IT'S THAT TIME OF THE YEAR again, a time to prepare for the holidays. For those of us in home building, it's a frenzied time to get homes completed and closed before year-end, and my favorite year-end ritual—finalizing our 2006 annual plans. What would the fourth quarter be minus the agonizing hours invested in developing next year's budget, a budget we know we can beat, and importantly, one that corporate will accept?
As the theme of this December special issue attests, strategy is a critical component of the annual planning process. This, in turn, highlights the importance of choosing a solid methodology to measure the success of our strategies. You can only manage what you measure.
US VS. THEM For many of us, annual planning rears up as the quintessential negotiation, a highly charged and emotional process. Compensation and performance measures invariably tie to the achievement of an annual plan. On opposing sides, operational managers often find it advantageous to constrain performance expectations around them, even as corporate brethren push operating divisions to set ambitious “stretch goals.”
A hypothetical battle emerges.
Division President: “While we enjoyed a great market last year in Fort Myers, it wouldn't be prudent to bet on this market continuing at this pace, it just can't. Interest rates are rising, the hurricanes are going to impact in-migration, building costs are skyrocketing, and we have a huge shortage of building materials and labor. I would be thrilled if we can maintain our top line, and limit our decline in gross margins to 400 basis points. The only way I would be able to gain some top line growth is with significantly greater investment on the part of corporate in this market, but let me assure you, margins have to decline in order to maintain volume.”
Corporate: “It's the same thing every year. You guys sandbag the heck out of your numbers and come coasting in at year-end. Every year, we hear the same story from you. We're not going to be fooled anymore. Demographic trends in southwest Florida are some of the strongest in the country. Your land position is very strong in a market that is becoming more and more land constrained. While interest rates have risen, rising income levels offset the rate increases. As far as we are concerned anything less than 15 percent top line growth would be foolish and there is no reason to expect any deterioration in gross margins! As far as additional investment, you've got to do more with less.”
What seems to paralyze us is that this annual planning tug-of-war has little to do with creating shareholder value, and has everything to do with compensation and performance evaluations. Can operational managers be faulted for wanting the bar set as low as possible in order to maximize their compensation? We fail to observe a bigger, underlying problem—a disconnect between the creation of shareholder value and the reward systems in place in most home building companies.
MEASUREMENT OPTIONS Corporate finance methodologies that allow us to analyze financial performance and investment are plentiful, including discounted cash flows, net present value, and internal rate of return analyses. Still, one of them, the concept of Economic Value Added (EVA), developed and pioneered by Stern Stewart & Co., deserves attention.
Stern Stewart defines EVA as a business unit's net operating profit, less a charge for capital at a rate equal to the opportunity cost of invested capital. Theoretically, your shareholders can invest in your company or somewhere else. In making an investment decision, shareholders require a minimum return. This is the opportunity cost of the funds invested. EVA is the profitability of a business unit above and beyond this opportunity cost. If a business unit achieves an EVA of zero, it has achieved the minimum required return demanded by investors, but has neither added to nor subtracted from shareholder value.