The Pipeline

Thriving on the Velocity Side ofReturn on Assets

BuilderMT/Sales Simplicity Client ConferenceSeptember 9-12, 2014

Overview

• Margin and Velocity as components of ROA• a visual image of homebuilding production• connecting operating performance to

business outcomes• Production Thinking: Mental Models• the cost of variation reflected in cycle time• a process of continuous improvement • Velocity: BuilderMT-Sales Simplicity thinking

Margin and Velocity

• Margin x Velocity determines Return on Assets (co-equal, DuPont identity).

• Margin is a function of how much you make on every house; Velocity is a function of how many houses you can build with the available inventory and capacity.

• two parts: margin is the easier, more natural part; velocity is the more difficult, less intuitive part.

Operating Scenarios

Two building operations with the same amount of work-in-process, same capacity cost, same working capital, same risk profile:

1. Company A generates a 24% GM and turns its unit WIP twice a year.

2. Company B generates an 18% GM and turns its unit WIP four times a year.

Which would you pick?

Higher margin or faster turn?one operation outperforms the other operation 2:1

  Company A % Company B %Revenue $40,000,000 100 $74,000,000 100

Cost of Sales -30,400,000 -76 -60,700,000 -82Gross Margin 9,600,000 24 13,300,000 18Operating Expense -6,000,000 -15 -6,000,000 -8Net Income $3,600,000 9 $7,300,000 10         Return on Sales   9%   10%

Inventory Turn   5.3x   9.7x

ROIA   48%   97%

The Image of Homebuilding Production

What does the pipeline do? What does it carry? How do you measure it?• Size = houses under construction (WIP)• Capacity = rate of closings (output) relative to

the amount of work-in-process• Length = time (duration; cycle time)• Cost = all of the indirect, non-variable costs

considered Operating Expense (overhead)

Understanding the Connection

• The business outcomes of profitability and Return on Assets are driven by the operational measures of productivity, cycle time, and inventory turn.

• These measures of business and operating performance are linked by the common elements of Throughput, Inventory, and Operating Expense.

What happens to money?

Throughput (T) = rate at which money is generated, through sales (note: Throughput is Gross Income, not Revenue).

Inventory (I) = money invested in what is intended to be sold.

Operating Expense (OE) = money spent turning Inventory into Throughput.

There are operational sides and financial sides.

Linking Operating Measures to Business Outcomes

Productivity = Throughput ÷ Opr. Expense

Inventory Turn = Throughput ÷ Inventory

Cycle Time = (Inventory ÷ Throughput) x days

Net Income = Throughput - Opr. Expense

ROA = (Throughput - Opr. Expense) ÷ Inventory

Systems

• The relationship and interaction between dependent parts of a whole.

• Characterized by natural order, cause-and-effect, and structure.

• Homebuilding companies are not loose collections of independent, unrelated processes, resources, departments, programs, policies.

• There is hierarchy

Systems-thinking

• It is a method of thinking and reasoning.• It is rooted in cause-and-effect, ordered

behavior.• It is how problems are solved, constraints

managed. • It requires focus and prioritization: we have

limited capacity, resources, capital, opportunity; we cannot improve everything, everywhere, at once.

Mental Model:Margin and Velocity

Conventional

Focus on margin, because margin is what we know and it is what comes most naturally to us.

Pipeline

Focus as much on velocity as we do on margin, because – as the co-equal determinants of economic return – that is what creates sustainable competitive separation.

Mental Model:Size

Conventional

The answer to the question about size is always answered in terms of houses sold and the Revenue generated.

Income Statement view and perspective of size.

Pipeline

The answer to the question about size is expressed in terms of the level of work-in-process, and to a lesser degree, by the capacity afforded it by its Operating Expenses.

Balance Sheet view and perspective that supports the concept of a limited-size business model.

Mental Model:Growth

Conventional

If size is defined by Revenue, a building company should be willing to increase work-in-process and Operating Expense as the tradeoff for higher Revenue.

“More-with-more”

Pipeline

If size is defined by the level of work-in-process or the capacity afforded by its Operating Expense, a building company should not emphasize growth; it should focus on becoming more productive.

“More-with-less”

Mental Model:Productivity

Conventional“More-with-more” The answer to more Revenue and more output is more of

everything else – more production capacity, more resources, more plans, more steps, more complexity, more reports, more money, more starts, and more work-in-process.

Pipeline“

More-with-less”

The answer is to produce more Revenue and more output with less of everything else – less waste and rework, fewer non-value-added steps, fewer but better measures, fewer resources, a smaller, more intelligent portfolio of plans, less money, less work-in-process, fewer excuses.

