Escape from Averageness

"The absence of business logic is simply astounding."

2010-02-09T11:49:00.006-05:00

The intrepid, results-based consultant shook her head, partly in amusement, partly in disbelief. "Just when you think they get it, they don't", she thought to herself. It was another reminder that, early on, RB Builders was still capable of coming to bewildering conclusions, the latest of which centered around the company's team-based performance compensation plan, known as the GIPP, acronym for the Gross Income Participation Pool.

The GIPP was an early prerequisite for the intrepid, results-based consultant even agreeing to become involved with RB Builders, that stipulation, along with a mandatory transition to variable costing, and the subordination of all improvement initiatives to a more focused, constraint-management approach.

The GIPP was new. It was supposed to replace the company's previous practice of paying individual bonuses based on multiple measures, and consisted of a team-based approach focused on performance related to a single business outcome, specifically, increases generated in Gross Income above a specific baseline.

Under the GIPP, the baseline performance was referred to as the Gross Income Baseline (GI Baseline), while the budgeted performance was dubbed the Gross Income Target (or GI Target). The difference between the GI Baseline and the GI Target was referred to as the Gross Income Reserve (GI Reserve). The GI Reserve was scheduled to be paid out progressively, based on the achievement of a number of predetermined "bonus buckets", called Gross Income Milestones. The aggregate teammate share of the GI Reserve represented one-third of the GI Reserve, while the remaining two-thirds was split evenly between owners and retained earnings.

But, now, the GIPP was getting push-back, ostensibly from one of the Regional Vice Presidents. In fact, he wanted to cancel it. It was too late in the planning schedule to start changing the GIPP, let alone cancel and replace it.

The intrepid, results-based consultant was having none of it.

"We have credit facilities that we have to restructure, repay, and replace. We need the cash", explained the Regional VP.

"Where did you get this idea?", she asked.

"It is the best approach to a situation that is growing more difficult by the day", he replied. "We cannot justify bonuses in this economy, in this housing market. We have nothing against bonuses in good times, but they are just not warranted now."

"So, you just want to cancel the GIPP? YOU CANNOT BE SERIOUS!"

"Nice McEnroe impersonation", said the CEO.

"Glad you liked it." The intrepid, results-based consultant turned her attention back to the Regional VP.

"You are concerned that your division will be unable to meet its debt service obligations, if it rewards performance above its baseline?", she asked, rhetorically. "Really? Where is the money going to come from?

"The GIPP will not pay out anything unless there is a reserve created by performance that exceeds the baseline. You do realize that the GIPP is designed to be completely self-funding, that it does not cost the division or RB Builders' owners one red cent?

"You do understand that, right?

"With limitations on investment and work-in-process, and with management controls on non-variable expenses", she continued, "is there any likely scenario under which additional Gross Income will result in less cash flow? Is there any likely scenario under which every cent of that additional Gross Income will not drop straight to the division bottom-line? Where it can be utilized for -- oh, I don't know, say -- debt service, or distributed to teammates and owners before it became retained earnings?

"I can understand being careful with important decisions in uncertain times.

"I can understand increased diligence in determining a baseline that reflects current reality. I can understand having a more progressive structure to the payouts, so that each successive milestone is worth more. I can understand adjusting the distribution of the reserve between teammates, owners, and retained earnings, to 25-25-50, or 30-30-40, instead of equal shares, in order to provide more money to meet extraordinary debt service requirements.

"But, to deny yourselves -- you, your teammates, your owners -- the opportunity to do better? That, I do not understand.

"The absence of business logic is simply astounding."

Principled Lean: Give Toyota Credit

2010-01-27T12:51:00.004-05:00

The remarkable decisions coming out of Toyota this week -- to stop selling most of its car models, to stop even producing most of its car models, until they solve the gas pedal problem -- are thought-provoking. Even for someone like me, who interprets Lean Production within a particular industry vertical, and judges Lean as less of a religion and more a part of the toolset homebuilding companies need.

Toyota could have -- and should have -- responded more quickly to this problem. Clearly. But, give them credit for walking the walk when they did respond. They stopped the line to fix the problem. They matched the rate of production to the self-imposed limitation on demand; if you are not going to sell cars, then you might as well not make them. They took a longer view than the next couple of quarters' earnings reports.

As I have said previously in this column, homebuilding is not automobile manufacturing.

Homebuilding production is project portfolio management, not continuous flow. Kaizen and PDCA pose limitations to solving anything but the simplest of problems. At best, Lean is only part of the solution for homebuilding companies. There are lots of areas where Toyota -- and Lean Production -- just get it wrong. In particular, Toyota produces to forecast, not direct demand, more the result of a flawed value stream than a flawed production system.

But, they understand how to solve problems with standards, they understand that inventory is an asset only on some balance sheet (and is a liability in every other sense), and they have the courage to make tough decisions and live their principles.

I wonder how many homebuilding companies would have done the same.

"God with us"

2009-12-19T15:41:00.008-05:00

The intrepid, results-based consultant wearily plopped into one of the chairs in the airport club of this week's carrier. Friday evening, she thought to herself, should make it home before the storm making its way through the mid-Atlantic cancelled her departure.

"Headed home?", the man in the chair beside her asked.

"Yes."

Last week of work this year. She was headed home for a well-deserved break with her family and friends. She was looking forward to it immensely.

Her mind turned away from work. She thought about the season. She wondered what Bethlehem must have been like, thought about the young mother and father with their new-born son, to everyone else, just another child born into the world, controlled and protected by the Roman Empire.

She considered the grace, love, and mercy of the Creator of the universe, the Author of all that was good. She thought about the words of Paul, buried deep in his first letter written to the small group of believers in Corinth, describing faith, hope, and love, the principles of the grace she pondered.

