Part IV: The Cost of Variation

(excerpted from The Pipeline: A Picture of Homebuilding Production, originally posted on Escape from Averageness in June 2010, updated and reposted here)

“And – how much do you think all of this variation is costing your company?”

The intrepid, results-based consultant paused, then decided to rephrase the question.  “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.

“According to you, a system will protect itself from variation and uncertainty with some combination of longer cycle time, higher work-in-process, and excess/unused capacity.  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 a utilization rate of 67%;  in essence, we waste one-third of our capacity.

“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”, said the CFO.  “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 – I would say that it is ‘costing’ us the opportunity of the Gross Income on those 100 closings we missed in 2007;  our Gross Income Margin was 22%;  we had $50 million in Revenue;  we had 200 closings, which makes the average sales price $250,000;  the rest of 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?”

 

(The Pipeline: A Picture of Homebuilding Production is available on the publisher website (virtualbookworm.com), and the author website (thepipelinebook.com), as well as amazon.com, barnesandnoble.com, and booksamillion.com)