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

(initially published on EFA on January 17, 2012, updated, incorporated, and republished here, every year, as the second in a five-part series)

 

From Part I of this series, readers of Escape from Averageness know that we disagree with the cost allocation structure of the Income Statement recommended by the National Association of Homebuilders in its Chart of Accounts:

Yes – the NAHB Chart of Accounts permits comparisons with other builders.  Yes – the NAHB Chart of Accounts complies with GAAP reporting requirements.  Yes – it 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.

Strong words, purposely stated.

For anyone headed to the 2014 International Builders Show in February, planning on attending sessions on the Business management and Operations track, reading that post and the posts that follow in this series should raise legitimate reservation, and challenge conventional thinking and advice, regarding any session extolling this method of cost allocation.

Several 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 the Chief Financial Officers of their company, but the group included a number of Controllers and Vice Presidents of Finance.  It included both large and small builders, both 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 with the NAHB Income Statement format.

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 used 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.

Then, regarding the more critical issue of the assignment/allocation of costs:

Q: Where do the following equivalent line items appear on your Income Statement (either as a part of Cost of Sales or a part of Operating Expense): Indirect Construction Cost, Selling Expenses (including Commissions), and Financing Costs?

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, in effect, a non-variable cost that should be allocated to Operating Expense);  60% said they allocated Selling Expense (including Commissions) to Operating Expense (where it should be, insists NAHB, notwithstanding the fact 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 if the LIP balance never varies;  and, 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 arguments for treating aspects of Indirect Construction Cost, Selling Costs, and Financing Costs as a Cost of Sales (a direct, variable cost), and there are arguments for treating parts of them as an Operating Expense (an indirect, non-variable cost);  the variable portion should be Cost of Sales, and the non-variable portion should be Operating Expense.

The problem becomes, 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 indiscriminately blend costs that are either variable or non-variable, in terms of how they behave in relationship to changes in Revenue volume.  This practice obscures cost behavior, and it prevents the use of important management accounting tools.  Generally-speaking, 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

 

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