Mental Model:Productivity

Pipeline“More-with-the-same” We want more-with-less; we

will accept having planned, finite, and controlled levels of money, resources, and work-in-process with which to produce as much Revenue and output as we can.

We want more of these: speed, velocity, quality, focus, accountability, involvement, partnering.

Pipeline

“Marginally-more-with-significantly-less”

The answer to the current market and economic situation is to confront the dual reality of marginally higher Revenue that must be produced with significantly less available resources, with less available skilled construction labor.

Mental Model:Costs

Conventional

Since Net Income is a residual measure, treat all costs the same; reduce them wherever possible.

(absorption costing approach; GAAP-compliant, NAHB-supported)

Pipeline

Manage costs based on how they behave in relation to Revenue.

Control (extract max value from) the direct, variable costs associated with COS.

Leverage the indirect, non-variable costs associated with Operating Expense.

(variable costing approach; Contribution Income Statement)

Mental Model:Production Balance

Conventional“Balanced capacity”In order to achieve balanced production (an even rate of sales,

starts, and closings), a production system has to have balanced capacity.

As the trade-off, the system accepts the effect of variation and uncertainty that appears anywhere and everywhere.

Pipeline“Unbalanced capacity”I

n order to achieve balanced production, a production system purposely creates unbalanced capacity, and focuses its effort on managing the resource that limits the output of the system.

It accepts, as the trade-off, a level of reserve (protective) capacity on its other resources.

Mental Model:Production Capacity

Conventional

“Increase production capacity.”

In order to increase the rate of closings and Revenue generation, we have to increase the number of resources and the amount of work-in-process.

Pipeline

“Increase productivity.”

In order to increase the rate of closings, we have to reduce cycle time – we have to increase the rate of closings with a planned, finite, and controlled amount of work-in-process and production capacity.

Mental Model:Production Flow

Conventional

“Even-flow is a mechanism.”

Intent: even rate of closings, pushed by an even, protected rate of starts.

The order and rate of starts is prescribed by a start slot mechanism, protected with a sales backlog.

Does not address capacity or productivity; does not control the level of WIP.

Pipeline

“Even-flow is an outcome.”

Result: even rate of starts, pulled into the system at the rate of closings.

Order of starts is prescribed by the slotting mechanism; release rate is determined by the load/capacity of the constraint resource.

Capacity is finite; WIP is controlled.

Mental Model:WIP

Conventional

A production system’s level of work-in-process at any point in time is the disjointed, unplanned, and uncontrolled outcome of a set of factors, including sales, starts, closings, community openings and closings, and terms and conditions of credit facilities.

Pipeline

A production system’s planned, finite, and controlled level of work-in-process at all points in time is an amount that considers the maximum allowed by its D/E ratio, the amount necessary to achieve its targeted closings at its achievable cycle time, and the minimum amount required to protect the system from variation.

Mental Model:Cycle Time

Conventional

It is measured only as the mean (or average) duration of a specified set of jobs.

The average cycle time of a production system reveals nothing about the system’s performance, simply that some percentage of the jobs took more time and the remainder took less.

Pipeline

It is calculated using the level of work-in-process and the number of closings during a specified period of time; it provides the clearest possible picture of the operating performance of a production system.

The measured duration of individual jobs provides forensics.

Mental Model:Scheduling

Conventional

“We protect the completion date of every task.”

In an effort to manage schedules and assure on-time completion, a level of safety is built into the duration of every task in a project, into every job phase of a house.

Task durations are based on 95% probabilities.

Pipeline

“We protect the completion date of the project.”

The safety is removed from individual tasks and a portion placed in buffers, so that schedules become shorter and project completion dates are still protected.

Task durations are based on 50% probabilities.

Mental Model:Scheduling

Conventional

“We manage the schedule of every job.”

The tasks in the schedule for each job are managed, and the schedule is adjusted, daily, to reflect progress, and any changes to the estimated completion date.

There is no confidence in task finishes or starts, job completion date, or on-time delivery.

Pipeline

We manage the project buffer on each job.”

Penetration of the project buffer on each job is managed, in terms of the ratio of work remaining to buffer remaining.

The key issue is the amount of work remaining on each job, not the percentage of work completed.

Mental Model:Cost of Variation

Conventional

The cost of variation in a production system is the amount of additional, unnecessary costs or expenses incurred or left unused.

Cost World

Pipeline

The true cost of variation in a production system is the lost opportunity of the Gross Income that would have been produced on each house the company failed to build.

Presuming it was achieving breakeven, all of this lost Gross Income would have dropped to Net Income.

