Margin or Velocity?

In the business of homebuilding, it is not enough to have revenues that exceed costs, or to have a positive cash flow;  a homebuilding enterprise must also generate an acceptable economic return from its homebuilding operation.

Because it has an operational (as opposed to investment) focus, the most appropriate measure of economic return is Return on Assets, expressed best by the DuPont identity, which separates economic return into two components:  margin and velocity.  Return on Assets = Return on Sales x Asset Turn.  Return on Sales (Net Income ÷ Revenue) is the margin side of ROA;  Asset Turn (Revenue ÷ Average Assets) is the velocity side of ROA.

For some unexplainable reason, homebuilding is not an industry that has ever given these two components of economic return the same standing.  There has always been an unequal attraction.  In good times or bad times, the emphasis – the priority – has been on improving margin;  the argument for any effort to increase velocity is brought – kicking and screaming – to the table.

That emphasis and priority is heightened coming out of a downturn.  Emerging from the most recent downturn, it was assured that builders would instinctively move first to repair margins.  And – if past recessions are any indication – it can be predicted that it will be another two to three years before most builders might start any effort to become more productive and do more with the production capacity they pay to have at their disposal.

Assured.  Predictable.  Dangerous.

Sustainable competitive separation is the result of doing what others will not do, what they cannot do.  Things that are too tough, that require too much rigor, too much discipline, too much resolve.  Perhaps margin is the correct initial focus coming out of a recession.  But – generating a higher Return on Sales is not the difficult part;  it is the more natural part, where builders’ inclination lies.

Margin is necessary, but it is not sufficient.

Sustainable competitive separation requires more;  it requires doing the difficult part, as well;  the part to which builders are less-inclined.  It requires continually and relentlessly finding ways to become more productive, finding ways to do more with less, finding ways to increase the rate completions/closings with a planned, finite, and controlled level of work-in-process.

Real, sustainable, competitive separation requires proficiency on the velocity side of Return on Assets as much as proficiency on the margin side of ROA.  Working to improve margin without also working to increase velocity is fighting the battle with one arm tied behind your back.

As one of our clients expressed it, in writing a review of The Pipeline: A Picture of Homebuilding Production:  “All homebuilders focus on margin.  It’s what we think about.  It’s what we benchmark about with other builders:  ‘What did you sell that house for?  How much did you pay for that lot?  What were your construction costs per sq. ft.?’  What we need is the ability to more fully understand the relationship between margin and velocity, as the co-determinants of economic return.”

That understanding will be needed sooner than most builders think.

During the homebuilding collapse, constrained capacity wasn’t an issue;  the industry bled-off the capacity it was unable to utilize.  Now, it is an issue.  Even at a relatively low rate of new home sales, there is now insufficient production capacity to meet current demand.

What will the situation turn into, in the next several years, when – as Calculated Risk’s Bill McBride predicts – the level of annual new home sales rises 60% from current levels, to a modest level of 750,000 to 800,000?

Replacing lost capacity without any increase in productivity has two negative effects:  First – it is more difficult, because it requires finding even more of what there currently isn’t (more resources).

Second – it becomes just another more-for-more proposition, an offer of more capacity at a higher cost;  not higher productivity;  not additional throughput achieved with the same capacity.

Will higher direct labor cost result in the availability of additional capacity?  Can the additional direct labor cost associated with securing more capacity be automatically passed through in the form of higher sales prices?  Can higher overhead cost automatically be recovered?  Wouldn’t higher velocity – increased productivity – be a better approach to dealing with the situation than living with the effect higher costs would have on margin?

Why do we argue so forcefully for the drivers of higher velocity?  Why do we argue so relentlessly for better processes, for shorter cycle times, for faster inventory turns, for higher productivity, for a managerial accounting approach that provides visibility into operations, for better-managed production systems, for team-based performance compensation based improvement to a single business outcome that is impacted by every position in the enterprise and reflects both components of economic return?

Why do we advocate so strongly for adoption of an urgent, rapid-results process of continuous improvement that focuses on whatever currently constrains an enterprise’s ability to generate more of that single business outcome?

Why was a book like The Pipeline: A Picture of Homebuilding Production written?  Why are we launching into a series of sponsored, open workshops on the principles and disciplines of homebuilding production?

This is why.