"Father", she said softly. "Thank you.

"Thank you for giving me a faith that looks back into history and trusts that the claims this child would one day make about Himself are true, and that every moment of time and event of history either points towards, or proceeds from, that truth.

"Thank you for giving me a hope that looks forward, and understands that one day, notwithstanding that I have eternal life right now, this world that I live in will end, that I will be transformed, that the pains of this world will end, and that I will live constantly and eternally in your presence.

"And, thank you for giving me a love that will sustain me, motivate me, and give me purpose and perspective, for as long as You choose to keep me on your earth."

The intrepid, results-based consultant thought about the events of that night, long ago. There was a birth. There would later be a death and a resurrection. But, right now, her thoughts were about newness and life.

"And you shall call his name Immanuel".

"God with us".

Three Ways to Measure the Pipeline

2009-12-01T16:10:00.006-05:00

Excerpted from "The Pipeline".

The intrepid, results-based consultant helps RB Builders understand how to measure its production system:

"We need to create a visual reference", said the intrepid, results-based consultant. "Whether we choose to call it an analogy, a concept, or a metaphor, the clearest picture -- the best visual image -- we can convey of the RB Builders production system is that of a pipeline.

"We live in a world of systems. A homebuilding company is not some loosely-connected set of independent, and unrelated, parts. It is not some collection of processes, departments, systems, resources, policies, and other isolated pieces of a whole. A homebuilding company is both a system, and a part of a larger system. It is a set of interdependent parts that must work together to accomplish a stated purpose.

"Viewed as a pipeline", she said, "production systems have neither unlimited capacity nor unlimited size. If you increase the level of work-in-process, the only way the system can hold the additional work is to lengthen the pipe. The diameter of the pipe is fixed. If we put more work-in-process in the pipe, it does not become a bigger, wider pipe. It just becomes a longer pipe. So, what is the length of the pipe?"

"The length of the pipe is the time it takes to build a home", replied the VP of Construction. "It is cycle time."

"That's right", she said. "Duration, or cycle time, is the measure of the length of the pipe. The longer the pipeline, the more time it takes to get from one end of it to the other. In fact, given the same amount of effort, the added friction and the increased number of corners resulting from the added length actually tends to reduce the output."

One of the superintendents raised his hand. "Okay. So, are you saying we need a bigger, wider pipe?"

The intrepid, results-based consultant quietly smiled. "Well, that depends", she replied. "Does your production pipeline have a cost?"

"Everything has a cost", said the VP of Construction, turning to the CFO. "Am I right?"

The CFO smiled wryly, nodded affirmatively, and replied, "Yes, everything has a cost."

"So -- what is the cost of your pipeline?", she asked.

"Well, we have never thought about it that way", the CFO responded. "I suppose the cost would be whatever we spend to have a pipeline in place. The nature of a production pipeline is that of a relatively fixed object, heavy and difficult to move. I would say that the cost of our pipeline is all of the non-variable cost we incur every year, to have the capacity to build homes."

"Yes", she replied. "The cost of the pipeline is what RB Builders pays every year, in the form of operating costs and resources, to have the use of it. You pay for the cost of the pipeline, whether you use it or not. That puts the cost of the pipeline squarely in the category of non-variable costs.

"In order to understand productivity and production capacity, you must first understand how costs behave in relation to Revenue, and, more importantly, how you manage those costs on the basis of that behavior.

"On the one hand, you want to control your direct, variable costs -- you want to reduce the cost. Really, though, what you want to do is extract maximum value from it. Value is the difference between the price you sell a house for, and what it cost you to deliver it.

"On the other hand, you want to leverage your indirect, non-variable costs. Those are the costs you expect to incur regardless of the Revenue you generate, and you want to produce as much output -- as much Revenue, as much Gross Income -- as you can from them.

"So, would a bigger, wider pipe cost more than your current pipe?"

Thinking for a moment, the CFO replied, "Yes, it would. There is a connection between the size of a pipe and its cost. There is also a connection between the size of a pipe and its capacity, but that is an issue of utilization. When we invest in a pipe, the cost of the pipe is related to its size.

"So -- yes -- a bigger, wider pipe would cost more than our current pipe."

"Wait a minute. I want to talk about utilization", said the VP of Construction. "Our production pipeline is usually full. Are you saying that we do not utilize our production capacity?"

"No. Well, maybe", said the CFO. "I do not know how effectively or efficiently we are using the capacity the pipe was designed to achieve. All I am saying is that there is a relationship between the size of the pipe we design or buy, and what it costs us. The price of the pipe is related to its size. It is up to us to utilize the investment, to use the capacity."

"There are three ways to measure the pipeline", said the intrepid, results-based consultant. "Its size is defined by the amount of work-in-process it is intended -- it is designed -- to carry. Its length is determined by its cycle time. Its capacity is defined as the rate of output -- the rate of throughput -- that a pipeline that size can produce, with a planned, finite, and controlled level of work-in-process."

Lean Homebuilding

2009-10-29T13:56:00.004-04:00

Excerpted from "The Pipeline".

The intrepid, results-based consultant helps RB Builders understand the benefits and limitations of Lean Production:

"This part is going to be production physics. It is going to seem very theoretical, and I am not even giving all of it to you. You are going to have to trust me and accept it as laws of physics. Not blindly. With an open mind. I need you to grasp the basic concepts, and just stick with me. I promise I will give you something concrete.

"But -- you simply cannot understand what we are doing in reality, unless you understand the concept.

"I apologize. That is the way it is."

"Do not apologize", said the CEO. "Just do it. We have trusted you in a lot of ways, and, so far, you have not let us down. We will do our best to keep up with you."

