The Cost of Process Variation and Waste

(originally published on EFA, on August 26, 2012, as “The Cost of Tolerating the AS-IS State of Business Processes”, reduced to the essence of the argument and republished here, part of our retrospective Above Average: The Best of Escape from Averageness, 2009-2012)

SAI has been mapping business processes – documenting, analyzing, and improving workflow – in the residential construction industry for more than 15 years.  During that period, we have managed dozens of engagements, across a broad range of geographical markets and builder types, multiples of processes, involving thousands of discrete steps.

Most of our clients are well-managed homebuilding companies, some of them exceptionally well-structured and well-managed, by the standards with which this industry is judged.  The list includes past and present National Housing Quality (NHQ) Award winners and past winners of Professional Builder’s Builder of the Year award.  Certainly, all of them were forward-looking enough in the first place to be concerned with Business Process Improvement.

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

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

The most basic – the most universal – proposition of business is this:  The goal of an enterprise is to make money;  the way that it makes money is through the value that it delivers to its customers;  that value is delivered by the work that the enterprise performs, and that work has to be performed in some method of workflow.

The effort to deliver customer value costs the enterprise something.

Set aside the substantial costs a homebuilding company incurs in the business sub-process known as Start-to-Completion (STC).  For a number of reasons, STC is excluded from the scope of the typical 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.  On an Income Statement, it is Cost of Sales.

Cost of Sales is considered to be a converted or transformed cost, the cost of the non-value-adding effort of which is passed on largely hidden, in the form of higher pricing from the sub-contractors and suppliers to which virtually 100% of the work is outsourced.  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 to receive the same benefit;  it can be affected by non-value-adding effort in areas outside of Cost of Sales;  it is significant;  it is expensive.

But, it is not the issue under discussion.

This discussion is about the consumed cost of non-value-adding effort, reflected in a building 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) or as a consumed cost that should be reduced, as a “more-for-less” proposition or a “more-for-the-same” proposition – there is clearly a pointlessly-incurred cost associated with wasted effort, with effort that produces no value.

That cost diminishes Net Income.

How much?

In builderonline.com, John Caulfield highlighted data from The Shinn Group’s 19th annual Financial and Operations Study, based on information provided by 450 builders that are participants in the Shinn Group of Companies’ Builder Partnerships.  More than two-fifths of the builders surveyed reported Operating Expenses of more than 25% of Revenue (Shinn’s recommended target is less than 25%). The report said the most profitable builders were the ones that kept their Operating Expenses under 20% of Revenue.

Out of the Shinn data and the SAI data, let’s consider a favorable scenario:  a hypothetical builder with modest overhead (20%) and a low level of wasted effort (25%).  That makes this hypothetical builder’s cost of wasted effort five-percent 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’s one matter, if you are a homebuilding company the size of Pulte (a mere $197.5 million per year 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, incidentally, bracketed by two of the consistently successful builders that we took through the effort to map their business processes, and who’s data is included in our calculations:  Jagoe Homes (Owensboro, KY) and Charter Homes & Neighborhoods (Lancaster, PA).

Let’s be clear:  If you are the size of a Jagoe or a Charter, and unlike Jagoe or Charter, you do nothing to improve the AS-IS – if you 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 per year.