Part V: “What is the real cost?”

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

“That calculation does not even scratch the surface”, the CEO 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”, he said.  “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 that capacity 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.”

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

 

2005:

  • WIP = 100
  • CLOSINGS = 225
  • CYCLE TIME = 160 days

 2007:

  • WIP = 100
  • CLOSINGS = 200
  • CYCLE TIME = 180 days

2008:

  • WIP = 100
  • CLOSINGS = 240
  • CYCLE TIME = 150 days

 

  • WIP = 80
  • CLOSINGS = 240
  • CYCLE TIME = 120 days

 

  • WIP = 100
  • CLOSINGS = 300
  • CYCLE TIME = 120 days

 

  • WIP = ?
  • CLOSINGS = ?
  • CYCLE TIME = 90 days

 

  • WIP = ?
  • CLOSINGS = ?
  • CYCLE TIME = 90 days

 

Turning and nodding at the data table on the board, he said, “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.”

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

 

  • WIP = 60
  • CLOSINGS = 240
  • CYCLE TIME = 90 days

 

  • WIP = 100
  • CLOSINGS = 400
  • CYCLE TIME = 90 days

 

“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?

“It is a valid option, perhaps a necessary option, but set aside the idea of making RB Builders a smaller company – 240 closings, but reducing WIP to only 60 units.  Focus on Max-T.  Focus on 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 could 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 $3,400,000 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.

“That would be tough, given the economy and housing market we are facing in 2008.  But, if we succeed in reducing our cycle time from 180 days to 90 days, it means we get to progressively split a GI Reserve of $12.5 million instead of a GI Reserve of $1,500,000.

“And, you know what?

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

 

(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)