconsulting.com).

Delivered by SAI Consulting and Continuum Advisory Group.

Sponsored by MiTek Industries and Specitup.

Details:  www.buildervelocity.com

 

Pipeline Workshops™: Improvements to the Pipeline Game™

Posted March 3, 2019 By Fletcher Groves

“Pipeline games™ were a brilliant way to demonstrate and drive home the significance of cycle time improvements and improving trade partner efficiencies on ROA and Net Income.”  (Keith Porterfield, COO, Goodall Homes, Gallatin, TN)

“Pipeline games™ are a very innovative way to demonstrate the critical nature and relationship between cycle time, inventory turn, margin, and return on assets.”  (Vishaal Gupta, President, Park Square Homes, Orlando, FL)

Simulating production principles is a big part of every Pipeline workshop™.  We hear, over-and-over, that the opportunity to simulate production in a progressive series of scenarios is what enables builders to actually “see” production, to see production principles in action.  Because it is both a production simulator and a business game, the Pipeline game™ is what makes Pipeline workshops™ so intense, so interactive, and so competitive.

The Pipeline game™ has always been a tremendous tool for teaching both production and business principles, but we are never content.  We constantly improve it, introducing significant changes over the past five years that make it even more effective.

One of the earlier changes was to shorten the game, so that we could run more production scenarios in the same amount of time, and so that each operating decision became more consequential.  Another change, designed to make the game more realistic, was to have it depict the outsourced nature of homebuilding production as it is universally and currently performed.

That later change begs a deeper dive.

In the earliest version of the game, the resources that did the work reflected both capacity and the cost of that capacity;  the problem was, that arrangement more reflected a manufacturing operation than a homebuilding operation.  In order to realistically depict the current, outsourced nature of homebuilding production, capacity has to be separated from cost.

Why?  Because, the external resources that determine production capacity are a part of Cost of Sales (making them a direct, variable cost);  Cost of Sales is a measure of product cost, not capacity cost;  Operating Expense (the indirect, non-variable cost of internal resources) is what determines capacity cost.

Using the resources to reflect both capacity and cost required us to essentially disregard Revenue and Cost of Sales, and treat Throughput  (i.e., Gross Income) as Revenue.  In the improved version of the Pipeline game™, we restored Revenue and Cost of Sales to the picture, making Throughput (i.e., Gross Income) the residual;  in effect, we now account for the margin side of Return on Assets.

Because they do the work (not simply manage it), the external resources in a Pipeline game™ now define the production system’s capacity, and the cost of those resources is reflected in Cost of Sales, stipulated as a percentage of Revenue;  as it relates to Revenue, they are a direct, variable cost associated with the construction of a home.  Operating Expense is now an imposed cost, reflecting the budgeted cost of the internal capacity required to manage work-in-process;  that makes Operating Expense an indirect, non-variable cost, as it relates to Revenue, and the completions and closings that produce it.

This represents a significant stride in reconciling Revenue, Cost of Sales, Throughput, and Gross Income, making operating decisions easier to connect to financial outcomes.  The result is a production simulator and business game that is vastly more reflective of a homebuilding operation, with lessons that are now much easier for builders to understand.

This change continues to pay-off.  But – we don’t ever stop trying to improve the learning;  as a result, the Pipeline game™ keeps getting better and better.

For example, at a recent Pipeline workshop™, we introduced a scenario that contrasts the currently accepted growth and operations strategy (a completely outsourced building model) with a radically different growth and operations strategy (a completely integrated building model), in order to explore the difference between a strategy based on a broader, shallower footprint and one based on a narrower, deeper footprint.

 

Come.  Participate.  Learn.

The next Pipeline workshop™ will be held March 20-21, 2019 at the Ponte Vedra Inn and Club, in Ponte Vedra Beach, Florida.  Cost is $895.00;  for team pricing, inquire here:  flgroves@saiconsulting.com).

Delivered by SAI Consulting and Continuum Advisory Group.

Sponsored by MiTek Industries and Specitup.

Details:  www.buildervelocity.com