Throughput World

Laws of Variability(production principles defining system’s reaction to

variation)• Law of Variability: increasing levels of

variation progressively degrade the performance of a system.

• Law of Variability Buffering: a system will protect itself from variation through some combination of:

• Inventory (higher work-in-process)• Capacity (excess/unused capacity)• Duration (longer cycle time)

Law of Duration(Little’s Law: production principle defining cycle time)

(Units-in-Process ÷ Units Completed) x Daysn

(solves for closings, work-in-process, or cycle time)

(80 ÷ 240) x 360 = 120 days

(60 ÷ 240) x 360 = 90 days

(80 ÷ 180) x 360 = 160 days

(120 ÷ 240) x 360 = 180 days

(120 ÷ 180) x 360 = 240 days

The Saga of RB BuildersCycle Time Scenarios – 2008

Year Work-in-Process

Closings Cycle Time (days)

2005 100 225 1602007 100 200 1802008 100 240 150

  80 240 120  100 300 120

60 240 90100 400 90

The Saga of RB Builders2008 Baseline Business Scenario (same as 2007)

(2008 Baseline = 200 closings, 2008 Target = 250 closings)

  Overall Unit %

Revenue $50,000,000 $250,000 100

Cost of Sales -39,000,000 -195,000 -78

Gross Margin 11,000,000 62,500 22

Operating Expense -8,500,000 -42,500 -17

Net Income $2,500,000 $20,000 5

What is the cost?(200 closings, 100 units of WIP = 180 day cycle time)

180 days is 33% longer than the schedule, 50% longer than what is possible; the variation-induced cost is either:• $2.8 to $4.3 million of wasted capacity, plus

cost of having up to twice as much as work-in-process as necessary, or

• $4.9 to $9.2 million in lost Contribution (above breakeven, Net Income), earned at lower margins, on up to 200 closings.

Variation and UncertaintyHow does this situation happen?

• we pad task durations to provide safety (assurance) for completion dates; we increase duration.

• the schedule lengthens (1.64/.61)• Ex.: 90 days (50%) becomes 148 days

(95%).• the safety is consumed by common behavior:

• Student Syndrome: procrastinate.• Parkinson: let the work expand to time

provided.• Multi-tasking: spread the time across more

jobs.

Cascading

Extend the reaction to variation/uncertainty – padding task duration, human reaction – beyond the task level; delays and consumption of safety cascades to:• the task level• the job level• the community level• the company level

Scheduling Projects

• Traditional (Critical Path) project scheduling v Lean/TOC (Critical Chain) project management.

• managing single projects v project portfolios.• Objective: reducing task duration and

removing the safety in tasks.• manage the buffers, not the schedules.

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Project Buffer Fever Chart

Percentage of Completion

Bu

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Production Planning and Management

Every method of production planning and management involves scheduling a sequence of tasks to be performed by resources, and deals with three questions:

1.What sets the pace of production?

2.What is the protection from variation?

3.How is it managed as a system?

Pipeline Gameboth production simulation and business game

Pipeline Workshopfour teams, progressive simulation, inventory turn (left)

and cycle time (right)

Pipeline WorkshopRevenue (left) and Net Income (right)

Pipeline WorkshopReturn on Invested Assets

Production Principles(summary)

1. Pipeline: creating a visual image.

2. creating a connection between operating performance and business outcomes.

3. understanding production as a system of interdependent, connected parts.

4. managing variation.

5. blending methods towards a solution.

6. moving toward PPM/CCPM. (portfolio, critical chain)

Critical Dimensions

Improving business performance boils down to getting the job done – viewing the issue, sustaining the effort, and getting the results – in three critical dimensions:

1.Discipline: narrow focus, distinctive value

2.Context: a company of business-people

3.Perspective: get horizontal

Continuous Improvement

• begin with a clear picture of current reality.• implement a team-based performance

compensation plan based on the milestone achievements of a single business (financial) outcome, that is the difference between a baseline and a target.

• design a series of single, rapid-cycle projects, targeting measurable results, focused on the most pressing opportunity.

Continuous Improvement(continued)

• develop a savvy, mutually-accountable, motivated team pursuing a system-wide goal; it requires more than performance compensation.

• build an internal capability and capacity for implementing continuous improvement, innovation, and learning.

BuilderMT/Sales Simplicity

Determine how the WMS and Sales Simplicity modules address these areas:• the ability to toggle between versions of

Income Statements intended for different/specific purposes

• the redesign and improvement of business processes

• a choice between CPM and Critical Chain scheduling in PPM

Additional Information:

� SAI Consulting, Inc.� (904) 273-9840

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