The Cost of Process Variation and Waste

(originally published on EFA® in August 2012 as “The Cost of Tolerating the AS-IS State of Business Processes”, reduced to its essence, updated, and republished as part of two retrospectives, “Above Average: The Best of Escape from Averageness®, 2009-2012” in 2013 and “Still Above Average: The Best of Escape from Averageness®, 2009-2021” in 2021)

SAI has been mapping business processes – documenting, analyzing, improving workflow – in the residential construction industry for more than two decades.  During that period, we have managed dozens of engagements, across a broad spectrum of geographical markets and builder types, multiples of processes, involving tens of thousands of discrete steps.

Most of our clients are well-managed homebuilding companies, some of them exceptionally well-managed by the standards with which this industry is judged.  The list includes past National Housing Quality (NHQ) Award winners and past winners of Professional Builder’s Builder of the Year award.  All of them, at the very least, were forward-thinking enough to be concerned with improving their business processes in the first place.

Nevertheless, the data from these process mapping engagements, anecdotal or otherwise, in its totality, suggests that fully 25% of the work these otherwise very competent builders were performing added no value whatsoever;  it is almost certain that the actual percentage of non-value-added work was considerably higher.  No two process steps have equal weight, but acknowledging the percentage of non-value-added work has merit;  it has validity in assessing whether a process is badly-designed, is being poorly managed, or both.

If you are a homebuilder, the point is this:  What are such badly-designed and/or poorly-managed processes costing you?

What are they really costing you?

The most basic – the most universal – proposition of business – applicable to any industry, but applied here to homebuilding – is this:  the goal of a homebuilding enterprise is to make money;  the way it makes money is through the value that it delivers to its homebuyers;  that value is delivered by the work the enterprise performs, and that work has to be performed in some method of workflow.

The effort to deliver homebuyer value costs the homebuilding enterprise something.

Set aside, for now, the substantial costs a homebuilding company incurs in the business sub-process known as Start-to-Completion (STC).  For a number of reasons, we exclude STC as a process from the scope of a process mapping engagement (see the original post).  The cost of that part of the effort to deliver value – including all of the very real cost of wasted effort associated with scrap, jobsite conditions, jobsite mistakes, scheduling conflicts, design issues, etc. – is not reflected in the data we just referenced.

That is because, on an Income Statement, that cost should be classified as Cost of Sales.

Cost of Sales is considered to be a converted or transformed cost, and the cost of the non-value-adding effort is passed on, largely hidden, in the form of higher pricing from the sub-contractors and suppliers that perform all of the work.  The cost of non-value-adding effort contained in Cost of Sales diminishes Gross Income;  it depletes the value delivered to the homebuyer, who paid more than he should to receive the benefit for which he contracted.  It can be affected by non-value-adding effort in areas outside of Cost of Sales, as well.  It is significant.  It is expensive.

But, it is not the issue being discussed.

This discussion is about the consumed cost of non-value-adding effort, reflected in a homebuilding company’s Operating Expense.  Whether you choose to view Operating Expense as a productivity issue or as an excess capacity issue – as a consumed cost that should be leveraged (our preference), versus a consumed cost that should be reduced – there is clearly a pointlessly-incurred cost associated with wasted effort, associated with effort that produces no value.

That cost diminishes Net Income.

How much?

A number of years ago, John Caulfield highlighted data from one of the Shinn Group’s annual Financial and Operations Studies, based on information provided by 450 builders that were participants in the Shinn Builder Partnership programs.  More than two-fifths of the builders surveyed reported Operating Expenses above 25% of Revenue (at the time, Shinn’s recommended target was to keep Operating Expense at less than 25% of Revenue, but, in so many words, urged builders to keep Operating Expenses significantly lower, at under 20% of Revenue).

Out of the Shinn data and the SAI data, let’s consider a favorable scenario:  a hypothetical homebuilder with favorable overhead (20% of Revenue) and a low level of wasted effort (25%) within that overhead.  That makes this hypothetical builder’s cost of wasted effort five-percent (5%) of its Revenue;  for every million dollars of Revenue, the cost is $50,000, a cost that comes right off the builder’s bottom-line.

That cost is one thing, if you are a homebuilding company the then-size of Pulte (an annual cost that then represented a mere $197.5 million in lost-but-potentially-recoverable Net Income).  It’s another matter, one that likely strikes closer to home, if you are a homebuilder with Revenue in the $40 to $45 million range – a range bracketed, at the time, by two of the consistently successful builders that SAI had taken through the effort to map their business processes, and who’s data was included in our calculations:  Jagoe Homes (Owensboro, KY) and Charter Homes & Neighborhoods (Lancaster, PA).

Let’s be clear:  If you are the then-size of a Jagoe or a Charter, and – unlike Jagoe or Charter – you do nothing to improve the AS-IS, do nothing to remove the waste and variation associated with the current state of the processes you depend upon to deliver value to your homebuyers, that bogie is a cool $2.1 million, incurred every year.

Not exactly chump change.