The National Association of Home Builders Chart of Accounts enables builder-to-builder comparisons, complies with GAAP reporting requirements, and allows consultants to give the same presentation every year at the International Builders Show. But, to the extent that its Income Statement presents costs as anything other than a true delineation based on behavior in regard to Revenue--from a management standpoint--it should send up a red flag.
Whatever value the template may serve, our argument here is that it doesn’t enable a builder to understand easily how the company makes money.
Let's explore this dilemma.
The ability to generate cash, make a profit, and produce an economic return depends on an understanding of cost classification. That is: how costs are classified or associated according to structural hierarchy, cost objects, and behavior.
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. As long as the classifications don't change, they are still comparable. Right? Does it matter where costs are incurred, what caused them to be incurred, or whether they vary in relationship to one another or any other measure?
Yes, it does matter. Costs are the most operative part of a home builder’s Income Statement, and an understanding of how costs are allocated and classified provides a basis of operational insight that--in our experience--is an absolute necessity. Understanding where costs are incurred and whether they are incurred directly or indirectly is important, but the 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 presents a builder with the truest picture of what its production capacity costs are, where its breakeven point lies, and how the company analyzes changes in costs, production levels, and margins.
It's not only the truest picture, but the only picture.
Variable Costing is a vital element of managerial accounting. At its core is the understanding that costs have attributes, and those costs cannot be managed as if their attributes don’t exist.
Builders need to control their direct, variable costs--the costs that should be “above the line” on their Income Statement; they need to either reduce the cost, or extract maximum value from having incurred it. At the same time, they need to leverage their indirect, non-variable costs--the costs that should be “below the line” on their Income Statement; those are costs expected to be incurred regardless of the Revenue the cost generates; the objective should be to produce as much Contribution as possible from having incurred the cost in the first place.
Controlling and extracting value from direct, variable costs is how a builder improves margins; leveraging indirect, non-variable costs is how it increases velocity–how it increases productivity, how it utilizes production capacity.
Economic return is Return on Assets; ROA is margin multiplied times velocity; it is velocity acting upon margin.
Builders must distinguish between variable and non-variable costs to have any picture of breakeven, the rate at which it absorbs overhead. If Cost of Sales contains non-variable costs, and Operating Expense contains variable costs, that understanding of breakeven is destroyed.
Three examples of problems we've seen home building companies encounter when they rely too heavily on the NAHB COA Income Statement template:
1. It treats Indirect Construction Cost as a cost 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. Do Indirect Construction Costs vary according to Revenue? Probably not. For the most part, they are non-variable costs that will be incurred regardless of the Revenue produced.
2. It treats Selling Expenses (including Real Estate Commissions) as an Operating Expense, part of overhead. Anything allocated to Selling Expense should, therefore, be a non-variable cost. Is that the case? No. The bulk of Selling Expense is a variable cost.
3. It treats Financing Costs as an Operating Expense. However, construction period interest would only be a non-variable cost, if a builder had its construction lines of credit fully-drawn every day of the accounting period, or if the LIP balance on the LOC never varied. Is this typically the case? No. And, are loan fees non-variable costs that do not fluctuate with volume? Depends.
The bottom-line: Report your financial condition and meet your tax reporting obligations, as required. Compare your company with other builders, if you choose. But--give yourself cost information that guides your operating decisions.
(updated and republished on Escape from Averageness every year, as the first in a five-part series; this is an issue addressed in Pipeline workshops; learn more here: http://buildervelocity.com)