The intrepid, results-based consultant smiled, nodded appreciatively, and then continued. "From an overall enterprise standpoint, RB Builders has decided that it wants to embrace -- as strongly as possible -- the tenets of Lean Homebuilding, particularly when it comes to standardization of work, elimination of waste, visual management, kaizen, PDCA problem-solving, A-3 planning and policy deployment, and other areas.

"Culturally-speaking, RB Builders has decided that it wants to become a Lean Homebuilding enterprise, embodying the most useful and transferable elements of Lean Thinking. In the case of RB Builders, Lean Homebuilding's most beneficial contribution, to this point, is having embedded a process of continuous improvement.

"However -- Lean Production, even crafted as Lean Homebuilding, is not the total answer. By itself, Lean Production -- or Lean Homebuilding -- cannot get RB Builders to where it needs to go.

"As useful, beneficial, and vital as Lean Homebuilding has been in the area of continuous improvement, it has not been as effective in the area of production management, in the areas of what is generally known as "flow", at least, not straight out-of-the-box.

"Like every other worthwhile production method, Lean Production does not come from a homebuilding environment. That is a problem, because -- as a homebuilding company -- RB's production system has different parameters, faces different conditions, and imposes different requirements.

"We could discuss this for hours, but we do not have the time", she said. "Let me give you several quick examples to highlight the type of "Lean issue" we see in various areas of production.

"First of all, Lean Production places a heavy emphasis on what it terms "Just-in-Time" replenishment, or JIT -- the principle of producing only what is needed or ordered, leveling demand, leveling production, pull, continuous flow, etc.

"But -- how does that work in homebuilding?

"As the second example, consider production leveling, or heijunka. A typical Lean manufacturer levels production based on forecast orders, not actual customer orders. Some companies are better at making and adjusting forecasts than others, but, at best, it is a mix of "change-to-order" and "build-to-order". It is really "build-to-forecast". To the extent there is variation in the forecasts, they either have to carry a large inventory of finished goods, have to promise very long delivery dates, or have to live with a lot of excess, and unused, capacity.

"That would be the equivalent of RB Builders having to very accurately forecast the demand for every plan it offered in every community -- or -- live with some combination of an enormous inventory of completed homes, in addition to its required work-in-process), live with long delivery date promises, or live with a ton of unused production capacity.

"How in the world does something like that ever work in homebuilding?

"Finally", she said, "consider the challenge of achieving continuous flow with a totally outsourced labor force, in a fragmented value stream, with as many manufacturing facilities or production plants as we have communities. How would we make that work?

"Think about it."

"So -- are you saying that we should abandon our commitment to Lean Homebuilding?", asked the VP of Construction.

"No. That is not what she is saying", answered the CEO. "She is saying find a way to use the tools that work best for us, without regard to the religion or the denomination from which they came.

"She is saying, understand the playing field. She is saying, understand the parameters. She is saying, understand the world we live in.

"She is saying, do what works. She is saying, above all, get results."

"Ten Years After"

2009-09-28T15:37:00.005-04:00

In the Spring of 1998, building upon its many years of process improvement experience in other industries, SAI Consulting began to help homebuilding companies map -- to document, analyze, and improve -- their business processes. Ten Years After (with a slight nod to the Woodstock Generation), we thought it would be worthwhile to reach back across the spectrum of those clients, to offer insight from our observations of their experiences and how their efforts have fared.

A COMMITMENT TO PROCESSES: The difficulties, the sometimes indifferent results, and the "tailing-off" of continuous improvement and process maintenance efforts leads us to conclude that the clients who find themselves in that position were not committed to the role of processes as the primary mechanism for how they created value for customers.

In almost any other industry, the central role of processes is indisputable. We have long characterized the homebuilding industry as having a "deal-driven" mentality, a proclivity to non-standard, non-repetitive work, which it substitutes for process discipline. Owners and management would rather spend their time deploying assets than leveraging their non-variable expenses (and thereby, becoming more productive).

It is a contra-process management mentality that manifests its presence when, no matter how many times they have done a particular sequence of tasks, they act as if they have never done it before.

THE MEANS TO AN END, NOT THE END IN ITSELF: The clients who enjoyed the greatest success from their project, and from their effort, were the ones who understood that processes were simply a means to an end, just one of the tools at their disposal in the pursuit of improved operating performance and the resulting business outcomes.

Mapping their processes was universally an eye-opening experience for these clients, but it was not that fact that made the difference. It was what they did with what they saw. Yes, they removed non-value added activities and value-killing characteristics in their processes, and they made the remaining value-adding activities flow more smoothly. But, they also began to systematically solve core problems and remove limitations.

They went far beyond the processes that were their initial step.

LEADERSHIP AND COMMITMENT AT THE TOP: The successful projects had the buy-in and commitment from owners and senior management, in stark contrast to the unsuccessful projects, in which owners and senior managers were either indifferent, acquiescent, or hostile.

Invariably, the feedback on the unsuccessful projects received from the clients themselves, concluded that those projects were doomed from the outset by the attitudes and behavior of owners and management. It was not uncommon to learn that there were agendas that had little to do with better processes and continuous improvement. There was little appetite for -- or expectation of -- the change that would be necessary to achieve results.

In contrast, the most successful projects were resolutely lead by owners and managers who had a vision of what the work could accomplish and a determination to see that result achieved. These leaders and their teams also demonstrated a willingness and capability to make the changes that were necessary.

LEARNING AS AN OUTCOME: We have never had a homebuilding client that actually understood anything about processes, workflow, and process improvement going into the engagement. For the most successful and far-reaching projects, clients treated learning as an outcome.

For those clients, it was not enough to simply document, analyze, and redesign processes and workflow. In the most successful projects, clients took it upon themselves to learn about processes, production systems, and much more. In the less successful projects, clients learned little about anything.

