Thoughts about the strategic discipline, business context, and production perspective necessary for achieving exceptional business and operating performance as a homebuilding company.
Tuesday, March 2, 2010
The Death of Private Homebuilders?
John McManus (www.housingcrisis.com) is always an interesting and worthwhile read, particularly his two most recent entries (PRIVATE HOMEBUILDERS MOMENT OF TRUTH APPROACHES WITH 2ND HALF OF 2010 and ORLEANS HOMEBUILDERS FILES VOLUNTARY CHAPTER 11).
Orleans Homebuilders, of course, is a publicly-held company.
One of John's points: "Private home builders are in a fix because most of them depend heavily on banks, and banks are in a fix. The recent increase in the Fed Discount Rate doesn't mean a lot to most of us, but it certainly doesn't bode well for businesses that draw on bank capital with the intensity that home builders do. If it's more expensive for banks to borrow, it's going to be more expensive for their commercial customers to do so, one way or another, and it will be in shorter supply."
One can debate the ultimate winner of this seeming game of chicken between builders and their lenders (include the FDIC if you want to triangulate it). Perhaps survivor would be a better term. Or, maybe, it is just some financial version of the Circle of Life, in which new versions of builders and TARP-less banks emerge as new creatures, eerily traversing the post-apocalyptic landscape, past the skeletons of the previous Era of Homebuilder Entitlement.
Long, long ago, before I became a builder, before I became a consultant, I was a banker, more specifically, a commercial and real estate lender. I have long memories from being on the other side of the table, but my most vivid recollection, from the disaster that was playing out in 1982, was the observation/advice offered by my Dad, who was also a banker:
"Son, leverage is something that makes good times better and bad times worse".
The jury is maybe still out, maybe for awhile longer, but "out" is the operative term, the words of builders and lenders to each other echoing like the lyrics of an old Hall and Oates song: "You're out of touch. I'm out of time."
In mid-2009, I posted an entry to "Escape from Averageness", titled "Apocalypse Now: Is a Shattered Industry What it Takes?". It is archived. You can read it again. But, it bears repeating. Two of the points about our vision of this post-apocalyptic Fixed Residential Investment landscape were that it would be one in which builders achieve 6:1 Inventory Turns, and therefore, need negligible working capital for production operations, and one in which cash on the Balance Sheet is not the defining competitive advantage.
To which , I would add, it would be one in which builders do not even use debt financing for land and lots, let alone allow it on their Balance Sheet.
"The absence of business logic is simply astounding."
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."
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.
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.
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."
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."
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.
