Part III: The Cost of Variation and Long Cycle Time

(excerpted from The Pipeline)

“So – how much do you think all of this variation is costing your company?”, asked the intrepid, results-based consultant. “Let me ask it two different ways: How much is the lack of productivity costing you? How much is chronically-long cycle time costing you?

“Variation, productivity, cycle time. They are all connected.”

“Our cycle time is 180 days, and we are doing it with 200 closings produced on 100 units of work-in-process”, said the CFO. “Without getting into an explanation of statistics, we have about a 50% variation from the standard of 120 days and a 100% variation from the cycle time we instinctively believe we should be achieving, which is 90 days.

“As you have taught us, a system will protect itself from variation and uncertainty with some combination of longer cycle time, higher work-in-process, and excess/unused capacity. Our cycle time is very long, which translates into a large buffer. Our work-in-process is where we planned it to be, and only 25% higher than the lowest amount it could possibly be, which is 80 units at a cycle time of 120 days. So, I do not think this is a case of RB Builders having a buffer of additional work-in-process.

“Here is the kicker:

“If we honestly believe we can produce 300 closings with our current production capacity, then we have a huge buffer of excess/unused capacity, which calculates into an overall utilization rate of 67%. In essence, we waste one-third of our capacity. As you have pointed out, that is hardly the picture of high productivity. The inability to utilize our capacity translates into significantly fewer closings. We are paying for the capacity and the work-in-process to produce 300 closings, but we only closed 200 homes. That is a gap of 100 closings.

“In terms of what all of this is costing us, there is clearly a cost associated with excess work-in-process and unused production capacity”, the CFO continued. “The additional, “beyond-necessary” work-in-process certainly makes us a bigger company than we need to be, and the excess/unused production capacity alone costs us over $2,800,000 a year.

“But – I do not think it is about cost. I think it is about opportunity. Unless we opt for cost-cutting and reducing overhead – a “same-for-less” proposition – then, I would say that it is “costing” us the opportunity of all the Gross Income on those 100 closings we missed in 2007. Our Gross Income Margin was 22%. We had $50 million in Revenue. If you divide that by the 200 closings that we achieved, the average sales price was $250,000. From there on out, the math is pretty simple.”

The CFO walked up to the erasable board, and wrote:

$250,000 X 22% X 100 = $5,500,000

“We gave up $5,500,000 in Gross Income.”

The conference room was completely silent. Everyone was aware of the Gross Income Baseline, Target, and Reserve, and the impact an additional $5,500,000 would have on the payout of Gross Income Milestones under the new results-based performance compensation plan RB Builders had just enacted.

The silence was broken by the words of the CEO.

“No. That calculation does not even scratch the surface”, he said. “What is the real cost?”

He walked to the front of the conference room.

“If all that this excessive variation, lack of productivity, and longer-than-necessary cycle time cost us was $5,500,000 in Gross Income, that would be bad enough”, bristled the CEO. “But – this is also $5,500,000 that would have dropped straight to our bottom-line, in the form of additional Net Income.

“In terms of the cost of our production capacity, utilizing it would have cost us nothing – zip, nada, zero. It is non-variable cost. It is overhead. We already paid for it.

“I am not finished with this issue.”

The CEO turned to the erasable board, picked up a marker, and added two more rows to the data table:

WIP = 100

WIP = 100

WIP = 100

WIP = 80

WIP = 100

WIP = ?

WIP = ?

Turning and nodding at the data table on the board, he asked, “Forget the 180 day cycle time we have now. What do you think RB Builders would look like at a cycle time of 90 days, instead of the 120 days specified under our job schedules?

“It is a rhetorical question. For all of about five more seconds.”

The CEO made a quick calculation and filled in the Closing and WIP data that was missing from the table.

WIP = 60

WIP = 100

“We could go with virtually any combination – any strategy or tactic – of higher Throughput and lower work-in-process to achieve a 90 day average cycle time, but say that we elect to go with a tactic of “Max-T”, a tactic of generating maximum Throughput with a planned, finite, and controlled level of work-in-process. Forget 200 closings on WIP of 100 units, which would be the current cycle time of 180 days. Forget 300 closings on WIP of 100 units, which would be the cycle time specified in our construction schedules. What about 90 days? Although it is a valid option, set aside the idea of making RB Builders a smaller company – 240 closings, but reducing WIP to only 60 units. Focus on Max-T. What about 400 closings on WIP of 100 units?

“What happens?”

The CFO handled the question. “Well, if our Gross Income Margin remains the same – which it likely would not, because of price elasticity of supply and demand – then we would generate an additional $11 million in Gross Income, every penny of which, as you point out, drops straight to our bottom-line in the form of additional Net Income.

“Which means that our unwillingness – or our inability – to do anything about the current level of variation that drives our long cycle times is costing RB Builders as much as $11 million in Net Income every year. That is a lot of money.”

“Yeah”, said the CEO. “Even for a company that would then have $100 million in Revenue. I want everyone to be clear. Our 2008 baseline is $50 million in Revenue, from which we expect to produce $11 million in Gross income and $2,500,000 in Net Income. Our 2008 target is $60 million, producing $12.5 million in Gross Income and $3.4 million in Net Income. As all of you realize, all of our very-considerable bonuses are tied to the Gross Income Reserve that represents the difference between the baseline and the target.

“By appearance, this kind of performance would be over-the-top. But – if we pull it off – it means that instead of progressively splitting a GI Reserve of $1,500,000 three-ways between our owners, Retained Earnings, and all of us, dropping our cycle time from 180 days to 90 days means we get to split a GI Reserve of $12.5 million.

“And – you know what?

“Despite the fact that its Revenue had doubled, RB Builders would be the same size company. It would have the same amount of WIP, the same overhead, the same working capital requirement, the same level of debt.”

One Comment

  1. Ping from Leslie Day:

    Your words make the Mathematical importance of variation and long cycle time come to life. I sent this out to all our Construction Professional teammates, I found it to be quite an educational tool. Thanks!