ADAPTING THE SOLUTION TO THE CONTEXT: To the extent that clients entered their project with a preconceived notion of the direction of the solution that would come from mapping their processes, they often sacrificed a better, stronger set of improvements.

Homebuilding is not automobile manufacturing or healthcare. It has a unique set of requirements that exist within their own context and parameters. Solutions do not come in convenient, dehydrated packages, to which you add water. Blindly imposing solutions from different environments did not work. The most successful engagements crafted the solution (including the processes) to match the specific requirements of the homebuilding industry.

NOTE: The entire report, including the process mapping methodology used, the survey itself, an analysis of the survey responses, the problems and issues, and the recent advances, improvements, and solutions in process management, is available upon request.

The Velocity Side of Return on Assets

2009-08-15T13:21:00.003-04:00

In a recent weblog entry ("There's No Longer Room To Cut -- It Is Time To Start Growing"), Jamie Pirrello (Big Builder Contributing Editor) makes a number of points about the current reality faced by privately-capitalized builders. John McManus (Big Builder Editor in Chief) adds his comments on the Housing Crisis weblog.

Those points are, chiefly, that (1) builders have cut as much overhead as they can, (2) they need top line (revenue) growth, (3) in a period of lower demand, they must take market share from someone else, and (4) taking market share from someone else requires differentiation born of superior talent delivering superior value.

John concludes that the need to have the right product in the right price position in the right location with the right process and the right vendor structure, supported and sold by the right team is a tall order for privately-capitalized builders, particularly as a competitive strategy.

Undoubtedly. But -- is that a sufficient strategy?

In what currently passes as the housing market, builders may be more consumed with liquidity and cash flow, but the reason they are in business is not about survival. It is about economic return, which also takes into consideration profitability. The most widely-accepted measure of economic return (Return on Assets) is a function of both margin (Return on Sales) and velocity (Asset Turn). ROA is not just about how much a homebuilding company makes on each house it builds; it is also about how many houses it can build with what it spends every year for its production capacity.

The mental model of the homebuilding industry in good times is "More-for-More". More Revenue, more income, in exchange for more of everything else -- more capacity (non-variable cost), more investment (land, models, work-in-process), more cash. In challenging times, the mental model becomes "Less-for-Less" -- less Revenue, less income, as a result of less capacity, a slower burn rate, and (maybe) less investment. A more-for-more proposition is always about size and growth; a less-for-less proposition is always about cutting costs.

However, neither of these mental models (more-for-more; less-for-less) have anything to do with the velocity side of economic return, or have anything to do with higher productivity.

The mental model of higher productivity is "More-for-Less" -- more Revenue, more income, with less capacity and less investment. It seeks more-for-less, but it would settle for more-for-the-same. If a homebuilder does not go after higher productivity -- if it will not tackle the velocity side of Return on Assets -- it is left with only higher margins with which to carve out any sustainable competitive separation. Since the market determines the price, all that that builder can do is to try to increase the margin by extracting more value from his variable costs.

Builders do need to extract -- to create -- as much value as they can, with better designs, better quality, better pricing, fewer defects, better locations.

Higher margins are necessary, but they are not sufficient.

Builders need velocity. They need to turn their work-in-process faster, which will result in faster cycle times. They need to increase productivity.

And, what -- you ask -- is "productivity"? From any managerial standpoint -- operations, manufacturing, production, or otherwise; from any industry vertical standpoint -- auto manufacturing, homebuilding, or any other industry; from any enterprise standpoint -- Toyota, or anyone else; from any expert or business leader standpoint -- Drucker to Goldratt to Ohno, the conventional, accepted formula for calculating productivity is Revenue divided by Operating Expense.
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The only way a homebuilding company can lower its price breakeven point in a margin-constrained housing market is to leverage its capacity -- to increase the amount of Revenue it can generate with the same level of Operating Expense.

Skeptical about the application to the homebuilding industry? Join the crowd. The broad efforts to increase productivity and capacity utilization get scant attention when the perception is the homebuilding industry has excess capacity (another worthwhile topic that I will get around to someday).

For now, consider the following simple scenario:

Same local housing market, two builders in direct competition, each has the same dollar value of overhead, which they will spend regardless of how many houses they sell and build. Builder A has a cycle time of 150 days; Builder B has a cycle time of 90 days. Builder A turns his work-in-process 2.4x per year; Builder B turns his work-in-process 4.0x per year. Builder A can build 20 houses a month and breaks even at 19 houses a month. Builder B also breaks even at 19 houses, but can build 34 houses a month. Same margins, completely different Net Income scenarios, because every dollar of Gross Income above the breakeven point drops straight to both builders' bottom-line. But -- which builder can push it to the hard deck?

Because of its higher productivity, Builder B is in a much better position to compete on margin, an advantage that works in both good markets and bad markets. With 60% more Revenue, most would consider Builder B to be a much bigger homebuilding company. But, it is not. Builder B is the same size as Builder A, when the measure of size is capacity.

Productivity is a much more sustainable basis for creating competitive separation, because it is so much harder to achieve. There is always a risk in generalizing, but the homebuilding industry, as a whole, lacks the resolve and discipline to do the hard work required by more-for-less. And, that, ostensibly, is why the publics have the advantage over privately-capitalized builders. The publicly-capitalized builders have better access to cash and financing.

But, better access to cash and financing only creates financial capacity; it does not create production capacity. It does not make publicly-capitalized builders more productive. Arguably, the homebuilding industry owns no production capacity, because builders generally do not do any of the value-creating work; at best, they do value-enabling work. Unless it is a craft builder, a homebuilding company merely strip mines the value stream (selective, tactical vertical integration; yes -- another story).

