Part I: The NAHB Chart of Accounts Income Statement: Comparative, Compliant . . . and Utterly Useless.

(initially published on EFA on April 12, 2009, updated and republished here, every year, as the first in a five-part series)

 

Yes – the NAHB Chart of Accounts permits comparisons with other builders.  Yes – the NAHB Chart of Accounts complies with GAAP reporting requirements.  Yes – the NAHB Chart of Accounts 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 – from a management standpoint – utterly useless.

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

The ability to generate positive cash flow, make a profit, and produce a satisfactory economic return begins with an understanding of cost.  An understanding of how costs are classified or associated according to structural hierarchy and cost objects, but most importantly, an understanding of how they are classified according to behavior.

Why does it matter how costs are classified?  All of the costs of building a home and running a building company are accounted for in the calculation of residual Net Income, right?  As long as the classifications don’t change, they are still comparable, right?  So – what does it matter where they are incurred, what caused them to be incurred, or whether they move in relationship to anything?

And – even if it does matter – why start with costs?

It starts with an understanding of cost, because costs are the most operative part of a building company’s Income Statement, and a deep, intuitive, and instinctive understanding for how costs are allocated and classified provides a basis of operational insight that cannot be acquired through any other means.

Understanding where costs are incurred and whether they are incurred directly or indirectly is marginally important, but the truly distinguishing characteristic of costs is how they behave.  The operative question:  Does the cost vary with the volume of an activity, or does it not? 

Cost behavior is so distinctive, because it presents a building company with the truest picture of what its production capacity costs, where it achieves (and passes) breakeven, and how it analyzes changes in costs, production levels, and margins.  Not only is it the truest picture, it is the only picture.  It requires a variable costing approach to managerial accounting.

There is no more vital understanding to have – in all of managerial accounting – than an understanding of variable costing and the Contribution Income Statement format.  This is true, regardless of how the financial statements of a building company are reported or presented.  It is true, regardless of the quest for comparativeness to support the industry’s fascination with meeting “industry best practices”.  It is true, regardless of the talking heads at IBS telling builders that all they need to do is just stay between the lines.

At the core of the variable costing approach is the understanding that all costs are not created with the same attributes, and, therefore, cannot be managed the same way.  There is a reason why builders need to differentiate between variable and non-variable costs.

Builders need to control direct, variable costs, the costs that are “above the line” on their Income Statement;  they need to reduce the cost and/or extract maximum value from having incurred it.  On the other hand – and at the same time – they need to leverage their indirect, non-variable costs, the costs that are “below the line”.  Those are costs builders expect to incur regardless of the Revenue the cost generates, and they want to produce as much output (Revenue, Gross Income) as they can, from having incurred the cost in the first place.

A building company has to control and extract value from its direct, variable costs;  that is how margins increase.  At the same time, it has to leverage its indirect, non-variable costs;  that is how velocity increases – how productivity increases, how production capacity is utilized as fully as possible.  It bears repeating that the preferred measure of economic return – namely, Return on Assets – is margin x velocity;  it is velocity acting upon margin.

A building company has to distinguish between variable and non-variable costs, in order to have a picture of breakeven, of the rate at which it absorbs overhead.  If its Cost of Sales contains non-variable costs, and its overhead contains variable costs, that understanding is destroyed.

That is the problem with the NAHB COA Income Statement.  Three examples, in point:

The NAHB COA Income Statement treats Indirect Construction Cost as one of the costs 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).  But – do Indirect Construction Costs vary according to Revenue?  Probably not.  For the most part, they are non-variable costs that will most likely be incurred regardless of the Revenue produced.

The NAHB COA Income Statement treats Selling Expenses (including Real Estate Commissions) as an Operating Expense, as a part of overhead.  Anything allocated to Selling Expense, therefore, should be a non-variable cost.  Is that the case?  Obviously not.  The bulk of Selling Expense is a variable cost.

The same argument could be made (albeit less strenuously) regarding Financing Costs, which the NAHB COA Income Statement also treats as an Operating Expense.  However, construction interest 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 lines of credit never varied.  Are loan fees non-variable costs that do not fluctuate with volume?  Clearly, they are not.

My advice?  Report your financial condition and your tax obligations, as required.  Compare your building company with other building companies, if you choose.  But – give yourself cost information capable of guiding your operating decisions.

Next:  Part II:  The Problem with the NAHB Chart of Accounts Income Statement

 

(this issue is addressed at a Pipeline workshop;  learn more here:  http://buildervelocity.com and http://saiconsulting.com/buildervelocity-pipeline-workshops/)