Part II: Margin x Velocity

(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.”