And, so, it becomes a matter of geographic expansion, a quest for market share, and competing on margin, because that is all they have.

I do not believe the single family run-rate (as John puts it) will remain at a place-keeping 550,000 units; the demographics support much higher long-term demand. In some ways, a return to normal demand would be the worst movement that could happen, because, if it comes soon enough, it will allow a return to business-as-usual.

A Real Fish Story

2009-07-25T14:34:00.005-04:00

As a consultant, you become accustomed to common themes: same industry vertical; same problems; if you are particularly unimaginative or lazy, the same solutions. Occasionally, though, you get an opportunity to work on something different. Such was the case with an engagement with which we have been involved over the past 10 months. In it, is something homebuilders might want to consider.

Gro-Grouper, Inc. is a marine aquaculture business formed for the purpose of providing a fresh, high-quality marine finfish (Black Grouper) to upscale restaurants, fresh markets, and on-line retail customers, located anywhere within the United States. It aims to become the largest provider of this species in North America, and it will have the only production facility in the world that provides a renewable source of Black Grouper, raised in an environmentally-sound, ecologically-sustainable manner -- fish that are spawned, raised, and processed in its own recirculating marine aquaculture tank facility, and packaged and distributed through a dependable, on-demand, next-day replenishment system. It has a better product delivered through a vastly superior supply chain.

We helped to develop the business case and the resulting business plan. Just emerging from the planning stage, Gro-Grouper is now seeking its second round of capital to fund its pilot.

It is compelling; it is sustainable; it is green; by every indication, it will be enormously profitable; it is breathtaking in its innovation and approach; it is good for everything and everybody concerned; it exploits only the problem -- the crisis -- that created the opportunity.

In a single word, it is . . . cool.

The thought occurred to me. What would this type of project look like in the homebuilding industry?

Sadly, it would never happen. We would never see an idea this sweeping, this ambitious, emanating from homebuilding. We would be told to nibble around the edges, told to engineer incremental improvements that did not change anything about the underlying business model. We would be told that the goal is industry best practices, that being no-worse-but-no-better than everyone else will somehow create sustainable competitive separation.

The excuse would have been that homebuilding is different; the presumption would have been that nothing fundamental needs to change.

Well, homebuilding is different. It has its own requirements and parameters, and it cannot simply copy, for example, the Lean Production practices of the Toyota Production System. That, however, does not preclude change or tenure business-as-usual. And, as for change, I can only imagine how secure the French felt behind the Maginot Line.

I was talking with a homebuilding executive the other day. We were discussing new approaches to long-standing ways of doing business. He wondered whether it was worth the effort to fight for change. I told him that his company was not worth working for if it did not change, that the homebuilding industry was not worth working in if it did not change, and that he should at least ask himself why he was struggling for 10% Net Income Margins in the best of times, when he could be making 40% Net Income Margins growing fish.

Apocalypse Now: Is a Shattered Industry What It Takes?

2009-06-24T13:11:00.006-04:00

Everyone likes to talk about the "green shoots" that appear and disappear in the housing market and homebuilding industry, as the hopeful evidence for a return to business-as-usual. I think the worst Residential Fixed Investment disaster in three generations should count for more than a return to business-as-usual.

If we are going to pay this steep a price, why not just blow up the dysfunctional business model of production homebuilding?

It is a solution that has undoubtedly crossed the minds of every one of us who understand Lean Production and the Toyota Production System; those of us who understand constraint management and Critical Chain Project Management; those of us who understand Six Sigma and the effect of variation; those of us who understand production physics; those of us who stare across the chasm, and roll our eyes at everything we see.

Custom homebuilding is excluded. The building of one-off or highly-individualized homes could benefit from the selective use of the tools in the toolbox, but custom homebuilding is a separate, specialized value stream. It is a separate culture.

So, what is the vision of a post-apocalyptic home building industry?

To cite a few:

-- One in which the deal-driven mentality that pervades the industry is at least relegated to the land side of the business, and is replaced with a much more disciplined, process-centric approach to production home building.

-- One in which the constant question is: "Does this create value?" And, the decisions are based on the outcome.

-- One in which builders achieve 6:1 Inventory Turns, and the debate about build-to-order (presale) versus build-to-forecast (inventory or spec) becomes a moot point (Note: Toyota has not solved this one, either; they still build-to-forecast and swamp dealer lots with inventory).

-- One in which building companies need negligible working capital for production operations, and one in which cash on the Balance Sheet is not the defining competitive advantage of large, public homebuilding companies.

-- One in which homebuilding companies do not strip-mine the value stream by outsourcing 90% of the work, with all of the attendant duplication in overhead and difficulty in coordinating schedules and resources, and, instead, actually build the houses.

-- One which understands that a homebuilding company is first and foremost a project portfolio organization.

-- One in which geographic expansion and increased market share are not the only models for growth.

-- One in which the absurd cost approach used in the NAHB Chart of Accounts Income Statement is changed, so that builders can actually use the information that it provides to make decisions. You know, small decisions, like determining breakeven and the cost of production capacity.

-- One in which a preoccupation with "Industry Best Practices" is recognized as the self-limitation that it is.

-- One in which agility and speed counts for more than size. One in which a savvy, accountable, and motivated homebuilding team trumps an executive committee.

-- One in which the mental model is "More-for-Less", not "More-for-More" or "Less-for-Less".

Well, one can only hope.

The NAHB Chart of Accounts Income Statement: Comparative, Compliant . . . and Utterly Useless.

2009-04-12T01:54:00.011-04:00

Yes -- the NAHB Chart of Accounts permits comparisons with other builders. Yes -- the NAHB Chart of Accounts complies with GAAP reporting requirements. Yes -- the NAHB Chart of Accounts allows certain consultants to give the same presentation every year at IBS. However, to the extent that the NAHB Chart of Accounts presents its Income Statement as anything other than a true delineation of costs based on their behavior in regard to Revenue, it is utterly useless.

