SAI Consulting Articles.

Breaking the Code: Understanding the Factors That Drive Operating Performance.

Competitive, highly-leveraged, and cyclical; costs that are difficult to control; work performed in the field by an indifferent labor force. Homebuilding is one of the most challenging businesses to manage in a consistently profitable manner.

For many homebuilding companies, their current level of operating performance will probably not be enough to keep them in business during the next decade. As we have seen with every other industry, the surplus in production capacity will eventually reduce the number of active homebuilding companies, ending what has historically been a revolving door of weaker companies being replaced with newer (but not necessarily better) companies.

Homebuilding companies that intend to survive in this environment will need to work relentlessly to improve operating performance and increase profitability, by viewing every management issue from the perspective of its contribution to bottom-line performance. Waste, errors, and rework, customer satisfaction, product design, process cycle time, and all of the other issues have to be understood in their roles as performance drivers, and managed for their effect on performance outcomes � in the form of better cash flow, lower costs, higher profit margins, better return on investment.

How do you do it? Where do you start? Where do you focus? How do you make it stick? In our opinion, there are two make-or-break issues that homebuilding companies must address in order to significantly improve operating and financial performance � the structure of hard construction cost and the length of process cycle time.

Moreover, they have to address these issues in a framework of contemporary management based on three critical dimensions � disciplined decision-making, visionary leadership, and a process-centered view of how work is performed.

The issue of construction cost and process cycle time has to be viewed in the context of quality cost. Quality is not about goodness; it is more than a debate about durability, reliability, brand recognition, or fit-and-finish. Quality is fundamentally about cost.

One of the clear findings from our 1996 Reference Point survey of management practices was that homebuilders do not track the cost of waste, inefficiency, and poor quality, nor do they understand where these costs are occurring in their companies (see our commentary, �How the Giants Measure Quality�, Professional Builder, April 1997).

As a result, most homebuilding companies tend to have a very unrealistic view of quality cost, estimating, on average, that it is less than five percent of annual revenue. By comparison, the documented level of waste, inefficiency, and poor quality in most manufacturing industries is in excess of 25% of annual revenue, and it is even higher in service industries. The extent of the problem becomes believable only after homebuilders understand how pervasive these costs are in their own operations.

Every homebuilding company needs to understand and measure these costs. Cost of Quality (COQ) represents the difference in cost between how you actually run your company, and how you should run your company. In the case of a homebuilding company, COQ deals with both product (what you build) and process (how you build), and it includes all of the following costs:

COQ includes every non-value adding feature of a product and every non-value adding activity of a process that occurs in a homebuilding operation � features and activities associated with anything the customer (homebuyer) does not want, and is unwilling to pay extra to receive.

If there is real internal controversy on the level of these costs, the only way the issue can be resolved is with a detailed COQ analysis � a step-by-step procedure to analyze the design and specifications of the product, document the activities that constitute the

company�s operating and business processes, and assign the appropriate cost for all of the waste, inefficiency, and poor quality. Most companies can settle for a simple estimate.

Once the consequence of waste, inefficiency, and poor quality has been measured and placed in a context that is universally understood (i.e., money), the real issue becomes what to do about all of the non-value adding features associated with the product, and the non-value adding activities associated with the process.

By any measure, the stakes are enormous. We estimate that just a 10% reduction in the level of waste, inefficiency, and poor quality would translate into at least a 30% increase in the net profit margin of the average homebuilding company.

While there are other management issues that impact financial performance � decision-making and leadership are two that come to mind � it is hard to imagine any critical operational issue that is not linked to financial performance through some impact on COQ.

The best way to impact the cost of waste, inefficiency, and poor quality in a company is to bring the full range of cost issues into play, which means that you have to view the COQ issue as both an opportunity to reduce cost and an opportunity to increase production capacity.

Reductions in variable cost do not have the same benefit � the same result � as reductions in fixed expense. The primary reason for reducing variable cost is to increase gross profit margins, while the primary reason for addressing the fixed cost structure is to improve production capacity. That is why a strategy aimed at creating additional production capacity and reducing variable cost can increase market share and dramatically improve profitability. That is what building homes better, faster, and less expensively is really all about.

Whenever we introduce the concept of improving cycle time, we explain that reducing the time required to design, sell, build, and close a home has the following benefits:

Improving cycle time, however, creates a dilemma; what does a company do with the resulting increase in production capacity � downsize the company, or fill capacity? The first tendency is to view any improvement in cycle time as an opportunity to do the same amount of work with fewer resources, but the real advantage in improving the Contract-to-Closing process lies in the opportunity to do more work with the same (or fewer) resources.

Consider our experience as we worked with a $26 million homebuilding company to improve their Contract-to-Closing process. Like many homebuilding companies, this particular client was struggling to improve operating performance in a very competitive housing market, as evidenced by their declining market share and relatively low profit margin.

At the conclusion of the project, we asked the senior management of this company what they thought of their effort � an effort that had reduced the complexity of their most important process by almost 50%, and virtually eliminated hand-offs, reviews, and other non-value adding activities.

