“You are building houses. Simplify your life.”

It is interesting, the discussions you can get into with clients.  This is the response I recently provided to a senior manager at one of my homebuilding clients, regarding his questions, statements, and ideas about production management and key performance measures.

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I will simply refer to him as Gary (because it has nothing to do with his real name);  his part of the discourse has been reduced somewhat to get to the essence.  Bear in mind as you read this – Gary submitted all of his questions, statements, and ideas on his own initiative.

I just answered his questions.

Give him credit for even taking the time to think in these terms, and having the courage to speak his mind and ask the questions.

This is how real learning occurs.

Gary:  “My brain has been wrapped around this question for a while.  I am not an accounting guru but I am a good strategist.  I haven’t thought through what I am sending you from a double-entry accounting perspective, but I would like to follow a logical progression of a ROIA strategy.

“Since WIP is a Balance Sheet account, I have been confused with an over simplification of how our team has used ROIA as the main measure of success.  Although I totally agree with using it as a main measure of success, I worry that misapplying it may lead to poor decision-making.”

Fletcher:  “As long as you are talking about money, Work-in-Process is a Balance Sheet account.  And, Return on Invested Assets is the best measure of economic return, the best measure of enterprise success.  However, ROIA (or any related measure) is an outcome, the result of something else.  It is not a driver.  It is the ultimate lagging indicator (like looking at the scoreboard after the game is over), not a leading indicator.

“As such, it can be generated, but it cannot be managed.

“If you want to look at what needs to be managed when ROIA is the ultimate outcome, look at the Key Performance Indicators, Return on Sales (margin) and Asset Turnover (velocity).  Even the KPIs are largely outcomes, the result of other actions.

“All of this thinking was explained, sometime back, in [your company’s] Current Reality Assessment®.  Go to the Intermediate Objectives (IO) Map.”

Gary:  “As an example, WIP right now is being viewed as the number of homes under construction, not the dollar volume of homes under construction.  To oversimplify my concern, if all I am worried about is completing houses in 90 days, I may tend to make non-market-driven decisions early-on and only sell starter homes that I can finish quickly.  If the market is asking for something different, I will soon find it hard to keep my pipeline full.”

Fletcher:  “Well, that contention is also correct, as long as you are now not referring to the Balance Sheet.  But, understand, many measures (such as Work-in-Process) are like coins;  they have two sides, heads and tails;  they have an operating (physical) side and a financial side, but they are the same coin, regardless of which side you are viewing.

“So – yes – WIP is both the number of homes under construction and the dollar value of those homes.  Just for the record, since those homes under construction are never fully drawn in terms of progress draws, Asset Turnover will always be faster than Inventory Turn.

“But, why would cycle time be the only measure, the most important measure, the measure that drives every other decision?  It is a necessary condition that affects just one side of economic return.”

Gary:  “If I am going to be market-driven, I might find that the biggest area of demand for my services, for example, is downsizing active adult empty nesters.  They are going to want a more substantial home than a starter home with more amenities which will take longer to complete.  They will tend to pay cash for their home.

“From an accounting perspective, I would be receiving progress payments throughout the job which I would also collect profit on.  This would decrease my Inventory (WIP) account and add money to my Cash and Retained Earnings on the Balance Sheet and my Income Statement.  Even If I had not finished the home, this would still have an on-going effect on my ROIA.”

Fletcher:  “First of all, Revenue is not recognized on Work-in-Process (and certainly not Net Income or any other residual measure);  WIP and Inventory are transfer accounts.  Typically, even completed Inventory is not transferred (and, thus recognized) until it is closed.  That is when it moves from the Balance Sheet to the Income Statement.”

Gary:  “Given that ROIA is calculated as EBITDA / Inventory (WIP), how do you calculate Inventory (WIP) in various scenarios:  (1) a spec home where the contractor is carrying the cost of construction;  (2) a pre-sold home where the contractor is carrying the cost of construction:  (3) a pre-sold home where the buyer is paying the cost of construction and a portion of the profit all the way through.

“If velocity is a function of going from dig to close, that doesn’t necessarily reflect how a Balance Sheet would look at it, given my revenue recognition policy for the above scenarios.  If, on the other hand, a Balance Sheet inventory carry is reduced by every progress payment with its accompanying profit, it changes the picture.

“That allows a builder to not be as concerned about the size of the home they’re building but how fast they are bringing in profit draws from that home and ultimately completing them.”

Fletcher:  “ROIA is calculated for a specific period of time on the Income Statement and at a specific point in time on the Balance Sheet.  If you take that fact, and add the fact about acceptable transfers, it begs the question:  Why are you focused on recognizing Income Statement accounts during construction?  And – why are you focused on ROIA during construction?

“If you are that concerned with the time value of money, I am surprised you are not advocating discounted cash flow, as well.

“I think you are way too far into the weeds on this, to the point of making it very difficult and complicated to manage your production.

“I believe a far better approach would be to set your expectations, restrictions, and limitations – your acceptable guidelines – upfront on every plan you offer (and every lot, if that is a consideration), on the possible financing arrangements, and then let the market speak.

“Make [your company] indifferent to what any buyer chooses.

“Then, run your production system;  schedule your starts, control your work-in-process, manage the constraint, build as fast as you can (run everything as a relay race), regardless of what you sold before you started, or what you started before you sold.”

Gary:  “With this thought process, I have been toying around with a modified equation that might look at pipeline size a little differently.  Instead of units, I would look at it as dollars under construction and the total square feet that represents.  I would then put a limitation on our team for a pipeline size that equates to square feet under construction vs. number of units under construction.”

Fletcher:  “You are building houses.  Simplify your life.”

 

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