The NAHB COA Income Statement is useless because it prevents a builder from understanding how it makes money.

The ability to generate positive cash flow, make a profit, and produce a satisfactory economic return begins with an understanding of cost. An understanding of how costs are classified (or associated) according to structural hierarchy and cost objects, but most importantly, an understanding of how they are classified according to behavior.

Why does it matter how costs are classified? All of the costs of building a home and running a building company are accounted for in the calculation of residual Net Income. So -- what does it matter where they are incurred, what caused them to be incurred, or whether they move in relationship to anything?

And -- even if it does matter -- why start with costs?

It starts with an understanding of cost, because costs are the most operative part of a building company's Income Statement, and a deep, intuitive, and instinctive understanding for how costs are allocated and classified provides a basis of operational insight that cannot be acquired through any other means.

Understanding where costs are incurred and whether they are incurred directly or indirectly is marginally important, but the truly distinguishing characteristic of costs is how they behave. Operative question: Does the cost vary with the volume of an activity, or does it not?

Cost behavior is so distinctive, because it presents a building company with the truest picture of what its production capacity costs, where it achieves (and passes) breakeven, and how it analyzes changes in costs, production levels, and margins. Not only is it the truest picture, it is the only picture. It requires a variable costing approach to managerial accounting.

There is no more vital understanding to have -- in all of managerial accounting -- than an understanding of variable costing and the Contribution Income Statement format. This is true, regardless of how the financial statements of a building company are reported or presented. It is true, regardless of the quest for comparativeness to support the industry's fascination with meeting "industry best practices". It is true, regardless of the talking heads at IBS telling builders that all they need to do is to "stay between the lines".

At the core of the variable costing approach is the understanding that all costs are not created with the same attributes, and, therefore, cannot be managed the same way. There is a reason why builders need to differentiate between variable and non-variable costs.

Builders need to control direct, variable costs, the costs that are "above the line" on their Income Statement. They need to reduce the cost and/or extract maximum value from it. On the other hand -- and at the same time -- they need to leverage their indirect, non-variable costs, the costs that are "below the line". Those are costs builders expect to incur regardless of the Revenue the cost generates, and they want to produce as much output (Revenue, Gross Income) as they can, from having incurred the cost in the first place.

A building company has to control and extract value from its direct, variable costs, and it has to leverage its indirect, non-variable costs. That is how productivity increases. That is how production capacity is utilized as fully as possible.

A building company has to distinguish between variable and non-variable costs, in order to have a picture of breakeven, of the rate at which it absorbs overhead. If its Cost of Sales contains non-variable costs, and its overhead contains variable costs, that understanding is destroyed.

That is the problem with the NAHB COA Income Statement.

The NAHB COA Income Statement treats Indirect Construction Cost as one of the costs that is deducted from Revenue to determine Gross Profit (the only difference between Gross Margin and Gross Profit is the inclusion of Indirect Construction Cost). But -- do Indirect Construction Costs vary according to Revenue? Probably not. For the most part, they are non-variable costs that will most likely be incurred regardless of the Revenue produced.

The NAHB COA Income Statement treats Selling Expenses (including Real Estate Commissions) as an Operating Expense, as a part of overhead. Anything allocated to Selling Expense, therefore, should be a non-variable cost. Is that the case? No. The bulk of Selling Expense is a variable cost.

The same argument could be made (albeit less strenuously) regarding Financing Costs, which the NAHB COA Income Statement also treats as an Operating Expense. Construction interest would only be a non-variable cost, if a builder had its construction line of credit fully-drawn every day of the accounting period, or if the LIP balance on the line of credit never varied. Are loan fees non-variable costs that do not fluctuate with volume? Clearly, they are not.

My advice? Report your financial condition and tax obligations as required. Mindlessly compare your building company with other building companies if you choose.

But, figure out how to manage costs.

Fast, Nimble, Adaptable

2009-03-19T21:53:00.007-04:00

I want to comment on recent posts on two other web logs. One of them is at housingcrisis.com and the other is Bill Lurz's Ear to the Ground web log on housingzone.com. In different ways, both posts speak to the dangers of averageness -- and the antidote to that averageness -- that "Escape from Averageness" addresses.

On the "Bottoms Fish" post (on housingcrisis.com), the point is made that "home sales volume may hit its low point this year . . . that point finally means that from a sector standpoint, some homebuilders will have reached their moment of opportunity. Access to cash and capital will have a lot to do with who is there to jump on the chance to thrive amid a wide landscape of distress -- lowest direct costs per square foot will be a building company's lever back into high volume business. Equally important . . . will be who will nail the right product for the moment . . . "

On the "Game Plan for the Future?" post (housingzone.com), Bill Lurz describes what he terms the "land-heavy, debt-light" land acquisition strategy of Pat Neal: "For a number of years, he has been buying land -- when he finds a good deal -- for cash, with his own money, then entitling it to the maximum density he can get. But he does not always build to that density. This strategy allows Neal to build to the market. Whatever product will sell best is what he builds."

Although secondary, certainly unintentional, and probably unnoticed, both cases validate the need for homebuilders to deliver extraordinary levels of distinctive value to a narrowly-defined segment of the homebuying market. They also both hint at the main attribute required to drive that kind of value: a fast, nimble, adaptable business operating model.

That type of value and that attribute simply does not emerge from a focus on "industry best practices".

The problem with best practices

2009-03-01T20:50:00.004-05:00

Virtually every consulting engagement that I have lead at SAI Consulting, has, in some way, dealt with processes. There is a reason. When you talk about an enterprise, whether it is a homebuilding company or a company in some other industry vertical, the most basic proposition of that enterprise -- the reason for its existence -- is the value that it creates for customers and other stakeholders. That value is created by the work that it performs, and that work has to be performed in processes.