Their first comment was, �Well, there�s no question that we�ve made the process simpler and faster, and that it will result in far fewer problems and errors. But, we haven�t managed to reduce the number of people involved in the process. We haven�t saved any money.�

Explaining the production capacity issue, we asked our client, �What would happen if you viewed this as an opportunity to increase production, rather than an opportunity to reduce overhead, and what would happen if you leveraged that improved productivity against an effort to reduce your hard construction cost?�

�You mean, sell more homes, just because we have the capacity? It won�t work. We would have to lower our prices too much in order to fill the new production capacity in this market.�

�Well, we agree that there are probably better ways to increase market share, but, if price is the only consideration, how much of a discount are we talking about?�

To demonstrate our point about the relationship between cycle time improvement and variable cost reduction, we prepared a very simple three-year proforma income statement (see the attached spreadsheet) based on a plan in which the company would work to increase production capacity (through improved cycle time) by 20% in the first year, and then work to reduce hard construction cost by a net five percent in the second year. (As an aside, 20% improvements in cycle time and five percent reductions in hard construction cost are realistic and achievable goals � goals that have already been attained by other homebuilding companies.)

As we began to work the model, we explained that the eight percent price discount only needed to be applied to the sale of the marginal units; in other words, the plan was to �buy� the additional market share required to fill the new-found production capacity, and use a start slot system to regulate and allocate the pricing discounts in the market.

Since the model assumed no improvement in variable cost structure in the initial year to offset the price discount, the gross profit margin showed a drop of almost 8% (from 25.5% of revenue to 23.5%). However, the net profit margin increased almost 38% (from 2.4% of revenue to 3.3%), projected solely as a result of the gains from cycle time improvement.

When reductions in hard construction costs were finally realized in the second year, the gross profit margin showed an increase of almost 15% (from 23.5% of revenue to 26.9%), while the net profit margin more than doubled (from 3.3% of revenue to 6.7%).

Cumulatively, the improvement in the projected gross profit margin was more than five percent (on 20% higher revenue), coupled with an almost three-fold improvement in the projected net profit margin (again, on 20% higher revenue). Calculated on base year revenue, the projected margin improvements were even more impressive.

Bottom-line? A $31 million company with almost $1.5 million more in net profit, where 30% of the additional revenue being generated falls as net profit. Bottom-line? A company with better market share and higher profit margins.

Double-digit improvement in gross profit margins; three-fold improvements in net profit margins. The projections are eye-opening, but does it push the envelope in terms of performance improvement? Several observations might suggest otherwise:

What are the limits of performance improvement in a homebuilding operation? More importantly, what are the constraints that prohibit this level of performance in the vast majority of homebuilding companies? Most importantly, what level of operating performance will be demanded in the future?

We honestly don�t know the complete answer to the first two questions, and time will tell whether enough additional operating performance can be coaxed out of the business operating structure of today�s homebuilding company to meet the ever-increasing expectations and requirements of homebuyers, the ever-increasing capabilities of competition, the challenge of government regulation, and the shifting circumstances of economic business cycles.

We do know, however, that the long-term viability of any homebuilding company rests on ever improving levels of operational performance, and our guess is that many homebuilders � too many � will fail to make any improvement in their operating performance. Other homebuilders will find ways to modify their current operations to solve some of their problems and make some improvements in their level of operating performance, much like the results we illustrated for our client.

For these homebuilding companies, survival will be difficult, if not problematic.

A few homebuilders, just like the leading companies in almost every other industry, will find ways to fundamentally rethink themselves � their processes, systems, organizational structures, compensation, and value propositions � to achieve dramatic improvements in their level of operating performance. These are the companies that make survival for everyone else so difficult.

Achieving dramatic � or even moderate � improvements in operating performance is hard, involved work � if it was easy or simple, every homebuilder would be doing it. It is hard work because performance can�t be improved without doing things differently, and change is threatening to most people � both management and employees. It is involved work because improving the level of operating performance requires effort in three critical dimensions: There is a decision-making dimension and a leadership dimension, but, most importantly, there is a process dimension.

First � and foremost � homebuilders need to eat, drink, and breathe their processes � the complete, end-to-end sets of activities that are the only means by which work is performed, and the only manner in which value is added to products and services. Tasks, jobs, departments, functions, and organizations are not processes, and thinking, planning, structuring, organizing, managing, training, or measuring in terms of anything other than processes is a waste of time and effort.

Second � homebuilders have to learn to build their processes, operational structures, management systems, and corporate cultures around their own value proposition � the combination of price, quality, and service that is most important to � and reflects the values of � a specific group of buyers. The selection of a value discipline requires a conscious decision to carefully and purposely choose a target market, and narrow the company�s focus to that specific band of the value spectrum.

Finally � homebuilding companies need to transform � to fundamentally change � their relationship with their employees. Open, participatory management is an empty concept, empowerment a meaningless phrase, if these terms do not carry a commitment to treat associates as businesspeople, instead of employees.

Only when they are treated as businesspeople do employees understand that they are competing in a marketplace to earn a profit; only then are they willing to hold themselves mutually accountable for the operational and financial performance of the company.

In our work with homebuilding companies, we always stress the point that there is a certain chemistry to the management of process-centered enterprises.

If management fails to address the process dimension, they won�t be able to improve the basic manner in which work is performed. If they fail to address the decision-making dimension, they will improve the wrong processes, develop the wrong systems, create the wrong organizational structure, and build the wrong corporate culture. If they fail to address the leadership dimension, there will be no underlying business logic � no why � to the work people are asked to do, no motivation � no want-to � to work together, productively, creatively toward common goals.

Are improvements in the operational performance of a homebuilding company worth the cost and effort? We can only encourage those homebuilders on their journey with the prospect of radically more efficient, more effective, and more profitable companies, with their business conducted in an environment that is less aggravating, less stressful, and more rewarding.

Service and Administrative Institute

October 1997