Do you base your annual budget on the number of units you think you can sell? If so you’re not alone: for most builders, the primary factor in budgeting is what they believe next year’s sales numbers will be. But this is approach is incomplete.
The reason so many budgets are inaccurate is that their foundation is wobbly. A realistic budget is built on a three-legged stool—an understanding of the company’s sales, financial and production capacities. That third leg tends to be weak. Even builders with a firm grasp on their sales and finances often fall short when it comes to analyzing their production capacity. This weakness yields inaccurate budget forecasts and ensures that they miss opportunities to become more profitable.
The key to understanding production capacity is using the right method of calculating cycle time. (A great resource for cycle time analysis and the power of velocity is Fletcher Grove’s book The Pipeline.)
The Problem With Measured Cycle Time
Most building companies track cycle time by using measured cycle time, which is the average time to complete a unit in given time period either as reported by the scheduling system or derived by a manual measurement process. Measured cycle time is useful as a diagnostic tool but since it ignores the critical relationship between work in process and the rate of closings, it is not appropriate for planning or budgeting.
Another significant practical problem with measured cycle time that it’s easily distorted (intentionally or unintentionally) by the company’s incentive systems. Cycle time is widely used to determine incentive pay for construction managers. To be fair to those construction managers the company will often deduct events beyond their control, such as weather or supplier delays, from the time it took to complete each unit.
Of course this can be a reasonable approach for setting incentive pay, or as the basis for a forensic process to determine why cycle time has increased or decreased. But it doesn’t make for accurate planning because the budget planners end up assuming that it takes less time to build a home than it really does.
Calculated Cycle Time is More Accurate
A more accurate basis for capacity analysis is calculated cycle time: a mathematical expression of the relationship between Work in Process and the Rate of Closings. (Calculated cycle time is a ratio derived from Little’s Law of Production, a formula for analyzing and improving workflow that’s used by various industries.)
By mathematically forcing a transparent accounting of the time required for a unit to move from start to closing, the use of calculated cycle time removes human judgment from the metric, rendering it pure. (Yes, human judgment is a critical part of competent management and leadership regime, but it’s best not to apply said judgment until after the math has been completed.) That’s why I call it the missing link in most builders’ budgeting processes.
Calculated cycle time for a given time period is simply unit work-in-process (UWIP) divided by total units closed (TUC) multiplied by the number of days in the period. So you would calculate cycle time for the year with the following:
Yearly Cycle Time = UWIP/TUC X 365
Once you have calculated this number you need to analyze how the actual UWIP is distributed across your field organization. How many units can your superintendents or field managers effectively build at a time? This is a critical metric. Understanding it will truly reveal your production capacity for any given time period and desired level of closings.
Say that your division has 20 superintendents who can each handle 20 UWIPs. That makes your theoretical production capacity 400 UWIP. At a calculated cycle time of 120 days, the division has a theoretical capacity to produce 1217 units in a year.
Closed Units = (UWIP/Cycle Time) X Days
= (400/120) x 365
= 1217
Clearly, this number must be balanced with the company’s sales capacity as well as its financial capacity to fund those 1217 units. That’s the budgeting process. But the use of calculated cycle time will inject some additional rigor into that process.
The Payoffs
Completing the capacity picture by including true production capacity along with sales capacity yields the following benefits.
1. In a resource-constrained environment like today, the use of calculated cycle time to determine true production capacity will help the builder develop a more conservative, and therefore more realistic budget.
2. With a more realistic budget the builder will tend to make more intelligent resource allocation decisions and will communicate more accurately with employees, trades and bankers. It builds credibility and delivers more stable performance.
Note that the UWIP capacity for each superintendent you arrive at may end up lower than what you would expect from the various industry rules of thumb. That’s because those rules are almost always too optimistic. They fail to adequately account for the many variables that come into play, such as:
- The drive time between jobsites
- Unit size and complexity
- Effectiveness of the company’s management information systems
- Componentization and modularization of the company’s building process
- Trade contract structure (whether turnkey or labor-only)
- Purchase order trends
- Supplier accuracy
- Trade capacity and quality
Trade capacity and quality deserves a column of its own. In meantime, I recommend that you ask probing questions about each of these variables. How does the current rate of variance purchase orders compare to your typical amount and is that rate increasing or decreasing? How accurate are your suppliers’ shipments as measured by the frequency and amount of incorrect items and incorrect amounts of materials sent to the jobsite? Etc.
I guarantee that, if you do this process thoroughly, you will identify ways to work more efficiently and enhance your effective capacity. In fact, builders who switch to this method are often able to close more units in a given time period, with zero additional fixed cost investment. Those additional closed units drop virtually 100 percent of their gross margin dollars to the bottom line.
As an example say a builder closes ten additional units in one year by improving cycle time and productivity. If the average selling price of those units was $300,000 and the Gross Margin percentage is 20 percent, that’s a Gross Margin of $60,000 per unit. An additional $600,000 goes to the builder’s bottom line from those 10 units. Driving up returns from the business this way should be a major, if not THE major, financial goal of the business.
So don’t sell your boring little annual budgeting process short! Work to understand your true production capacity in addition to your sales capacity and financial capacity. Use these three critical elements to create a more realistic budget. Then, with the budget numbers in hand, dig a little deeper into why the UIP, Cycle Time and Unit Closings numbers are what they are. This will uncover ways to improve your productivity, cycle time and profits.
And have a great 2017!
