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(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

 

Velocity Accelerators®: Critical Chain Project Management

Posted February 23, 2019 By Fletcher Groves

One of the areas we single-out for deeper discussion in a Pipeline workshop™ – what we call Velocity Accelerators® – deals with the imperative of replacing the current method of scheduling houses under construction.  Not one house.  Not every house, independently.

No – this is about the method of scheduling the entire portfolio of houses a builder has under construction at any point in time.

That’s because the nature of the workflow in homebuilding production is project portfolio management, managing what can be large amounts of work-in-process, managing what can be a large number of construction jobs.  Yes, there is workflow performed in processes, but those processes are a different type of workflow, and they are generally embedded in, and enabling and supporting of, the larger, more primary scheme of managing a project portfolio.

The process of building a home – what we call Start-to-Completion – is actually the management of multiple projects that share resources.  It is the structuring and the management of a portfolio of job schedules, with inter-dependencies and interactions of tasks and resources.

At its core, homebuilding is multi-project management.

The current method of project scheduling is known as the Critical Path Method (CPM), which evolved from the Program Evaluation and Review Technique (PERT) in the 1950s;  it has been in existence for almost 70 years;  it is the method used in every homebuilding ERP.

PERT and CPM were designed for one-off programs with large, complex structures (Polaris weapons system, the Manhattan Project), but the Critical Path Method has become the de facto standard for scheduling all types of projects:  aerospace/defense, software development, product development, research, and – yes – construction.

The problem with CPM is that it was not designed for managing a portfolio of projects, and it was not designed to function in environments where velocity is important, where faster cycle time and higher inventory turns are critical drivers of business outcomes.

Where it must contend with variation and uncertainty, CPM offers only a buffer of additional time – individual task durations lengthened to protect the completion date of each task, but not necessarily insuring the completion date of the project.

And – what is the cost of that added safety?  What is the cost of specifying 95% probabilities of completion over mean (50%) probability?

Statistically, it lengthens the job schedule by a factor of 1.64.  Which is how 90 day job schedules become 150 day job schedules.  Built-in safety that three well-known, yet typically un-checked, types of human behavior then conspire to waste.

For the most part, builders are oblivious to the effects of variation on their production system.  Yet, the cost of that variation is apparent and simple to calculate;  it is the Gross Income lost from all of the closings that never occurred, from houses that were never built with the capacity that was available;  for a profitable builder, it is Gross Income that would have certainly become Net Income, and ultimately, Net Profit.

It’s a lot of money.

Moreover, CPM considers task dependency (the predecessor-successor relationships of tasks) in its work breakdown structure, but it does nothing to resolve resource contention;  it does not consider situations in which tasks of different projects/jobs depend on the availability of resources that do not have sufficient capacity to meet the demand being placed upon them.

These two factors – dealing with variation and resolving resource conflict – should be anathema to homebuilders.

CPM was never designed to contend with the production environment homebuilding presents.  It is not the problem (the problem is variation and resource conflict), but CPM is benign to the solution.  ProChain Solutions’ Rob Newbold (Project Management in the Fast Lane) told me that he would go further, saying:  “CPM supports values that perpetuate the problems of homebuilders.”

Which brings us to Critical Chain Project Management.

Developed in 1997, Critical Chain addresses both task dependency and resource contention, and it replaces the padded durations intended to protect the completion date of every task with a smaller project buffer that is fully-capable of protecting the completion date of the project/job;  in the process, CCPM becomes much more aware of system capacity and constraints.

Understand what this different, changed approach means:  it means that Critical Chain substantially reduces the duration of projects – the cycle time of houses under construction – without impacting the reliability of their completion dates.

Consider the explanation of an exercise excerpted from the RB Builders: Lessons from the Pipeline© business case study being used in the upcoming Pipeline Workshop™ No. 11:

“RB Builders’ newly-acquired division has a construction schedule of 120 calendar days, but its calculated cycle time is actually 180 calendar days.  It is widely agreed that the division should be able to build its homes in far-less than the 120 days called for by the schedule, because that duration reflects ‘highly certain’ task durations.

“Switching from CPM to CCPM would immediately reduce the schedule from 120 days to 97 days, cutting the schedule by almost 20% with no diminution of confidence;  it would reduce the actual 180 day cycle time by almost half (46%).”

Critical Chain Project Management does more than just reduce the length of construction schedules.  It also specifies a set of rules preventing behaviors that consume (and waste) the safety CPM builds into task durations.  It installs a release mechanism that “pulls” starts into the system and keeps work-in-process at the levels required to produce faster cycle times.

It implements simple, visual tools to manage production.

Builders can put a number of these practices into place without changing the scheduling algorithms from Critical Path to Critical Chain.  They can use add-on applications that convert existing scheduling applications from CPM to CCPM.  They can implement standalone CCPM software applications.  However – Critical Chain will not be a complete, integrated solution for the homebuilding industry until its management technology providers wake up and address it.

It all starts with obtaining the knowledge necessary to insist on that change.

Come.  Participate.  Learn.  Insist on change.

 

Critical Chain Project Management is one of three Velocity Accelerators® (along with Business Process Improvement and Epic Partnering™) that will be explored at the next Pipeline workshop™, March 20-21, 2019, at the Ponte Vedra Inn and Club, in Ponte Vedra Beach, Florida.

Delivered by SAI Consulting and Continuum Advisory Group.

Sponsored by MiTek Industries and Specitup.

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

Details:  www.buildervelocity.com

 

(published on Escape from Averageness® every year since 2009;  updated, incorporated, and republished, here as the first in the five-part series)

The NAHB Chart of Accounts enables builder-to-builder comparisons, complies with GAAP reporting requirements, and allows the same consultants to give the same presentation year-after-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 managerial accounting standpoint, and therefore, from a larger 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 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 completely missing.  Understanding where costs are incurred and whether they are incurred directly or indirectly is important, but the distinguishing characteristic of costs is how they behave.

Here is 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 points are, 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 (benefit in excess of cost) from having incurred it;  they need to exploit it, optimize its potential, find productive ways to get more value out of it, and understand, if they didn’t generate the Revenue, they didn’t incur the cost.

At the same time, they need to leverage their indirect, non-variable costs – the costs that should be “below the line”, costs that will be incurred regardless of the Revenue generated;  the objective should be to produce as many closings 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 whatsoever of breakeven, i.e., 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.

These three examples of the problem with the NAHB COA Income Statement make our point:

  1. Indirect Construction Cost is treated 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.
  2. Selling Expenses (including Real Estate Commissions) are treated 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.
  3. Financing Costs are treated 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 construction line of credit 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/)