Those processes exist -- they are present -- whether intentional or not.

From a process standpoint, during the course of conducting those engagements, we have seen almost everything and worked on most of it. Business Process Improvement (BPI), Business Process Management (BPM), Business Process Reengineering (BPR), all of the notation languages, process flowcharting, process modeling, value stream mapping, the new execution languages that accompany it, not to mention the TQM, Six Sigma, Lean, Lean Six Sigma, and Theory of Constraints methodologies that act upon it.

To process management, you can add project management. Different, yet complementary.

Given the essential nature of processes (not to mention project management), I am struck by the homebuilding industry's fascination with "industry best practices". Were it any other industry vertical, the argument could be made that industry best practices might be a worthwhile baseline (although a dangerous measure to settle for).

Homebuilding is different. The deal-driven mentality that permeates homebuilding, coupled with an unfathomable disregard for process discipline, and a degree of outsourcing that relegates value creation to the level of strip mining, makes industry best practices a perspective you can just throw out. Not that the case for robust, dependable, effective processes has not been made. The National Housing Quality (NHQ) Award program, sponsored for more than 15 years by Professional Builder, NAHB Research Center, and others, was modeled after the Malcolm Baldrige Award program.

Processes are front-and-center in the NHQ, yet even those widely-regarded best practices are not widely-adopted (it is a measure of the depth of this housing market and economic debacle that its victims include previous NHQ winners).

But, the bigger problem is the limitation of best practices. At best, industry best practices promote a satisfaction with some sort of competitive equality, a settling for the expediency of the ideas of someone else. The problem with best practices is that it stifles creativity and innovation, works against creating competitive advantage, and creates the illusion of continuous improvement. It is one step above average-ness, something like above-average-ness.

My advice? Figure your processes out for yourselves, and regard industry best practices as something to understand, but nothing to settle for.

Making performance compensation live up to its name

2009-02-16T10:58:00.006-05:00

Reference Point is our periodic survey of management practices conducted with homebuilding companies listed on Professional Builder's Survey of Housing Giants. Ten years ago, we asked the senior management of these companies to respond to a series of statements intended to measure the context of business logic they attempted to infuse into their operations.

On a scale of one to ten, they scored a four.

Our conclusion was then, and is now, that the efforts of a homebuilding company to improve operating performance and business outcomes will largely fail, if it does not somehow succeed first in creating a homebuilding team that works toward commonly-held and commonly understood business goals, versus merely being a collection of so-called "teammates" working toward individual goals. What is missing, is an underlying business logic that forms the necessary context for understanding everything else.

To become the kind of savvy, accountable, and motivated homebuilding team that is required to compete effectively in the business world, everyone on the team has to learn the "business" of homebuilding, they have to understand their individual responsibilities as part of the overall team, and they have to understand what is at stake, individually and collectively.

Moreover, it is not enough that teammates merely understand the business outcome that is at stake, they must have a stake in that business outcome. That is the role of performance compensation.

What attributes should a good performance compensation plan have?

It should be simple. It should be visible and transparent. It should be compelling. It should bonus on a single business outcome, not an operating outcome. It should pay bonuses fast and frequently. It should be self-funding, meaning that the bonuses must pay for themselves out of the additional income that the company produces over and above the baseline plan (the one where everyone justifies their salaries and gets to keep their job). It should represent a very significant portion of the compensation of every teammate. It should include every single employee in the company. It should provide only for the possibility of winners or losers, not winners and losers. It should give managers the right to lead and to demand results.

Who has the P&L responsibility in your company? The answer needs to be, "Everyone".

Narrow your focus

2009-02-10T15:06:00.006-05:00

"In many ways, RB Builders was . . . just another homebuilding company . . . with a middle-of-the-road approach to delivering the value its homebuyers demanded . . . locked into an operating model -- into organizational structures, management systems, processes, cultures, and employees -- that could not deliver extraordinary levels of distinctive value . . . indistinguishable from other builders, and unable to create any type of competitive advantage . . . "

There are two sets of questions that lie at the heart of what a homebuilding company does, and therefore, what a homebuilding company is. The first set of questions is about the value buyers want. What band of the value spectrum do your buyers really want, and want so much they are willing to pay for it? Upon what combination of price, product attribute, and personal attention will they base their buying decision?

The second set of questions is about how the homebuilding company that you own, manage, or work for delivers that value. Can your company deliver extraordinarily and distinctive levels of that specific value with its current operating model? By operating model, I mean processes, organizational structure, management systems, even the type of employees you have, and the culture you promote.

You can make it as complicated as you choose, but, fundamentally, there are only three value propositions you can offer homebuyers on which they will base their buying decision. You can promise them the best comparable price ("Best Price"). You can promise them the best location, best design, or best quality, regardless of price ("Best Product"). Or, you can promise to meet their individual and particular (sometimes unique) requirements for both product and homebuying experience ("Best Solution").

Value is defined by homebuyers. While most of their decisions are a combination of all three factors, they do not assign them equal value. One of the factors tends to be the most influential and it trumps all of the others in the buying decision. Homebuyers do not demand equal levels of price, product attribute, and service. Yes, they would like to have extraordinary levels of value in all three, but they will demand -- they will choose -- to have extraordinary levels of value in one component over the other two.

On the other hand, that value is produced by you. Most homebuilders tend to see themselves from two perspectives, neither of which enable them to provide the extraordinary level of distinctive value their buyers require. First, they see themselves as "all things to all people", capable of meeting different bands of the value spectrum equally well. Second, they also tend to see the capabilities of their own operating model as no better than the average homebuilder.

Selecting the value at which to excel is a strategic decision. It requires focus, and that focus requires a choice about the component of value. The offer of value must choose one component over the other two. At the same time, the offer of the chosen component of value cannot ignore the threshold requirements that must be met for the components of value that were not chosen. It is a question of emphasis, not exclusion. The offer cannot focus on one component to the complete exclusion of the other components. If the value delivered in the other two components falls below the threshold, the customer will reject it and go somewhere else.

The choice of a value proposition -- and the choice of an operating model that delivers it -- breaks out on both geographic market and product segments. You can slice it any way you choose, but, at the end of the day, within every market and product segment, there is only room for two or three homebuilders to effectively compete. The rest are superfluous, irrelevant, unnecessary -- and unable to compete.

So -- you better narrow your focus.

The antidote to average-ness

2009-02-03T13:32:00.008-05:00

In the Lean World, the term "sensei" connotes the idea of wise counsel. My buddy Pascal Dennis would no doubt have a more authentic and appropriate term, but both of us would probably agree that serving the homebuilding industry can feel less like a sensei and more like being a voice in the wilderness. Qualifying as a true VITW would seem to require that you endure at least 10 years of frustration. On that basis, I could certainly qualify.

If I have learned anything over the years, it is to reduce things -- problems, solutions, challenges, opportunities -- to their essence. It was not always so. Ten years ago, when SAI was just beginning its work in helping homebuilding companies to understand and improve their business processes, I characterized the effort to achieve and sustain improvements in business performance as involving "a certain chemistry -- a complexity and a comprehensiveness", and, for that reason, "improving performance tends to be hard, involved work." I went on to say that, "It is hard work because performance cannot be improved without doing things differently, and change is threatening to most people; it is involved work because improving performance requires more than a simple, one-dimensional approach -- it requires a continuous effort on more than one front."

In retrospect, I do think it is hard, involved work, but not because it is complex. Even at the time I was saying how complex it was, I was also saying that "it seems to us that business performance improvement really boils down to getting the job done -- viewing the issue, sustaining the effort, and getting the results -- in three critical dimensions."

I would substitute "focused" for "complex", but I would also say that those three dimensions are as true and relevant today as they were 10 years ago. For a homebuilding company, improving operating performance and business outcomes still comes down to having a strategic and marketing discipline, creating a business context in which everything makes sense, and having a perspective toward how value is created.

Discipline: It has to narrow its focus, by designing its operating model to deliver exceptional levels of the specific and distinctive value demanded by a narrowly defined segment of homebuyers.

Context: It has to be a company of business-people. A savvy, accountable, and motivated homebuilding team comprised of savvy, accountable, and motivated teammates. It must teach its employees the real numbers of the business, give them the authority -- and responsibility -- to act on that knowledge, and then give them a real stake in the financial outcome.

Perspective: It has to organize and focus its efforts around the systemic manner in which it performs work and creates value for its buyers. Sometimes it is about process management. Sometimes it is about project management. Sometimes it is about solving problems, and sometimes it is about managing constraints. It is always about understanding the cause-and-effect nature of the system in which it operates.

Everything else is just a means to an end.

Does the world really need one more average homebuilding company?

2009-01-26T23:38:00.006-05:00

"As RB Builders did its planning and budgeting for the then-upcoming year, 2008 looked to have market and economic conditions very similar to those in 2007. In 2007, RB Builders produced Gross Margins of 22%, earning Gross Income of $11 million, down significantly from the 30%+ margins it enjoyed during the final, halcyon years of what had since become famously known as "The Age of Homebuilder Entitlement".

"In many ways, RB Builders was a product of that age, just another homebuilding company, satisfied with occasionally adopting the "best practices" of other builders, content to be good, no-better-but-no-worse than the other builders with whom it competed. It was a homebuilding company with a middle-of-the-road approach to delivering the value homebuyers demanded. Although its owners knew what housing cycles were like, its management did not. Terms like TEFRA and RTC were faint acronyms from a different era. For the past 10 years, life had been good. But, it was becoming a dangerous approach, because -- as the saying went -- "the only thing in the middle of the road are yellow lines and dead armadillos".

"It was becoming homebuilding no-mans land.

"Locked into an operating model -- into organizational structures, management systems, processes, cultures, and employees -- that could not deliver extraordinary levels of distinctive value, the company found itself dumped into a teeming mass of homebuilders that looked-alike and sounded-alike. Now, indistinguishable from other builders, and unable to create any type of competitive advantage, RB Builders was trapped and sinking -- like a modern-day dinosaur -- into the tar pits of average-ness."

That was a short excerpt from the opening of "The Saga of RB Builders". RB Builders is a mythical homebuilding company that we use from time-to-time to get our points across to clients. When I speak at IBS and other conferences, I sometimes ask my audience this question: "Does the world really need one more average homebuilding company?" For the longest time, I was convinced that their collective answer was simply, "Yes".

I think 2008 changed a lot of that thinking. But I doubt that the changed thoughts really provided any clue about what they should do about it.

In the beginning . . .

2009-01-23T22:16:00.003-05:00

My name is Fletcher Groves. I am a Vice President and Senior Consultant with SAI Consulting, Inc. SAI is engaged almost exclusively with clients in the residential sector of the construction industry vertical - marketing-speak for homebuilding companies.

Our consulting work occurs almost entirely on the velocity side of the return on assets equation. Our world is about improving operating performance and business outcomes. We have a distinct, constraint-management, systems-oriented approach to improving business performance, delivered via a distinct, results-based consulting approach.

We provide a lot of resources on our website (www.saiconsulting.com), but I look forward to the opportunity to share additional concepts with you in this format, and to hear your responses and your ideas.